The cost of recovery and reconstruction from the floods in Sri Lanka could reach $7bn, according to government officials. This is a staggeringly high amount the small island nation in South Asia cannot afford. It is roughly 7% of Sri Lanka’s gross domestic product and close to half of the government’s revenue for 2025. Sri Lanka’s total bilateral debt owed to China as of 2023 was $4.3bn, meaning the damages from the floods could be over one and a half times this amount.
Sri Lanka defaulted in 2022 for the first time but it has received global praise for its remarkable recovery, including from the International Monetary Fund. But Sri Lanka shows the world that, at a time of high debt globally, climate disasters can deal a heavy blow to many nations.
Sri Lanka’s economic context
Sri Lanka’s default on its external debt resulted in one of the most complex debt restructurings in the world. In 2022, Sri Lanka’s debt stood at 128% of GDP, its inflation was around 70% and its government revenue was around 8% of GDP, which was one of the lowest in the world. The IMF programme, which started in 2023, revolved around the broad targets of achieving 15% government revenue to GDP by 2025, bringing public debt down to 95% of GDP by 2032, bringing gross financing needs down to 13.5% of GDP and external financing down to 4.5% of GDP.
The government had to increase taxes, adopt cost-reflective pricing and introduce non-populist measures. These have contributed to immense hardship for the people of Sri Lanka, where a quarter fall below the poverty line. But this resulted in the country getting back on track in fiscal terms.
Before the flood hit in November, Sri Lanka was well on its way to meeting the IMF targets, which the previous Ranil Wickremesinghe government and the current Anura Kumara Dissanayake government have to be credited for. But today, Sri Lanka has limited fiscal space as stated by Moody’s. The government has few options as any further fiscal tightening measures could lead to social backlash.
Damage from Cyclone Ditwah
The death toll from the flood has crossed 600 people, with another 2.3m affected. That is around 10% of Sri Lanka’s population with more than half of them being women according to the United Nations Development Programme. Around 20% of land in Sri Lanka has been affected, causing damage to houses, commercial buildings, roads, bridges and electricity grids. According to UNDP, around 720,000 buildings (which is one in 12 buildings in Sri Lanka), 16,000km of roads, 278km of railway tracks and 480 bridges have been affected.
In addition to the short-term impact, this will have medium- to long-term costs as it will take time to rebuild. The government has announced relief spending measures to take care of the immediate needs of the flood-affected people. Sri Lanka has also received pledges for financial assistance from countries and organisations from around the world.
Macro-fiscal impact
With vast areas of agricultural lands, export-focused factories and tourist hotspots hit, this will result in pressure on the foreign reserves of the country. Sri Lanka will need to import food as it takes time for the agricultural lands to restart producing. Though the impact on tourism is limited to the central highlands of Sri Lanka and some coastal lands, the perception around the world will take time to change. These will result in lower foreign exchange earnings for Sri Lanka and more foreign exchange leaving the country.
Sri Lanka’s gross reserves are at $6bn, though according to IMF projections, it should have been over $7.2bn by the end of this year. It must be noted that even before the floods hit, Sri Lanka was struggling with increasing its gross reserves. Cyclone Ditwah makes the situation worse.
From a fiscal perspective, the damages are yet to be fully assessed so it will take time for the Treasury to assess the actual cost of the impact. But this will result in reduced tax revenues, increased spending for flood relief and reconstruction and higher social security spending to take care of the vulnerable people.
Overall, the floods will result in a widening fiscal deficit and higher gross financing needs unless there is concessionary funding coming in. If adequate concessionary financing does not come, Sri Lanka may have to rely on domestic borrowing, which can increase domestic interest rates.
Sri Lanka had achieved a primary surplus of over Rs1tn as its capital expenditure was not utilised and it exceeded its revenue targets. This came at the expense of not spending the allocated money on capital expenditure, which will affect long-term economic growth. However, this surplus could be used during this climate crisis and will be an advantage for the government.
Policy steps
In the short term, the government needs to prioritise social spending to take care of the most vulnerable. Social security spending will have to increase, and funding for health and education will have to increase to minimise the long-term impact to the economy. Adopting cash transfers for the vulnerable is needed.
President Anura Kumara Dissanayake has announced a list of immediate relief measures, which is the right step to take. In terms of public finance, the government needs to look into grants and concessionary funding from multilateral institutions and climate funds. Commercial borrowing can affect Sri Lanka’s debt sustainability in the medium to long term, especially as the country is economically vulnerable.
Climate shocks must be treated as a recurring macro-fiscal risk. The World Bank has identified Sri Lanka as a climate hotspot, so climate risk needs to be taken into account when fiscal planning is done. Sri Lanka needs to look at green bonds and resilience bonds for financing going forward as they offer support and can come with lower borrowing costs.
Sri Lanka should be a lesson for the world to take climate risks seriously and for the world to come together on climate adaptation and mitigation efforts.
Talal Rafi is an economist, expert member of the World Economic Forum and columnist for the International Monetary Fund on public finance.
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