An economy is largely steered by two fundamental policy instruments: monetary policy and fiscal policy. Monetary policy primarily deals with the regulation of money supply, interest rates, and inflation, aiming to maintain price stability and foster economic growth. In contrast, fiscal policy is centered around the government’s approach to collecting revenue and managing public expenditure, alongside the broader oversight of the national budget. These instruments work together to guide economic performance, stabilize markets, and promote long-term development.
Sri Lanka’s economy began to show signs of stabilization by mid-2023 after enduring one of the most severe economic crises since its independence. The downturn was the result of prolonged macroeconomic mismanagement, deep-rooted structural weaknesses, and a series of external shocks. These issues ultimately led to a sovereign debt default and an alarming depletion of foreign reserves in 2022. The social and economic fallout was significant: between 2021 and 2022, poverty levels surged by 10 percentage points, largely driven by a steep decline in real incomes, widespread job losses, and rampant inflation. However, with the adoption of reforms under the International Monetary Fund’s Extended Fund Facility (EFF), the country managed to halt further deterioration. These reforms helped limit the total contraction in GDP to 9.5% between 2021 and 2023, preventing what could have been a deeper economic collapse.
Macroeconomic indicators began to improve following these reforms. Inflation, which had peaked at a staggering 69.8% in September 2022, fell sharply to 4.0% by December 2023. Usable foreign exchange reserves, which had dropped to a critically low 0.3 months of import coverage, rose to 2.1 months by the end of 2023, signaling renewed confidence in external stability. Meanwhile, the public and publicly guaranteed (PPG) debt burden decreased from 119.2% to 111.7% of GDP over the same period, owing partly to debt restructuring efforts and fiscal adjustments.
By May 2025, the process of disinflation was still ongoing, though showing signs of easing. Year-on-year, headline deflation had slowed to 0.7%. However, food inflation surged to 5.2%, offsetting the deflation in non-food items, which stood at 3.3%. The Colombo Consumer Price Index (CCPI) recorded a 0.82% month-on-month increase, mainly due to rising food prices. Core inflation also rose, increasing from 0.8% in April to 1.2% in May, hinting at early-stage underlying price pressures. Analysts expect inflation to turn positive in early Q3 of 2025, gradually aligning with the Central Bank’s 5% target.
Sri Lanka’s fiscal situation, however, remains under considerable strain. Revenue and grant inflows as a percentage of GDP experienced a steep decline over the years. From levels exceeding 17% between 2000 and 2007, this figure dropped to around 12% during 2010–2018 and further fell to a worrying 8.0–8.8% during the crisis years of 2020 to 2022. Encouragingly, a rebound took place in 2023 and 2024, with revenue and grants increasing to 11.2% and 13.5% of GDP respectively, largely due to improved tax collection efforts and international donor support.
Nevertheless, recurrent expenditure has remained persistently high. It accounted for 17–21% of GDP in the early 2000s and, despite efforts to curb it to 12–14% by 2018, it surged again to 16–18% in 2023–2024. This rise is attributed to increasing public sector wages, subsidies, and mounting interest payments. In contrast, capital investment—critical for infrastructure and long-term growth—has been on a continuous decline. From accounting for 6–7% of GDP in the early 2000s, it fell sharply to just 2.7% by 2024. This stark reduction highlights a troubling shift away from development-focused expenditure, undermining the country’s long-term economic resilience.
Sri Lanka’s budget deficit has followed a fluctuating path. It had narrowed from 10.4% of GDP in 2001 to around 5% by 2018. However, the crisis forced it upward again, reaching 11.7% in 2021. As of 2024, the deficit eased to 6.8%, but this still reflects ongoing fiscal pressures. Government debt has also undergone significant changes over the years. From a high of 105.6% of GDP in 2002, it dropped to around 67–70% during the period from 2010 to 2014. Yet, due to the crisis, it climbed once again—hitting 96.6% in 2020, reaching 100% in 2021, and peaking at 114.2% in 2022. Thanks to restructuring measures, this figure declined to 96.1% in 2024. However, it is important to note that post-April 2022 debt figures exclude certain unpaid obligations resulting from the default, which may understate the true scale of the nation’s debt burden.
Several structural challenges continue to hamper Sri Lanka’s fiscal policy. First, there exists a persistent imbalance between revenue and expenditure. While revenues are beginning to recover, the pace is slower than the rise in recurrent costs. This imbalance has forced disproportionate cuts in capital spending, undermining growth potential. Second, while large fiscal deficits were necessary during the height of the crisis to mitigate social and economic impacts, they remain elevated even in the post-crisis period—suggesting weak fiscal consolidation. Third, debt vulnerabilities remain high. The rapid accumulation of debt and the 2022 default have significantly eroded fiscal space, while various off-balance-sheet obligations still pose risks to debt sustainability.
In light of these challenges, several policy measures are recommended to ensure long-term fiscal health and economic recovery. First, revenue mobilization must be enhanced by broadening the tax base, strengthening compliance systems, and reintroducing reforms in state-owned enterprises (SOEs) to improve their efficiency and contribution to public finances. Second, recurrent spending should be better controlled by rationalizing public sector wages and subsidies, and by managing liabilities more effectively to reduce debt servicing costs. Third, capital investment must be revived. The government should aim to restore public investment to at least 4–5% of GDP, which is essential to support infrastructure development and long-term growth. Fourth, a gradual reduction in the fiscal deficit is necessary. Authorities should aim to bring the deficit below 4% of GDP through a phased approach that balances fiscal responsibility with social protection. Finally, debt sustainability must be prioritized. A medium-term goal of reducing public debt to below 80% of GDP should be pursued, supported by robust economic growth and prudent fiscal management.
Sri Lanka’s fiscal policy stance in 2025 reflects a country attempting to recover from an unprecedented crisis. Though notable progress has been made in revenue collection and macroeconomic stabilization, significant challenges remain. Rising recurrent expenditures and depressed capital investments continue to strain fiscal space. A sustainable recovery will require the implementation of difficult but essential reforms. These include boosting revenue, reinforcing fiscal discipline, and ensuring long-term debt sustainability, all while maintaining support for a fragile but gradually recovering economy.
