Can Sri Lanka sustain its newly won upper-middle-income status?

Sri Lanka’s upgrade appears to be a statistical illusion rather than a reflection of the underlying economic realities. Given the delayed reforms, structural rigidities, market imperfections, and growth constraints, the country is unlikely to sustain its position in the upper middle-income category for long. To unlock the country’s growth potential and to keep its newly won income status intact, far-reaching reforms are needed specifically in the areas of trade liberalisation, investment climate, business environment, State-owned enterprises, human resources development, and technology and innovation

Sri Lanka has graduated from the lower-middle-income status to the upper-middle-income status, according to the World Bank’s latest annual country classification, based on Gross National Income (GNI) per capita. While this upgrade can be considered an important milestone in the country’s development path, it is questionable whether it can remain in this category for long without falling to the lower category. In July 2019 too Sri Lanka reached the upper middle-income status, but was downgraded back to the lower middle-income category just one year later due to the economic setback caused by the COVID-19 pandemic and the economic crisis. 

Many newspaper articles appeared during the last couple of days, highlighting Sri Lanka’s stunning return to the upper middle-income status, weaknesses of the GNI as an indicator of people’s quality of life, and the challenges faced by developing countries after reaching the upper middle-income status. Leaving aside those aspects, this column is intended to address the fundamental question of whether Sri Lanka has the capacity to retain its upgrade in the coming years amidst impending domestic and external vulnerabilities.

Single-variable classification

A country’s GNI per capita is derived by dividing its GNI by its total population. GNI measures the total domestic and foreign output claimed by residents of a country, including Gross Domestic Product (GDP) plus factor incomes such as worker remittances earned abroad by residents, minus income earned in the domestic economy by non-residents. The World Bank uses its Atlas method to convert GNI in local currencies into US dollars, which averages the exchange rate over three years while adjusting for domestic and international inflation. This method is widely criticised as it is entirely based on the single variable of GNI, which ignores income inequality, structural rigidities, growth constraints, and environmental degradation.

As per the World Bank’s classification, a country’s GNI per capita depends on population, economic growth, inflation, and exchange rate movements. An increase in population, a recession, a rise in inflation or a depreciation of the currency harms per capita GNI, and vice versa. 

Razor-thin margin

Sri Lanka’s per capita GNI was $ 4,670 in 2025, placing the country a razor-thin margin of  $ 34 per person above the upper middle-income cutoff of $ 4,636. Thus, the country is located at the very bottom of the upper middle-income bracket.

According to the World Bank, Sri Lanka’s reclassification reflects the country’s strong recovery from the severe economic crisis of 2022. Just three years after facing one of the worst economic downturns in its history, Sri Lanka recorded real GDP growth of 5% in 2025, supported by a rebound in industrial activity and growth in the financial and tourism sectors, it reports. The World Bank describes the country’s progress as a story of resilience, noting that while the country crossed the upper middle-income threshold by a narrow margin, the achievement demonstrates the effectiveness of ongoing economic stabilisation and recovery efforts.

Fragility of the elevation

Since population is the denominator in the classification formula, the decline in Sri Lanka’s population since 2022 helped to raise its GNI per capita. The population declined by 0.73% from 21,916 thousand in 2024 to 21,756 thousand in 2025. Such a superficial increase in GNI per capita caused by a population decline can be considered a mirage of prosperity, instead of a reflection of the country’s actual production and productivity growth. 

A significant improvement in macroeconomic stability following the economic reforms implemented in 2023, supported by the IMF-EFF program, provided a conducive environment for economic recovery with a GDP growth of 5% in 2025. Surpluses in the primary fiscal account and the current account of the balance of payments were significant achievements, along with low inflation, exchange rate stability, and growth recovery. 

Maintaining the average exchange rate at a stable level around Rs. 300 per dollar in 2025, as against Rs. 325 per dollar in 2022, helped to increase the GNI in dollar terms. The low inflation was another factor that augmented the real GNI.

Despite those positive achievements, a slight change in any of those variables could easily push Sri Lanka back to its original position, as the country crossed the income threshold with a thin margin. Therefore, the question is whether the favourable achievements could be sustained in the near future, given the country’s debt restructuring obligations and the delays in implementing the imperative structural reforms.

