Sri Lanka: From Debt to Discipline
Sri Lanka positioned at the strategic location in the Indian Ocean has been in the news lately and the country’s recent economic trajectory is a stark reminder of how policy missteps, governance failures, and external shocks can converge to create a profound crisis. The island country which saw tremendous post civil-war economic development, witnessed a near-total economic collapse by 2022 that triggered political chaos, humanitarian crisis, and a breakdown of social order. The country failed to withstand deep structural flaws in the entire system of governance, though its political leadership tried to window-dress but failed to avoid the policy failures. Yet, by late 2024, the country has begun a gradual recovery, demonstrating the importance of structural reforms, international assistance, and prudent governance in restoring economic stability.
The road to collapse
For a decade the country failed to maintain fiscal discipline and debt-to-GDP ratio was rising steadily, with tourism taking a massive hit in Covid times, shot in the foot of the economy that was already declining. It was already maintained by the policy experts and economists that the country is awaiting a massive economic crisis due to delayed economic reforms, populist politics and failure of leadership to navigate through tricky geopolitical terrains carefully.
The government in 2015 made some efforts to address the structural vulnerabilities in the economy but any policy proposal aimed at it never went through parliamentary consensus resulting in policy ambiguity. The priorities of the then political parties addressed the passionate electorate instead of looking into the structural gambit, to save the economy and hence the country. The government kept spending lavishly on projects that snowballed the fiscal deficits. The 2014 State of the Economy Report by the Institute of Policy Studies highlighted risky borrowing practices, over-reliance on foreign direct investment concentrated in the hospitality sector, and the dangers of temporary “quick-fix” measures.
Although an IMF backed economic stability program was in place back in 2018, trying to sterilize the economy, in 2019 the government took its eyes off the reform process and undermined the fiscal consolidation gains. In parallel, the independence of the Central Bank was compromised when politically aligned actors dismissed the 2019 Central Bank Bill, which sought to insulate monetary policy from government interference.
The policy analysts and international observers raised the red-flags about the unsustainable sovereign debt accumulation after the country was out of 30 years long civil war. By early 2022, these warnings had become reality, as Sri Lanka faced a full-blown economic and social crisis.
Fiscal Mismanagement and Monetary Policy
The main factor that drew the economic collapse was fiscal mismanagement, particularly under President Gotabaya Rajapaksa’s administration. First the major tax cuts were initiated, handicapping the government sector, resulting in a massive drop in registered taxpayers and shortage of government funds. Although the leadership was aware about the fallouts, it chose to go into the cesspool of disaster without putting in place any alternative plan to fix government revenue shortage, which enhanced the already languishing fiscal consolidation process. This increased the country’s dependence on foreign borrowing, which worsened with the passage of time. To bridge fiscal deficits, the Central Bank under Ajith Nivard Cabraal pursued an aggressive money printing strategy, issuing a record Rs. 432.76 billion in 2022 alone. This decision ignored repeated warnings from the IMF that continued quantitative expansion would precipitate economic collapse. Inflation soared, foreign reserves plummeted, and the rupee lost significant value against the US dollar.
External Debt
In order to manage the post conflict economic landscape, the successive governments tossed the borrowing habits, borrowing shifted from multilateral agencies to international sovereign bonds (ISBs), often at high interest rates. By 2020, external debt had reached $56.3 billion, over 119% of GDP. The political leadership in order to push for Chinese backed and financed projects at the cost of economic fragility showcased the high-visibility infrastructure projects like the Hambantota Port and Mattala Airport rather than productive investments. The global lending agencies eased borrowing facilities for developed countries and initially lowered borrowing costs for Sri Lanka, enabling a borrowing spree. However, as global rates rose after 2013, debt servicing costs surged. By early 2022, Sri Lanka faced $4 billion in debt repayments and only $2.31 billion in foreign reserves — a scenario that precipitated the decision to default on $51 billion of external debt by April 2022.
Policy Missteps: Agriculture, Tourism, and Remittances
It was observed that the country’s economy reached its breaking point after the government declared an abrupt shift to organic farming in 2021, an all-out ban on chemical fertilizers, resulting in a massive 20% drop in rice production and big financial losses in the tea sector. Tourism, a lifeline for the GDP, took a bit hit by Covid, preceded by Easter bombings which pulled the trigger. The failure of the Central bank to manage currency reserves, the remittances fell sharply and the workers abroad avoided formal channels. The last leg of the economy also was shot due to this.
Geopolitical Factors
The geopolitical disorder as it is termed popularly after the Covid reset and wars all across, the supply chains and imports are the first casualty, Sri Lanka has a greater reliance on imports especially fuel, food and tourism which were hampered significantly due to ongoing geopolitical turmoil. While some have attributed the crisis to China’s lending practices and “debt-trap diplomacy,” some scholars suggest that domestic fiscal mismanagement was the dominant factor. Chinese debt accounted for roughly 10% of Sri Lanka’s total external debt, with most distress originating from Western commercial loans and local policy failures.
