LNP – Fitch Ratings optimistic on Sri Lanka’s Budget

The Sri Lankan government’s budget highlights the authorities’ commitment to raising fiscal revenues as a share of GDP – an approach that, if successful, would alleviate a long-standing weakness in the sovereign’s credit profile, says Fitch Ratings.

Nonetheless, risks to the fiscal outlook remain significant, and plans to slow the pace of fiscal consolidation could weigh on prospects for debt reduction over the medium term.

The budget, unveiled on 17 February, is the first since President Anura Kumara Dissanayake of the Janatha Vimukthi Peramuna (JVP) was elected in September 2024, and provides greater clarity over the administration’s medium-term fiscal and economic reform agenda.

We view most of the budget announcements as being consistent with our assumptions made during our December 2024 assessment, when we upgraded Sri Lanka’s rating to ‘CCC+’, from ‘RD’ (Restricted Default). The provisional budget deficit outturn of 6.8% of GDP in 2024, for example, was in line with Fitch’s expectations.

The government’s goal of raising revenue/GDP to 15.1% in 2025, from 11.4% in 2023, would exceed our assumptions that the 15% threshold would only be achieved by 2026. The budget incorporates a 36.5% increase in revenue from taxes on external trade and a 13.1% increase in revenues from income taxes. Fitch believes the goal is achievable, given revenue-raising measures already announced and implemented. However, it will depend heavily on a smooth liberalisation of import restrictions, notably for vehicles. There remains a risk that the authorities could look to slow that process if higher imports weaken Sri Lanka’s external stability, for example by eroding foreign-exchange reserves. The medium-term fiscal outlook for Sri Lanka remains challenging, and we believe revenue growth is likely to slow sharply from 2026, unless additional policies are introduced.

Sri Lanka’s public finances remain fragile, and the budget projects a slowing of fiscal consolidation, with the deficit falling only to 6.7% of GDP in 2025. This reflects sharply higher spending on public capex (up by 61%), as well as increases in salaries and wages (up 12%) and subsidies (up 11%). The deficit could be smaller than the government expects if implementing such a large capex increase proves difficult. However, we believe Sri Lanka’s medium-term growth prospects would be impeded if public capex remains at the low levels seen in 2024 (2.7% of GDP), even considering other measures announced in the budget that have the potential to lift private investment in export-oriented sectors and infrastructure.

The budget’s projected pace of consolidation is slower than envisioned in Sri Lanka’s four-year USD3 billion Extended Fund Facility (EFF) programme, agreed with the IMF in 2023. The government still expects to achieve a primary budget surplus of 2.3% of GDP in 2025, in line with the EFF programme targets, while expected interest payments of 8.9% of GDP are significantly larger than anticipated in the programme.

We assume the divergence from the programme’s projections implied in the budget will not prompt the IMF to suspend disbursements under the EFF. However, the slow pace of fiscal consolidation is notable, given that the government’s projected medium-term growth rate of 5% is well above that envisioned in the EFF. Limited progress on debt reduction would weigh on Sri Lanka’s credit profile and could leave the government with little capacity to respond if the economy faces economic shocks.

–Fitch