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Debunking economic myths # 2: High 1Q GDP growth indicates sustained progress

Tuesday, 23 June 2026 06:55 -     - {{hitsCtrl.values.hits}}

 

Sri Lanka achieved a year-on-year GDP growth of 5.1% in the first quarter of 2026, compared with 4.7% growth rate in 1Q 2025. It was the highest first-quarter growth recorded since 2021, reflecting economic recovery. 

Following the economic crisis, the GDP contracted by 10.6% in 1Q 2023, and there has been a gradual recovery since then. Government authorities view the pickup of growth in 1Q 2026 as an indication of sustained progress towards a medium-term growth target of 7%, while expressing confidence that the announced growth target of 5% for 2026 is achievable. 

Such growth rates predicted by authorities are certainly welcome for improving people’s quality of life. But certain caveats behind such aggregate numbers need to be understood to meet the policy challenges ahead, without being carried away by occasional growth hikes. 

The Government’s optimistic targets contrast with the lower annual GDP growth projection of around 3% for the period 2026-2028 published in the recent IMF Country Report pertaining to the fifth and sixth reviews of the Extended Fund Facility. This seems to be a more realistic forecast, given Sri Lanka’s production capacity constraints and macroeconomic imbalances.

Low base illusion

The high growth in 1Q 2026 is mostly a reflection of the normalisation process of the economy, rather than steady-state GDP growth. It is masked by a low baseline effect from the past contractions of the economy. The real GDP was lower during the post-crisis period (Figure 1). As a result, the calculated growth rates for more recent quarters tend to be superficially high. 

For instance, the real GDP in 1Q 2025 was lower than the level prevailed in 1Q 2022 (Figure 2). Therefore, when the real GDP in 1Q 2026 is compared with that of 1Q 2022, the growth rate is only 3.2%, as against the year-on-year growth of 5.1%. This shows how a lower base could lead to exaggerating the growth numbers. 

Economic sugar rush

The construction sector was the main driver of GDP growth, which accounts for 7.5% of GDP. It grew by 16.3% in 1Q 2026 and contributed 1.1% to the GDP growth rate of 5.1%, equivalent to around one-fifth of the overall growth. 

Undoubtedly, the construction sector plays a vital role in developing economies by building essential infrastructure and other physical assets, which are essential to accelerate economic growth. It is also a key source of creating jobs across different skill levels, stimulating local supply chains, and attracting foreign investment.  

However, the construction sector is often referred to as an “economic sugar rush”, which means a short-term, unsustainable spike in economic activity.  Although it has the advantage of generating GDP upfront, eventually the initial momentum fades away, resulting in long-term growth stagnation. The excessive capital poured into mega infrastructure projects and speculative real estate development preempts resources from the vital technology and innovation-driven export-oriented manufacturing enterprises.  Such resource misallocation causes downward effects on the production of tradable goods and thereby discourages export-led growth. 

Export-led growth lacking

The moderate GDP growth experienced in the recent quarters was driven largely by the non-tradable sector, dominated by domestic-oriented economic activities, mainly construction, transport, domestic trade, and financial services. There is a downward trend in export-oriented industries. This is reflected in the decline in output of textiles and wearing apparel manufacturing, which is a major source of export earnings, by 3.8% in 1Q 2026.

 

Such growth rates predicted by authorities are certainly welcome for improving people’s quality of life. But certain caveats behind such aggregate numbers need to be understood to meet the policy challenges ahead, without being carried away by occasional growth hikes 

 

 

The country has failed to move to high-tech industries in contrast to fast-growing Asian countries. Sri Lanka’s high-tech exports account for only 1.4% of total manufactured exports, as against 58% in Malaysia, 56% in Singapore, 43% in Vietnam, and 28% in Thailand. Handicaps in science, technology, innovation, and knowledge-based products are major constraints to Sri Lanka’s growth dynamics.

Cost escalation effects

The rising production costs triggered by surging energy, transport, and borrowing expenses following the recent forex market volatility have dampening effects on economic activities. The recent rupee depreciation makes imported investment and intermediate goods costlier, although it has a positive impact on the export sector. A rise in borrowing costs can also be expected due to the recent increase in the Overnight Policy Rate (OPR) by the Central Bank, which was essential to deal with forex market volatility. 

Service sector is inward-oriented

The service sector is the largest contributor to the economy, accounting for 57% of GDP and providing employment for 50% of the country’s workforce. This sector is largely concentrated in domestic activities such as local wholesale and retail trade, transportation, financial services, and public administration. Approximately 88% of the output of the services sector is domestically consumed, and such products can be considered as non-tradables. Thus, Sri Lanka’s services sector is predominantly inward-oriented.

Export-oriented services, known as tradables, account for only 12% of the total services output. A positive development observed in recent years is the significant growth of tourism and service exports related to information technology, communication, and business process outsourcing. These service exports earn foreign exchange amounting to $ 7 billion, equivalent to 35% of total foreign exchange earnings from goods and services.

Way forward

Transforming the country’s production structure towards export orientation is essential not only to elevate the economy to a higher growth trajectory but also to ease the balance of payments difficulties.  To this end, a coherent policy framework is required targeting the agriculture, industry, and service activities. Policy strategies are necessary for high-tech-based education and skills development, infrastructure development, regulatory reforms, and fiscal incentives. Efforts should also be made to attract FDI for high-tech, high-value-added service activities, instead of continuously relying on low-tech exports such as apparel products.

The necessity to adopt such outward-looking policy strategies in the backdrop of the competitive, knowledge-based global economy should not be masked by complacency about temporary and unsustainable spikes in GDP growth.

(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)

 

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