By Prasanna Perera –

Despite two severe shocks like Cyclone Ditwah and the war in the Middle East, Sri Lanka’s economy has not collapsed and currently remain stable. This week offered two fresh pieces of evidence for that claim. On September 22, Fitch Ratings upgraded the country’s sovereign credit rating to ‘B-‘ from ‘CCC+’, marking the first time Sri Lanka has held this rating since November 2020. The following day, an IMF staff mission concluded its discussions in Colombo on the Seventh Review of the Extended Fund Facility. Whether this economic stability can be sustained, even after the IMF programme concludes in March 2027, will depend on how robust our key reforms, foreign reserves, energy prices, and government revenue streams turn out to be.

The Agreements Remain to be Seen

The delegation, led by IMF Mission Chief Evan Papageorgiou, visited Colombo from September 10 to 23 for discussions with the authorities, covering the Seventh Review under the Extended Fund Facility and the 2026 Article IV Consultation. The visit concluded on September 23, without staff-level agreement. Discussions will continue in the near term, with both sides now targeting around October for completion of the Seventh Review.

The IMF described the economy as remarkably resilient, pointing to eleven consecutive quarters of growth even as headline inflation climbed to 8 percent year-on-year in August, driven by a global oil price shock. The Fund also flagged the usual cluster of downside risks: the duration and intensity of the Middle East conflict, shifts in global trade policy, and the lingering effects of El Niño. Looking ahead, it identified three priorities: strengthening the medium-term revenue strategy, restoring energy cost recovery, and improving the execution of capital investment.

Under EFF, roughly USD 3 billion programme approved in March 2023, Sri Lanka has so far received about USD 2.4 billion, following the joint completion of the fifth and sixth reviews on May 27. The remaining amount is split evenly between the final two reviews, and completing the seventh review would secure a tranche of USD 347 million.

The IMF Agreement

In 2025, Sri Lanka’s economy recorded 5% growth for a second consecutive year. The primary account surplus stood at 5.4% of GDP, while the overall budget deficit narrowed to 2.3%. However, it is estimated that Cyclone Ditwah, which struck in late November 2025, caused approximately USD 4.1 billion in direct physical damage to agriculture and infrastructure. The shock that followed was the outbreak of the Middle East war on February 28. The IMF itself has stated that the most severe external shock to hit Sri Lanka since the 2022 crisis was not the cyclone, but the Middle East crisis.

Given this situation, the IMF lowered its 2026 growth forecast for Sri Lanka to 3%. The government introduced a relief package worth Rs. 100 billion, while the Central Bank raised its policy interest rate to 8.75% to contain rising inflation and the depreciation of the rupee.

Yet as of 2026, a certain slowdown in our economic growth rate is being recorded. According to data from the Department of Census and Statistics, our growth, which stood at 5.1% in the first quarter of 2026, fell by nearly a full percentage point to 4.2% by the second quarter. Although economic growth continues, this deceleration in the pace of growth will adversely affect our future plans and economic programmes.

While the IMF has shown flexibility in its programme and agreements considering these economic shocks, some reports suggest that certain frictions have emerged in the ongoing discussions between the IMF and the President and the government’s policymakers. The Executive Board noted on May 27 that Sri Lanka had breached both criteria of avoiding external payment arrears and refraining from imposing import restrictions. The first criterion was breached due to the loss of USD 2.5 million owed to Australia because of a cybercrime, while the second was breached by the imposition of a 50% surcharge on vehicle imports from May 16.

What Can Be Expected from the Seventh Review?

This review is based on end-June 2026 targets. In the previous review, both the minimum primary balance threshold lowered due to cyclone reconstruction costs, and the Net International Reserves (NIR) target lowered due to the impact of the war, were relaxed. Tax revenue targets, however, were tightened further. The overall target is to maintain this year’ primary surplus at 1.4% of GDP, before raising it back to 2.3% from 2027.

Fiscal Performance: A Good Start, But Proceed with Caution

A primary surplus of Rs. 1.24 trillion was recorded in the first half of the year’s budget, a 44.8% increase over the previous year. Tax revenue rose by 25.9% to Rs. 2.71 trillion, already 55.2% of the full-year target.

Two points of caution are warranted here. The first being timing. Although the IMF’s primary surplus target for the whole of 2026 is Rs. 509 billion, more than double that figure, has already been recorded within just the first six months. A key reason for this is that the government has not spent adequately. By early June, only 17.4% of the Rs. 1,380 billion capital budget had been utilized. Thus, part of this surplus is not genuine savings but deferred expenditure.

The second is the composition of revenue. Fiscal performance in 2025 was strong because of taxes levied on vehicle imports. As that surge in imports now returns to normal, tax revenue is expected to fall to 14.0% growth in 2026. A primary surplus of 2.3%, resting on a revenue base built on a temporary import surge, cannot be sustained.

