Sri Lanka's economic prospects have been boosted substantially by the ending of the civil war, and real GDP growth should average 7.4% a year in 2011-15. The agricultural sector will be supported by increased cultivation in the formerly conflict-ridden northern and eastern provinces (although floods will hit farm output in 2011). The recovery in consumer and business confidence will also spur economic activity. Private consumption growth will be the main driver of economic expansion, fuelled by rising incomes and remittances from expatriate Sri Lankans. Four pillars will support investment: reconstruction efforts in the north and east; public spending on infrastructure (long neglected during the civil war); business investment, as companies seek to capture market share amid rapid economic growth; and rising property investment. Our forecast that real investment growth will average 11.5% a year in 2011-15 could be surpassed if the housing market experiences a boom or foreign investment exceeds our modest expectations.

Economic growth would be stronger were it not for the fact that the past decade has seen an unsustainable fiscal expansion (including spending on the war). The fiscal retrenchment that is required will hold back GDP growth in 2011-15. Moreover, the external sector's contribution to growth will remain negative. Slow growth in Sri Lanka's dominant export markets, the EU and the US, will limit export opportunities, notably for apparel manufacturers. However, rising exports to other emerging markets, such as neighbouring India, will help to offset this effect, ensuring that growth in exports of goods and services (including tourism) remains strong, at 8% a year on average in the forecast period. Improving domestic supplies, especially of food, will help to curb import growth, but imports will nevertheless expand by 8.4% a year on average.

Several negative scenarios exist for the economy, including renewed conflict arising from ethnic tensions, and an outflow of funds (and consequent balance-of-payments problems) should foreign investor confidence deteriorate. Bad weather that significantly reduces agricultural output could slow GDP growth, as could an unexpected surge in inflation that forces the government to tighten monetary policy more than currently expected. However, as the north and east undergo post-conflict rehabilitation, there are also upside risks to our growth forecast that outweigh the downside possibilities.

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