Sri Lanka, one of the leading countries in the South Asian region, has now descended into a crisis due to flawed policies. Will it be able to undo the inflicted damage?
This piece is part of the essay series, Instability in India’s neighbourhood: A multi-perspective analysis.
Until recently, the island nation Sri Lanka was hailed for leading the South Asian region on the Human Development Index. It had been heading in most of the socio-economic indicators such as health, education, and demographic characteristics. However, faulty macroeconomic and foreign policies together with autocratic political decision-making amidst the civil war and the subsequent political instability have jostled this small island nation into an unprecedented socio-economic crisis. Though the perils of this crisis have advanced only in the last few months with the common people struggling for essentials and utilities, and some even moving below the poverty line, the crisis was much in the making with the advent of the Global Financial Crisis 2008 and Civil War 2009. Post the civil war, the push for debt-driven infrastructure development, fiscal profligacy in terms of borrow-spend policy, rising trade deficit and current account deficit were unsustainable. These unwarranted economic perils were accentuated by the Easter bomb blasts of 2019 whose repercussions were heightened by the deep tax cut measures adopted by the new government in 2019. The final blow came with the COVID-19 pandemic which resulted in a drastic fall in tourism and tax revenues.
The Sri Lankan economy is currently in the throes of an ongoing and unprecedented economic turmoil the root cause of which lies in economic mismanagement by successive governments in Sri Lanka. Amongst these, the reckless economic policies of the Rajapaksa government remain the foremost factor that has worsened the economic situation in Sri Lanka. In the aftermath of the Civil War (2009-2015), the Sri Lankan economy was characterised by high budgetary deficits. The autocratic political decision during the civil war and the consequent political instability or lack of political consensus amassing the country refrained the incumbent government from mandating corrective policy reforms. These have been intensified by an acute shortage of foreign exchange reserves post the pandemic implying that the country could not afford to pay for imports of staple foods and fuel on an enduring basis causing prices to rise. Increased commodity prices and higher imports of intermediate and capital goods further contributed to an upsurge in its import bills. As a result, the current account deficit stood at the US $3.2 billion in 2021 and its foreign reserves fell to US $1.93 billion by end of March 2022. The end result was a country that became bankrupt with no access to the financial markets except multilateral bailout package and sovereign development assistance.
The current crisis, thus, is an interplay of the inherited problems and the economic mismanagement by successive governments in Sri Lanka, a fall out of the civil war which was heightened by the Easter bombings of 2019, the COVID-19 pandemic and flawed economic policies.
The current crisis, thus, is an interplay of the inherited problems and the economic mismanagement by successive governments in Sri Lanka, a fall out of the civil war which was heightened by the Easter bombings of 2019, the COVID-19 pandemic and flawed economic policies. Notwithstanding these, the adversities have been further amplified by the current disruptions in the global supply chains with the advent of the Ukrainian crisis.
The underlying cause of the crisis can be attributed to the global financial crisis of 2008 and the long civil war which squeezed remittances to Sri Lanka and drained the country of its foreign reserves thereby compelling it to raise a loan of US $2.6 billion from IMF in 2009. In 2016, the Sri Lankan government sought further assistance to the extent of US $1.5 billion from the International Monetary Fund (IMF). Instead of adopting a counter-cyclical fiscal policy to boost aggregate demand and production in the economy, the country relied on some wrong policy choices. To adhere to the pre-election promises, President Gotabaya Rajapaksa slashed tax rates in December 2019. The Value Added Tax (VAT) rates were cut from 15 to 8 percent, corporate tax rates were reduced by 4 percent and indirect taxes such as nation-building tax, pay-as-you-earn tax and economic service charges were abolished causing a loss of 2 percent of GDP. These wide-ranging tax cuts enacted months before the COVID-19 pandemic hit deepened the crisis and further derailed the Sri Lankan economy.
To prevent the outflow of foreign exchange reserves-in May 2021, the Sri Lankan government completely banned fertiliser imports and declared Sri Lanka a 100-percent organic farming nation. As an immediate and complete shift to organic farming was not feasible, this move led to a substantial decline in agricultural produce, especially rice and tea and caused food inflation to soar. Exports of commodities like tea, coffee, spices, etc. were also badly hit. Though the government lifted the ban on the import of fertilisers for export commodities, by then the damage had already been done. Amid a persistent shortage of essentials, the consumer price inflation today stands at 40 percent and makes the lives of the people, more so for those people belonging to low socio-economic groups, extremely difficult.
Another contributory factor to Sri Lanka’s economic crisis is that it has amassed huge foreign debts that it secured for developmental infrastructure projects. Experts have also noted that the Sri Lankan economy is heavily weighed down by China’s debt-trap diplomacy. The Hambantota port investment which is built with China’s assistance is a classic example of this debt trap diplomacy and has cost Sri Lanka heavily. The Chinese investments in Sri Lanka are largely driven by strategic interests with Sri Lankan debt constituting about 10.8 percent of its total debt. Furthermore, heavy reliance on soft loans from the Chinese government and commercial loans from Chinese commercial financial institutions backing these infrastructure projects has proved counterproductive as these commercial loans contracted at inflated costs have put an additional burden on the exchequer.
Experts have also noted that the Sri Lankan economy is heavily weighed down by China’s debt-trap diplomacy. The Hambantota port investment which is built with China’s assistance is a classic example of this debt trap diplomacy and has cost Sri Lanka heavily.
