IMF warns debt risks remain high as repayment capacity tightens

• Capacity to repay IMF has weakened temporarily compared with Fourth Review 
• Under RFI and EFF, IMF credit outstanding is projected to peak at 3.1% of GDP in 2027, unchanged from earlier projections

Sri Lanka’s debt restructuring has delivered measurable relief, but debt risks remain elevated and the country’s capacity to repay the International Monetary Fund (IMF) has come under added strain following Cyclone Ditwah, according to the IMF’s December staff assessment.

While public debt dynamics have improved materially since the 2022 crisis, IMF staff cautioned that fiscal discipline will be critical as Sri Lanka balances recovery, reconstruction, and debt sustainability. The Fund said the gains achieved through restructuring could be undermined if emergency and reconstruction spending are not carefully managed within existing fiscal rules.

Between 2022 and 2024, Sri Lanka’s public debt declined from 125.8% of GDP to 105.7%, while gross financing needs fell from 33.9% of GDP to 21.9%. Interest payments relative to Government revenue also eased sharply, declining from 79% to 56%. Despite these improvements, the IMF said post-restructuring debt indicators remain high, requiring a calibrated fiscal strategy to preserve sustainability while supporting economic recovery.

The assessment placed particular emphasis on adherence to the Public Financial Management Act (PFMA) in deploying emergency spending. IMF staff said any supplementary allocations under the 2026 Budget should be used only when funding needs cannot be met through Budget reallocations, the annual Budget reserve, or the Contingencies Fund. 

Any breach of the primary expenditure ceiling, the Fund noted, would need to be justified under the Act’s escape clauses and accompanied by a recovery plan and corrective measures in subsequent budgets.

IMF staff said draft PFMA regulations covering Budget execution, fiscal rules, and enforcement procedures are being finalised and will help reinforce fiscal discipline, even during emergencies. The Fund also urged Sri Lanka to strengthen financial preparedness for future disasters through dedicated disaster funds, insurance mechanisms, and other risk-transfer tools.

Governance and transparency were flagged as central to sustaining confidence. The IMF said all emergency and reconstruction-related spending, including allocations through the Rebuilding Sri Lanka Fund and donor-financed projects, must comply with accountability requirements under the PFMA framework. 

This includes publishing procurement contracts, disclosing beneficial ownership information, and ensuring that any procurement deviations during disaster response are documented and publicly disclosed. Regular public reporting and independent audits were described as essential safeguards.

On Sri Lanka’s capacity to repay the Fund, IMF staff assessed it as adequate but subject to significant risks, with the assessment contingent on continued implementation of reforms under the Extended Fund Facility (EFF). High debt levels and elevated gross financing needs were cited as ongoing vulnerabilities that underscore the importance of institutional strengthening and durable fiscal frameworks.

Capacity-to-repay indicators have weakened temporarily compared with the Fourth Review. Under the Rapid Financing Instrument (RFI) and the EFF, IMF credit outstanding is projected to peak at 3.1% of GDP in 2027, unchanged from earlier projections. 

However, exposure relative to exports of goods and services has risen to 15.6% from 14.1%, while exposure relative to gross reserves has increased to 25.6% from 24.2%. Repurchases and charges are expected to peak in 2032 and remain broadly in line with earlier projections at 2.3% of exports and 3.6% of gross reserves.

The IMF said sustaining the gains from debt restructuring while meeting post-Ditwah reconstruction needs will depend on strict adherence to fiscal rules, strong governance, and continued commitment to the reform agenda underpinning the IMF-supported program.

It noted that adequate safeguards are in place. The Central Bank of Sri Lanka (CBSL) has implemented most recommendations from the 2023 Safeguards Assessment. The CBSL’s balance sheet continues to strengthen with equity reaching 1% of GDP at end-2024, reducing risks highlighted in the Safeguards Assessment. 

The CBSL continues to monitor its financial position and strengthen its balance sheet stress testing approach, including through an upcoming IMF TA. The CBSL has also strengthened its internal audit and risk management practices. The RFI requires an update to the Safeguards Assessment, which will be completed in due course, the IMF report noted. 

The IMF holds that at just 0.2% of GDP, the RFI is an appropriate instrument to help Sri Lanka safeguard its recent fiscal gains: 

“The RFI will provide crucial Budget support to finance disaster response, including restoration of essential services, macro-critical infrastructure repairs, and emergency assistance to those affected. The urgent balance of paymemts need triggered by Cyclone Ditwah is expected to be resolved within 12 months, without major changes to the authorities’ policy plans. Authorities’ track record of reform implementation, current policies under the EFF—particularly safeguards under the PFMA—and the limited size of the RFI mitigate risks to fiscal and debt sustainability. Authorities remain committed to the policy objectives of the IMF-supported program, which has underpinned a robust economic recovery, price stability, revenue-based fiscal consolidation, and the rebuilding of international reserves,” the IMF said.