The External Sector: Reserves Still at a Risky Level

By the end of August 2026, Sri Lanka’s official reserves had risen to USD 6.9 billion. It should be kept in mind that this figure includes the Chinese swap facility, which is not usable. The IMF expects reserves to reach USD 8.645 billion by the end of 2026, and USD 11.779 billion in 2027. I would like to note that meeting these targets will be an extremely difficult task, and the failure to do so would also jeopardize our debt sustainability. With this in mind, the IMF continues to state that debt sustainability risk remains high, given the heightened uncertainty around debt repayment.

A Ratings Upgrade, but Only a Partial Vindication

On September 22, Fitch Ratings upgraded Sri Lanka’s Long-Term Issuer Default Rating to ‘B-‘ from ‘CCC+’, with a Stable Outlook. It is the first time the country has carried this rating since November 2020. Fitch cited sustained macro-stabilisation policies and structural reforms that have eased external financing risks. Improvements in fiscal and external balances, alongside a modest rebuilding of reserves, were also noted as key drivers.

On the fiscal side, Fitch expects government debt to fall to 92.9% of GDP in 2026, down from 96.7% the previous year. The interest-to-revenue ratio is forecast to ease to 41.0% from 45.6%. These are real improvements. But context matters.

A debt-to-GDP ratio of 92.9% remains far above the 54.7% median for ‘B’-rated sovereigns. An interest-to-revenue ratio of 41.0% is roughly three times the 12.7% peer median, and that disparity should give any observer pause. On the external front, Fitch expects the current account to swing into deficit at 1.2% of GDP in 2026, reversing three consecutive years of surplus. Higher energy prices, tied directly to the Middle East conflict, are the primary culprit.

Challenges the Government is Yet to Contend With

The present government, like its predecessor government, has achieved economic stability. However, genuine economic transformation has not taken place due to failures in policy.

The first failure is reflected in the ongoing uncertainty in government revenue. Growth in government revenue in 2025 depended entirely on taxes from vehicle imports. We have still failed to introduce revenue sources capable of sustaining a durable fiscal position. VAT compliance gaps remain, there is no consensus on property tax reform, and the tax net remains narrow.

The current government, led by the President, proudly claims that it has achieved a budget surplus. It appears the government fails to grasp how this surplus is constraining economic activity. If the budget surplus is achieved by cutting capital expenditure, this undermines the country’s future economic growth.

There is no sign of energy prices being adjusted as agreed with the IMF. Energy prices remain politicized. The President had committed in writing to the IMF that fuel subsidies would be removed by the end of September. I expect the IMF will raise this pledge with the government during discussions.

The import surcharge currently in place also runs counter to the IMF programme. Although the government sought some relief from the IMF, stating that the 50% surcharge on vehicles would be limited to just three months, it has now been extended to December 31. This directly violates a continuous performance criterion.

The Significance of This Visit

If the seventh review fails, the 347 million tranche is jeapordised at a critical moment when Sri Lanka most needs to re-enter financial markets. This would raise serious concerns for future economic stability, debt-servicing capacity, and growth.

Watching the ongoing discussions, the likely result of this review is a conditional pass. We may receive an assessment stating “satisfactory progress, keep it up”, not unlike a school report, showing that fiscal targets were completed despite shocks that were unanticipated during the initial agreements. Nevertheless, I remain doubtful as to whether these reforms will endure even after the IMF-agreed programme concludes. Stabilizing an economy is the easy part. What is needed to transform that into long-term economic growth is political will.

Whether a further IMF programme follows is a different question. The Fund is leaving that decision squarely to the Government of Sri Lanka (GoSL). Mr. Papageorgiou was asked directly whether the government had sought a new arrangement. He said the choice would depend on what the government wanted to achieve, and whether it judged a new programme necessary. He also noted that the Fund can support member states in other ways, even without a formal programme, including through financial sector assessments.

In my view, the choice ought to be an easy one. Our recovery remains fragile. The economy has yet to fully recover, and several key indicators still lag behind their pre-2018 levels. But the government may read today’s improving numbers as proof of a full recovery. If it walks away from the discipline of a programme on the strength of what could be no more than a temporary remission, the underlying ailment is likely to return. And it is likely to strike the economy far more severely than before.

While reform is talked about, the present government has yet to demonstrate reform in practice. This leads to a growing sense that the government may prepare to break free of its IMF commitments in 2027, taking populist decisions prior to the election. If proven true, then, as the Opposition Leader has pointed out, the country will face a choice as to whether to enter yet another successor agreement or pursue some other form of engagement after March 2027 with the IMF to secure a better path.

*Senior Professor Prasanna Perera, Head, Department of Economics and Statistics, University of Peradeniya