Socio-Economic and Political Impact
A fragile political system with a declining economy is a perfect recipe for disaster, the consequences of Sri Lanka were profound and immediate. The year 2022 saw acute shortage of fuel, electricity, and life saving medicines, daily power cuts became a norm resulting in closure of essential wheels of economy, shortage of cooking gas shut the bakeries, hospitals went out of service, inflations went out of the roof at 60%, devastating livelihoods of common people. They took to the streets, converting into huge instances of social unrest. Incidents of burning of police vehicles, people thronging the presidential palace, an eventual fall of political offices in mid 2022. The political instability amplified economic uncertainty, deterring investment and complicating negotiations with international creditors. The education and health sectors were heavily affected. Schools postponed exams due to paper shortages, and hospitals operated under severe constraints, often reusing medical equipment or performing surgeries under suboptimal conditions. The tourism and export sectors, critical to foreign exchange earnings, faced widespread disruptions, affecting both corporate revenues and individual livelihoods.
International Assistance and IMF Engagement
After failing to come to terms with the severity of the crisis, Sri Lanka sought support from the IMF and other global agencies, interestingly this was the 16th loan arrangement. Most of the funds earlier agreed upon with global agencies didn’t work out or result in any credible returns, partly due to mismanagement, partly due to corruption. This time again the government had no choice but to agree to the bailout by the IMF. The IMF’s involvement included both financial support and technical guidance, with emphasis on debt sustainability, fiscal consolidation, and structural reforms. India, Japan, China, and the World Bank also extended emergency lines of credit and loans, helping to stabilize foreign reserves. India, for instance, provided $1 billion for essential imports, and Japan agreed on a $2.5 billion debt restructuring plan. Structural reforms required public sector downsizing, resulting in a temporary rise in unemployment from 5.7% to 8.3%. These austerity measures, though politically unpopular, were critical in restoring fiscal credibility.
Policy Responses and Recovery Measures
After the crisis went deep, a change of government happened over the horizon due to elections and India’s timely extension of credit-line. Sri Lanka undertook key policy measures to address the crisis. The first policy adjustment includes on the monetary side, with the central bank introducing a uniform policy rate replacing the dual-rate system that tightened liquidity to cut inflation. The second policy instrument is fiscal discipline, increasing tax rates, with a focus on debt restructuring and avoiding lavish expenditures. The third policy measure is to privatize and deregulate state monopoly in the energy sector, opening up the sector to multiple companies. The fourth element is partial reversal of organic farming, lifting ban on chemical fertilizers to restore crop yield. Lastly, the debt restructuring formula provided much needed policy interference to put the economy back on its legs.
By the end of 2024, most of the indicators showed credible positive signs, although challenges remain. The World Bank projected GDP growth of 4.4%, driven by industrial output and a revival in tourism. Inflation dropped to 0.5%, a dramatic improvement from the 64% peak in 2022. The IMF approved the third review of the $2.9 billion bailout program, acknowledging progress but emphasizing the need for continued reforms. Debt restructuring agreements with Japan and other bilateral creditors have extended repayment periods, providing breathing space for the economy. Improved policy credibility, coupled with international support, has begun restoring public confidence and encouraging investment.
Lessons for other South Asian states
The case of Sri Lanka offers insights for policy makers across the region to take governance seriously and acclimatise with the new challenges. Political stability is key economic success, transparency and accountability are the drivers in a globalised world they are part of. Fiscal prudence can’t be taken for granted and made subservient to political compulsions. An unstoppable habit of borrowing, irrational tax cuts, aggressive money printing can accelerate financial collapse. A good stock of reserves and effective engagements with multilateral institutions can stabilize the economic landscape in the long term. Structural reforms must balance fiscal discipline with social protection to prevent long-term social instability. Immediate reforms in monetary policy, debt management, and sectoral recovery can reverse deep economic downturns if executed cohesively.
Conclusion
Sri Lanka’s economic crisis is a sobering case study of how internal mismanagement, policy missteps, and external shocks can converge to destabilize a nation. The country’s subsequent recovery underscores the importance of structural reforms, prudent fiscal and monetary policy, and coordinated international support.
While full recovery is projected to take until 2026, the progress achieved by late 2024 illustrates that economies can rebound from near-collapse when political will aligns with sound economic strategy. For policymakers and economists worldwide, Sri Lanka’s experience is both a cautionary tale and a blueprint for crisis management — highlighting that resilience, transparency, and governance are as critical to economic survival as capital flows and fiscal instruments.
Sri Lanka’s path forward will require careful management of debt obligations, continued structural reform, and policies that foster social equity. The lessons are clear: economic mismanagement is costly, but recovery is possible when transparency, prudence, and international cooperation are prioritized.
Mehraj U Din Bhat is a Researcher in South Asian geopolitics.