Economic stagnation

According to official projections, the annual GDP growth will hover around 3% throughout the period 2026-2031. This indicates the limited growth potential in the medium term, and therefore, it would be difficult for Sri Lanka to remain in the upper middle-income category. Persistent low productivity is a major factor that drags down GDP growth. 

The bulk of investment is diverted to non-tradables such as construction, property development, and trading, instead of export-oriented, high-value-added industries. A similar pattern can be observed concerning foreign direct investment (FDI), which is usually meant to promote export-oriented ventures. Investment efficiency, measured in terms of the incremental capital output ratio (ICOR), declined over the years in Sri Lanka, reflecting a deterioration of productivity. 

Several major gaps in structural reforms hinder GDP growth in Sri Lanka in comparison with best-performing peers, as highlighted in the latest IMF country report. They include trade liberalisation, labour market flexibility, business regulations, and digitalisation. It emphasises the need for well-calibrated structural reforms and renewed public infrastructure to unlock higher and sustainable growth. It is estimated that such reforms can lift real GDP by 4 percentage points in the short term and 8 percentage points in the long term. 

Export dynamism is lacking

Sri Lanka’s failure to achieve sustained GDP growth is heavily correlated with its lack of export dynamism and overdependence on a static export basket. The economy has heavily relied on low-value-added, low-tech primary exports – mainly apparel, tea, and rubber – for decades. Given such setbacks, exports are projected to grow only by around 5% during the period 2026-2031. It contrasts with an annual export growth of 15% in Vietnam, which reached the upper middle-income along with Sri Lanka this time. 

The inconsistent trade policies, switching between export promotion and import substitution strategies from time to time, created an anti-export bias over decades. Such policies led to market uncertainties and discouraged foreign direct investment (FD), disrupting export-led growth.

Rupee depreciation 

As mentioned earlier, a depreciation of the rupee results in a decline in GNI per capita in dollar terms, and vice versa. The weakening of the balance of payments in recent months exerts severe pressure on the exchange rate. The trade deficit rose to $ 4,661 million in the first five months of this year, compared with the lower deficit of $ 2,730 million during the corresponding period last year. Faster growth of imports by 29% as against slackening export growth of 7.6% caused the deterioration of the trade balance. While worker remittances increased significantly by 26%, the decline in net inflows from services and foreign investment turned the current account into a deficit of $ 97 million in the first five months of this year from a surplus of $ 1,296 million in the corresponding period of 2025. 

The trade balance is unlikely to improve in the years ahead, as per official forecasts. The trade deficit is projected to rise continuously from $ 9 billion in 2026 to $ 11 billion by 2031. Given such an adverse trend, the rupee would continue to depreciate unless a significant increase in foreign exchange earnings from services such as tourism and IT services is materialised. The negative impact of rupee depreciation on GNI per capita in dollar terms is likely to push the country back to the lower middle-income category. 

Inflationary pressures

While the inflation-targeting monetary policy tools have helped to ease demand-driven inflationary pressures, the economy shows less resilience to supply-driven inflationary pressures emanating from the global price shocks, particularly the recent oil price increase caused by the war tensions in the Middle East. The year-on-year headline inflation rose to 6.8% in June from 5.5% in May. 

According to the Central Bank, inflation is projected to remain above the target of 5% in the coming months before stabilising close to the target in the medium-term with the support of appropriate policies. Nevertheless, it is predicted that the domestic inflation outlook will be heavily subject to global price fluctuations. As inflation has a downward impact on GNI per capita, the domestic inflationary pressures also reduce Sri Lanka’s chance to remain in the upper middle-income rank.

Need for broader reforms

Sri Lanka’s upgrade appears to be a statistical illusion rather than a reflection of the underlying economic realities. Given the delayed reforms, structural rigidities, market imperfections, and growth constraints, the country is unlikely to sustain its position in the upper middle-income category for long.

To unlock the country’s growth potential and to keep its newly-won income status intact, far-reaching reforms are needed specifically in the areas of trade liberalisation, investment climate, business environment, state-owned enterprises (SOEs), human resources development, and technology and innovation.

(The author, Emeritus Professor in Economics at the Open University of Sri Lanka, is the President of the Sri Lanka Economic Association and the Honorary Deputy Chairman of the Gamani Corea Foundation)