Sri Lanka GDP Rebounds As Debt Falls Rapidly

Sri Lanka’s economic trajectory in 2025 is exhibiting a remarkable recovery narrative, positioning the island nation as a compelling case study in post-crisis structural adjustment and fiscal consolidation. The government reports that the critical debt-to-GDP ratio is projected to decline sharply, moving from 114 percent in 2024 to 96 percent in 2025. This dramatic improvement follows a successful series of debt restructuring agreements finalized with both bilateral and multilateral creditors. Real GDP, which contracted severely during the 2022–2023 crisis period, is now targeted to return to pre-crisis levels, with medium-term growth forecasts ambitiously centered around 7 percent annually.

The key engines driving this impressive turnaround include a combination of sustained fiscal restraint, targeted, high-impact infrastructure spending, and a robust rebound in the tourism sector. Tourism accounts for about 5 percent of GDP and has been growing at a 20 percent annualized pace since mid-2024. Merchandise exports, which are concentrated in resilient sectors like apparel and tea, are projected to expand 6 to 8 percent year-on-year, reflecting both pent-up global demand and significantly improved domestic logistics efficiency.

The mechanisms underpinning Sri Lanka’s recovery are the result of deliberate and often painful policy calibration. Fiscal consolidation has been paramount, successfully reducing budget deficits from nearly 10 percent of GDP at the peak of the crisis to an estimated 6 percent. Concurrently, the central bank has maintained a relatively tight monetary stance, essential for stabilizing inflation. Inflation peaked at a crippling 28 percent in 2023 but is now converging toward a manageable 6 to 7 percent range. Key structural reforms, including the liberalization of select sectors and the privatization of underperforming state-owned enterprises, have been initiated to improve the long-term efficiency of public finances and restore eroded investor sentiment.

This improved debt profile has directly lowered sovereign risk, with 5-year credit default swap (CDS) spreads falling dramatically from over 800 basis points in 2023 to 420 basis points. This steep decline indicates regained market confidence and provides a tangible reduction in sovereign borrowing costs. Tourism receipts, combined with consistently strong remittance inflows from the diaspora, estimated at US $7 billion annually, have been critical in supporting the rebuilding of foreign exchange reserves. Reserves now cover roughly 3 months of import needs, providing a crucial buffer for the nation's import-dependent sectors.

From a sectoral and market perspective, the recovery is clearly visible across multiple dimensions of the capital markets. The Colombo Stock Exchange All Share Index (LK:CSEASI) has surged 15 percent year-to-date, with banking and consumer discretionary stocks leading the charge, reflecting both confidence in the durability of the domestic recovery and improved market liquidity.

The sovereign bond market has also been buoyed by the improving risk picture, with 10-year yields declining to 10.8 percent from a high of 13.5 percent a year prior. Furthermore, currency stability has largely been restored, with the Sri Lankan rupee depreciating only modestly against the USD over the past six months, aiding predictability for import costs. Institutional investors are increasingly starting to consider Sri Lanka for high-yield allocations in emerging Asia, particularly as risk-adjusted returns improve relative to regional peers that are still facing slower, more constrained recoveries.

Forward-looking risks remain quantifiable and hinge on both external and domestic factors. External shocks, specifically in global commodity prices, particularly oil, could quickly widen the current account deficit and pressure the rupee if tourism and exports do not maintain their current momentum. A 10 percent swing in crude prices, for instance, could reduce GDP growth by 0.5 to 0.7 percentage point and significantly erode fiscal balances. Domestically, the delicate balancing act of maintaining inflation below 7 percent while simultaneously supporting strong growth will require careful monetary coordination. Any perceived fiscal slippage by the government could immediately affect sovereign spreads and halt capital inflows.

Additionally, global financial conditions, particularly the U.S. interest rate trajectories, will continue to influence capital inflows and the cost of future refinancing efforts. Monitoring monthly export volumes, tourist arrivals, and diaspora remittance inflows will be critical leading indicators to gauge the sustainability of the recovery. If current trends persist through 2026, Sri Lanka could successfully consolidate growth above 6 percent while lowering debt-to-GDP toward 90 percent, setting the stage for a durable post-crisis expansion that is capable of attracting diversified institutional capital.