In 2025, Sri Lanka stands at a pivotal economic crossroads. Emerging from one of the most intense financial meltdowns in its post-independence history, the country is now pushing through a carefully engineered fiscal recovery. This comprehensive update unpacks how Sri Lanka is tackling inflation, shrinking its budget deficit, and pushing long-term debt sustainability while navigating the tricky terrain of public expectations, revenue pressures, and structural reform.
Sri Lanka’s fiscal policy in 2025 tells the story of a nation clawing its way out of one of the worst economic crises in its modern history. A combination of monetary and fiscal reforms has been central to stabilizing the economy and rebuilding trust among citizens and investors. Central to this turnaround strategy is Sri Lanka’s revamped fiscal policy targeting inflation control, debt reduction, and sustainable growth through systemic reform.
The Engine of Fiscal Recovery: Monetary & Fiscal Coordination
Effective economic recovery depends on a synergy between two essential tools monetary policy and fiscal policy. While the Central Bank focuses on regulating interest rates, inflation, and money supply to stabilize prices, fiscal policy plays a complementary role. It governs how the government raises revenue and spends on national development. In 2025, this balance has been critical in driving Sri Lanka’s economic reset and restoring market stability.
From Economic Meltdown to Managed Stabilization
By mid-2023, Sri Lanka began showing initial signs of stabilization following an unprecedented downturn triggered by years of macroeconomic mismanagement, excessive borrowing, and external shocks. The 2021–2022 crisis led to sovereign default and a dangerous depletion of foreign reserves. Poverty rose by 10 percentage points, job losses spiked, and inflation surged. However, reforms under the International Monetary Fund’s Extended Fund Facility (EFF) helped cap the damage. GDP contraction was limited to 9.5% between 2021 and 2023, a painful blow, but far short of economic collapse.
Macroeconomic Progress: Deflation, Reserves, and Debt Adjustment
Economic reforms started bearing fruit in 2023. Inflation, which had peaked at a jaw-dropping 69.8% in September 2022, plummeted to just 4.0% by December 2023. Usable foreign reserves, once hovering at a critical low of 0.3 months of import coverage, rebounded to 2.1 months by year-end signaling returning investor confidence. Similarly, public and publicly guaranteed (PPG) debt fell from 119.2% to 111.7% of GDP by the end of 2023, thanks to restructuring efforts and prudent fiscal moves.
By May 2025: Signs of Disinflation Emerge
Though disinflation remains ongoing, headline inflation slowed to 0.7% year-over-year by May 2025. However, food inflation persisted at 5.2%, neutralizing gains from non-food deflation. The Colombo Consumer Price Index (CCPI) showed a month-on-month increase of 0.82%, largely driven by food price hikes. Meanwhile, core inflation climbed from 0.8% in April to 1.2% in May, hinting at reemerging price pressure. Analysts believe inflation may stabilize around the Central Bank’s 5% target by early Q3 2025.
Revenue Bounces Back, But Spending Remains Problematic
One of the biggest wins of the recovery phase has been the rebound in revenue and grant inflows, which increased to 11.2% and 13.5% of GDP in 2023 and 2024 respectively. This rise was attributed to better tax compliance and international donor support. However, fiscal pressure remains as government spending especially on public wages and subsidies continues to rise.
Recurrent expenditure, once ranging between 17–21% of GDP in the early 2000s, had fallen to 12–14% by 2018. But by 2023–2024, it surged again to 16–18%, putting strain on public coffers. Meanwhile, capital investment essential for infrastructure and long-term growth dropped from 6–7% of GDP to a low of 2.7% in 2024. This shift toward recurrent, non-productive spending is a red flag for long-term fiscal health.
Budget Deficit and Debt: Still a Tough Climb
Sri Lanka’s budget deficit has followed a turbulent path. It dropped from 10.4% of GDP in 2001 to around 5% in 2018. But the crisis forced it up to 11.7% in 2021. In 2024, the deficit eased to 6.8% better, but still far from optimal. Government debt, which had fallen from 105.6% of GDP in 2002 to about 67–70% by 2014, spiked again to 96.6% in 2024. Though debt restructuring helped reduce the peak of 114.2% (in 2022), off-balance sheet liabilities may mean the true burden is higher.
Structural Challenges Still Haunt the System
Three main structural issues continue to dog Sri Lanka’s fiscal recovery:
- Revenue-Expenditure Imbalance: Revenues are rising, but not fast enough to offset growing recurrent costs.
- Heavy Fiscal Commitments: Social support and subsidies needed during the crisis still weigh heavily on the budget.
- High Debt Vulnerability: Despite restructuring, the sheer volume of debt and obligations from the 2022 default challenge debt sustainability.
What Must Be Done: The 5-Point Reform Blueprint
To overcome these issues, five key fiscal policy reforms are urgently recommended:
- Broaden Revenue Base: Improve tax collection, bring more people into the tax net, and enhance compliance systems.
- Control Recurrent Expenditure: Rationalize public sector wages and manage liabilities to reduce debt servicing.
- Revive Capital Investment: Boost infrastructure spending to 4–5% of GDP to fuel long-term growth.
- Reduce the Fiscal Deficit: Aim to gradually cut the deficit below 4% of GDP while balancing social needs.
- Ensure Debt Sustainability: A medium-term goal of reducing public debt below 80% of GDP must be pursued.
Sri Lanka’s 2025 fiscal plan is an effort to turn the page on crisis. Progress is visible, stabilized inflation, improved reserves, better revenue collection but the road ahead remains steep. Ongoing reforms must be implemented with consistency and discipline. This includes prioritizing growth-focused spending, managing public expectations, and restoring investor confidence.
A fragile but hopeful recovery is underway. The success of this journey will depend on how well Sri Lanka balances fiscal responsibility with social equity, and how swiftly it adapts to the dynamic global economy.
