Introduction

The recent changes in Sri Lanka’s economy have presented a landscape rich in both challenges and opportunities for local and foreign investors. The purpose of this brief is to explain the country’s journey through the economic crisis, subsequent economic reforms, pathway to stabilization and recovery, and the evolving legal frameworks and attempts to offer a unique insight into the current state of the economy.

In April 2022, Sri Lanka experienced a historic economic downturn prompting the Government of Sri Lanka (“GOSL”) to engage with the International Monetary Fund (“IMF”) for a 48-month External Fund Facility of USD 2.9 billion. Critical policy decisions, including tax increases and foreign exchange restrictions were implemented to stabilize the economy, thereby contributing to decreased inflation, increase of foreign reserves, and gradual currency stabilization.

Economic Reform

The Central Bank of Sri Lanka (“CBSL”) initially implemented high policy rates to control inflation, which impacted credit growth in the country. Thereafter, beginning from late second quarter 2023 onwards, CBSL lowered the rates to boost economic recovery; the Standing Lending Facility Rate and Standing Deposit Facility Rate currently stands at 10% and 9% respectively (January 2024).

As part of its broader fiscal consolidation efforts, Sri Lanka's hike in personal and corporate income taxes in 2023 are aimed at strengthening state revenues in the path to economic recovery. In January 2024, Sri Lanka witnessed an increase in its Value Added Tax (“VAT”) rate, rising from 15% to 18%, along with a reduction in the VAT registration threshold to Rs. 60 million and the removal of VAT exemptions from a large number of goods / services. Such revenue measures have drawn criticism about its impact on domestic spending and on the investment climate.

The fiscal policy adjustments by GOSL, particularly in the 2024 budget, demonstrate a commitment to economic recovery and stability. The allocation of significant funds for foreign debt restructuring, the proposal to divest state-owned enterprises, and the increase in borrowing limits reflect a strategy to strengthen the economy. These fiscal measures are supplemented by monetary policy adjustments aimed at balancing inflation control with economic recovery.

SOE Restructuring

GOSL has also embarked on an ambitious plan to restructure and divest several key state-owned enterprises in a move to optimize government expenditure. This initiative targets entities such as the Ceylon Electricity Board, Sri Lankan Airlines, Ceylon Petroleum Corporation, Sri Lanka Telecom, and Sri Lanka Insurance Corporation. These reforms are pivotal in enhancing operational efficiency, financial stability, and overall service quality, by not only reducing the fiscal burden on the government, but also improving the competitiveness and sustainability of these vital sectors.

Legal Reform

The new Central Bank of Sri Lanka Act (“CBSL Act”), which repeals the Monetary Law Act, marks a significant shift towards bolstering the CBSL’s accountability and transparency and illustrates an effort at attaining price stabilization. The new CBSL Act aims to modernize CBSL's operations and strengthening its role in ensuring resilience and integrity of the financial system.

CBSL regulates various financial entities in the country, including Licensed Commercial Banks, Licensed Specialised Banks, Licensed Finance Companies, Registered Finance Leasing Establishments, Authorised Primary Dealers, and Authorized Money Broking Companies. Accordingly, new CBSL Act provides for more stringent requirements for the appointment of directors and senior management in banks, increased supervisory powers for CBSL, and restrictions on monetary financing of the government (subject to exceptional circumstances), with overall enhanced measures for risk management and financial stability.

In response to the need to enhance the financial sector’s safety nets, as highlighted by the IMF and World Bank, GOSL recently introduced the Banking (Special Provisions) Act. This aims to strengthen the bank resolution framework under the Crisis Management Framework of Financial Institutions Regulated by CBSL. Whilst supplementing the CBSL Act, the Banking (Special Provisions) Act introduces provisions for the resolution of Licensed Commercial Banks, deposit insurance, and winding up/liquidation of such banks. On the other hand, the new Banking (Amendment) Bill proposes to impose stricter standards on the issuance of licenses, ownership, corporate governance, supervision, capital requirements, liquidity framework, permitted credit facilities, and other related matters.

Proposed Legal Reforms

GOSL also intends to introduce new legislation aimed at attracting both domestic and foreign investment. The proposed Investment Law is set to create a conducive and transparent environment for investors by streamlining processes and offering clearer guidelines. Concurrently, the Public Private Partnership Law is being proposed to foster public-private collaborations in developing and maintaining public infrastructure and services, providing a structured approach to private investment in public projects.

In the attempt to streamline revenue administration, amendments are underway to the Inland Revenue Act, VAT Act, various Finance Acts, Social Security Contribution Levy Act, Telecommunication Levy Act, and the Tax Appeals Commission Act. In similar vein, to enhance efficiency in tax collection and broaden the tax base, efforts are being taken towards mandatory tax registration of natural persons over 18, and introduction of digital solutions to streamline the tax collection process, making it more transparent, accessible, and less prone to corruption.

The proposed Secured Transactions Act is designed to establish a more efficient and reliable framework for secured financial transactions, enhancing legal certainty for both lenders and borrowers. This Act will likely facilitate improved access to credit, particularly for small and medium-sized enterprises. On the other hand, the proposed Microfinance Act aims to regulate and streamline the microfinance sector, ensuring better protection for consumers and promoting responsible lending practices.

Moreover, Sri Lanka's insolvency laws, overseen by the Companies Act for companies and the Insolvency Ordinance for individuals and partnerships, have faced serious criticism for their shortcomings. Thus, the proposed Rescue Rehabilitation and Insolvency Bill aims to modernize the framework, emphasizing restructuring for viable companies and offering relief to struggling entrepreneurs and small businesses.

GOSL intends to introduce several new laws to manage public debt, finances and assets. This includes proposed legislation such as the Public Debt Management Act, Public Financial Management Act, Public Asset Management Act, and the Public Enterprise Reform Law.

Other Reforms

The Colombo Stock Exchange has also pursued initiative to integrate environmental, social, and governance (ESG) factors into financial services and products. This includes the development of green bonds and sustainable financing instruments, which aim to support environmentally friendly projects and promote responsible investment practices.
GOSL is also prioritizing digital transformation and international compliance by advancing overdue cybersecurity legislation. This initiative will complement existing laws on data protection and financial crime, enhancing the integrity of the financial system.

Potential Hurdles and Solutions

Sri Lanka's rank in the Doing Business Index and its performance in enforcing contracts highlight challenges in attracting foreign direct investment. Stricter fiscal policies by GOSL, aimed at reducing debt burdens, might pose challenges for investors. However, the Colombo Port City, established as a special economic zone, offers a solution by facilitating easy business setup and offering tax incentives for strategic businesses. The Colombo Port City Commission recently announced that three licensed commercial banks have obtained the relevant license to operate within the special economic zone.

Additionally, GOSL is allocating LKR 100 billion towards automating services in government agencies dealing with investors, aiming to expedite approval processes, reduce bureaucratic hurdles, and enhance transparency, thus promoting a more investor-friendly environment.

Conclusion

The economy of the country is currently undergoing a transformative phase, poised to overcome economic challenges and embrace positive changes through legislative measures already introduced and proposed to be introduced by the Government. The country’s resilience and adaptability, coupled with proactive government initiatives and legal reforms, are expected to play a crucial role in steering it towards a promising and sustainable future.