Sri Lanka’s small and medium enterprise (SME) sector—responsible for 52 percent of GDP and employing nearly half the national workforce—has become the next decisive test of the country’s fragile economic recovery.

A proposal to establish a Rs. 300 billion “Bad Bank” to absorb distressed SME loans now places policymakers at a crossroads: act boldly to revive credit and growth, or risk entrenching stagnation in the real economy.

The Sri Lanka Chamber of Small and Medium Industries (SLCSMI) on Tuesday told journalists that they had unveiled a detailed blueprint aimed at restructuring an estimated Rs. 460 billion in non-performing loans (NPLs), much of it concentrated among SMEs battered by successive shocks—from the Easter Sunday attacks and the pandemic to sovereign default and climate-related disruptions such as Cyclone Ditwah.

While headline indicators suggest macroeconomic stabilisation, including lower inflation, improved reserves and a profitable banking sector, credit transmission to smaller enterprises remains severely constrained, Chambers think tank pointed out.

“This is not about rewarding defaulters,” said SLCSMI President Prof. Rohan De Silva. “It is about protecting the productive backbone of the economy. If SMEs collapse, the consequences will extend far beyond individual balance sheets.”

Despite strong liquidity and a return to profitability in the banking system, thousands of SMEs remain blacklisted at the Credit Information Bureau (CRIB), unable to access fresh working capital.

The Chamber argues that unless distressed assets are separated from viable enterprises, banks will remain structurally risk-averse, prolonging the paralysis in private sector credit growth.

The proposed “Bad Bank” would function as a specialised rehabilitation vehicle, purchasing or warehousing toxic SME loans and granting viable firms a five-to-ten-year restructuring window, shielded from parate execution, to rebuild cash flows. Senior Vice President Colvin Fernando described the initiative as an economic circuit-breaker rather than a bailout. “These are not failed enterprises,” Fernando said.

He added:”They are businesses hit by extraordinary external shocks. Unless we ring-fence these distressed loans, credit transmission will remain paralysed.”

The concept draws on international precedents where asset management companies were deployed after systemic crises. Yet such mechanisms succeed only when governed by strict asset valuation discipline, professional management and insulation from political interference. Without these safeguards, they risk becoming vehicles for concealed subsidies or fiscal leakage.

The most contentious element of the Chamber’s proposal lies in its funding model. It calls for a hybrid structure combining low-cost international financing, a levy on commercial bank profits and the utilisation of unutilised balances from the Employees’ Provident Fund (EPF) and Employees’ Trust Fund (ETF).

Prof. De Silva argues that the banking sector, having restored profitability partly through elevated interest margins during the crisis years, has both the capacity and systemic responsibility to contribute. “The banking system has returned to strong profitability,” he said. “A structured contribution toward SME rehabilitation is not punitive—it is an investment in systemic stability.”

The suggested mobilisation of pension fund balances, however, is likely to provoke scrutiny over governance and fiduciary safeguards, while a levy on bank profits may raise investor sensitivity in a sector that has only recently regained confidence.

Fernando acknowledged the risks, emphasising that transparency and strict eligibility criteria would be essential. “This must be professionally managed, transparent and focused strictly on viable enterprises. Without discipline and accountability, the entire purpose would be defeated,” he cautioned.

Adding urgency to the debate is the Government’s decision to lower the VAT registration threshold to Rs. 36 million annually from April 1, 2026, drawing more small firms into the tax net. The Chamber warns that tightening tax compliance while credit remains restricted could create a double squeeze. “You cannot increase tax burdens and restrict financing simultaneously without economic consequences,” Prof. De Silva observed, describing the timing as highly sensitive.

Immediate Past President Mohideen Cader underscored the scale of the stakes. With SMEs contributing 52 percent to GDP and already under severe strain, he warned that inaction would result in irreversible economic scarring.

The macroeconomic logic is clear: without restoring SME balance sheets, private investment and employment growth are unlikely to regain momentum. Yet the countervailing risk is equally apparent. A poorly designed vehicle could create moral hazard, transfer private losses onto public shoulders and introduce new contingent liabilities into an economy still emerging from sovereign default.

Sri Lanka’s IMF-backed reform programme has so far focused on fiscal consolidation and debt sustainability. The SME “Bad Bank” proposal introduces a more complex phase in the recovery narrative—one that shifts attention from stabilisation to growth. The question confronting policymakers is whether the economy can sustain recovery without unclogging the credit arteries that feed its most labour-intensive sector.

The Rs. 300 billion proposal is, in essence, a calculated gamble that repairing SME balance sheets will unlock lending, revive investment and restore economic momentum. If executed with rigour, transparency and independence, it could serve as a bridge from crisis management to expansion. If mishandled, it risks deepening vulnerabilities in a system that has only recently regained its footing. For an economy seeking to move beyond stabilisation, the stakes could hardly be higher.

By Ifham Nizam