The ongoing economic crisis can also be attributed to a drastic fall in the country’s lucrative tourism industry which stood at 1.9 million in 2019, registering a decline of 1.8 percent since 2018 and the decline in foreign workers’ remittances post the COVID-19 pandemic. Tourism with its share of more than 10 percent of GDP and remittance accounting for about 8 percent of GDP are the two biggest sources of foreign exchange for Sri Lanka. The fall in the revenue from these two sources has resulted in an unprecedented rise in Sri Lanka’s foreign debt which today stands at US $51 billion and has also plummeted the foreign exchange reserves which stood at US $1.9 billion as of March 2022. The panic/bankruptcy situation where the forex reserves are not sufficient to pay for imports or debt servicing has prompted credit rating agencies to downgrade the Sri Lankan economy and refrain from participating in international capital markets.
As the crisis deepened, Sri Lanka depreciated its currency with the hope to attract investments and remittances. Higher inflation coupled with depreciating currency would have helped Sri Lanka’s exports but Sri Lanka being a consumption-led growth economy had little to offer for exports. Moreover, a drastic fall in the value of the Sri Lankan rupee (almost by 75 percent in the last two months) has made imports of essentials like food, fuel etc., much costlier. These coupled with the government’s hasty move to seek frequent International Monetary Fund (IMF) assistance time and again without adopting appropriate and prudent macroeconomic policies have exacerbated the crisis. Lastly, to make matters worse, the government exchequer’s money was spent on unproductive projects such as Mattala Rajapaksa International Airport (the world’s emptiest international airport) and the Lotus Tower. As a result, the Sri Lankan economy has come to be characterised as a “twin deficits economy” by the Asian Development Bank wherein a budget shortfall prevails along with a current account deficit.
To curtail its depleting foreign exchange reserves, the Sri Lankan government has also relied on international sovereign bonds (ISBs) and resorted to loans from the IMF which today stands at US $12.55 billion. ISBs make up the largest share of Sri Lanka’s foreign debt with the Asian Development Bank, Japan and China amongst the other major lenders. These IMF loans, however, come with conditionalities such as reduction in budget deficits, tightening of monetary policy, cut in government subsidies and depreciation of the currency. As of February 2022, the country was left with only US $2.31 billion forex reserves but owed debt repayments of around US $4 billion including a US $1 billion international sovereign bonds (ISB) maturing in July. That is when Sri Lanka became bankrupt and the country has recently defaulted on the entirety of its foreign debt amounting to about US $51 billion. This together with increases in government debts casts serious doubts on Sri Lanka’s credibility amongst the global investors in current times.
Thus, the ongoing crisis in Sri Lanka is an outcome of several intermingling factors ranging from heedless economic policies, global market disruptions and domestic security issues. The country is trapped in a vicious debt cycle wherein to avail IMF’s assistance, it has to fulfil certain conditionalities. These conditionalities have restrained the government from making necessary expenditures, thereby slowing the economy and necessitating frequent IMF assistance and hence what follows is a never-ending debt spiral. For instance, the government devalued the currency by 15 percent in March to adhere to the IMF guidelines to boost exports. However, this move devalued the Sri Lankan rupee and raised inflation levels in the economy. As a consequence, the Sri Lankan rupee today stands at INR 360 per US dollar, making it the world's worst-performing currency.
The ongoing crisis in Sri Lanka is an outcome of several intermingling factors ranging from heedless economic policies, global market disruptions and domestic security issues. The country is trapped in a vicious debt cycle wherein to avail IMF’s assistance, it has to fulfil certain conditionalities.
In an assessment of the Sri Lankan economy by the IMF in March 2022, it came to the forefront that the government debt has risen to “unsustainable levels” and foreign exchange reserves are insufficient for near-term debt payments. IMF thus pinpoints that the government’s measures are insufficient to restore debt sustainability and hence advocates the need for debt restructuring in Sri Lanka. To break the “debt spiral,” it is thus imperative that the Sri Lankan government makes a cautious and calibrated move to restructure the tax system, reduce wasteful expenditure and look for alternative avenues to earn foreign exchange.
Interestingly, Sri Lanka’s increased dependency on external loans to run its economy in hard times has been bailed out by both China and India. The country’s reliance on Chinese loans has often caught the Sri Lankan economy in what can be characterised as a debt trap. On the other hand, India has followed the "Neighbourhood First policy" to strengthen bonds and help Sri Lanka to come out of the current crisis. India has so far committed US $1.9 billion to Sri Lanka in loans, credit lines and currency swaps and has committed US $2 billion in swaps. In November 2021, India had given 100 tonnes of nano nitrogen liquid fertilizers to Sri Lanka as their government stopped the import of chemical fertilisers facility. In February, US $500 billion was given to Sri Lanka by India as a short-term loan to help it purchase petroleum products through the ministry of energy and the Ceylon Petroleum Corporation on behalf of the government of Sri Lanka. In the last three months, India has extended further assistance of about US $2.5 billion to Sri Lanka, including credit facilities for fuel and food. Since mid-March, over 270,000 metric tonnes of diesel and petrol have been delivered to Sri Lanka. In addition, around 40,000 tonnes of rice have been supplied under the recently extended US $1 billion credit facility. Besides, the Reserve Bank of India (RBI) has extended a currency swap of US $400 million and deferred payments owed by the Central Bank of Sri Lanka under the Asian Clearance Union.
India must continue to provide the much-needed assistance to Sri Lanka, albeit with due caution, to preserve its strategic interests as prolonged instability in Sri Lanka may have a spill-over effect on India. Any kind of instability in Sri Lanka, be it political, social, economic or security, is not in India’s strategic interests. Due to its geographical proximity, India would be the first one in the South Asian region to feel the ramifications and repercussions of the Sri Lankan crisis if it goes uncontrolled.
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