By Ms Guncha Prakash
A man shot dead during clashes with the police, people standing in long queues to buy cooking gas and kerosene especially in this scorching heat, hospitals suspending routine surgeries and school exams getting postponed due to shortage of paper, is what is making headlines about Sri Lanka across the world. This unprecedented crisis has brought the Sri Lankan economy down to its knees and shall be marked as a watershed moment in the history of Sri Lanka for the future generations to come. What went so wrong that a country which ranked fourth in terms of Gross Domestic Product (GDP) in the South Asian region is struggling to meet even the basic needs of its citizens?An answer to this can only be arrived at through a detailed analysis of the situation at hand.
Sri Lanka: Pearl of the Indian Ocean
Sri Lanka, with a population of approximately 22 million, is endowed with natural beauty, biodiversity and precious gemstones, thus earning the nickname ‘Pearl of the Indian Ocean’. This attracts hordes of tourists each year, with tourism revenues averaging around US $178.08 million from 2009 to 2021. Apart from this, it remains the leading producer and exporter of tea and leading exporter of cinnamon in the world. With respect to social indicators, it has a literacy rate of 92 per cent, which is the highest in South Asia and Asia and human indicators only next to Japan.
However, the country is living its worst economic nightmare with Murphy’s law in full effect. It is reeling under extreme scarcity of food, medicines, fuels and other essentials. The gravity of the crises can be seen by the fact that a country that previously exported rice, has now become its net importer. The inflation rate measured on a year-on-year basis, stood at 17.5 per cent in February 2022 with food inflation skyrocketing to 24.7 per cent and power cuts lasting up to 12 hours. As a result, the people took to the streets on March 31, 2022 to express their frustration at the inefficient handling of the crises by the government.
To put it lucidly, one of the root causes of the crises in Sri Lanka has been its foreign exchange outflow being way more than its inflow, which are used to pay for imports of essentials such as petrol, food items and medicines. Sri Lanka earns a substantial share of its GDP through exports of tea, coffee, rubber and spices.Worker remittances, apparel industry and tourism are the top three sources of foreign exchange for the country. Apart from these, the government has raised money through international sovereign bonds and loans from the International Monetary Fund (IMF) and other countries time and again. However, these sovereign bonds, amounting to US $12.55 billion, constitute the largest share of Sri Lanka’s foreign debt. In addition, IMF loans have always come with conditionalities of the form such as reduction in budget deficits, tightening of monetary policy, cut in government subsidies and depreciation of currency. The increased government debts have also led to Sri Lanka losing its credibility among the global investors, preventing it from accessing international capital markets.
On the expenditure side, there has been a rise in import bills on the back of increased commodity prices and higher imports of intermediate and capital goods. Furthermore, the current account deficit reached US $3.2 billion in 2021 and its foreign reserves fell to US $1.93 billion by end of March 2022, seeming extremely gloomy in the face of US $4 billion to be repaid this year.
Sri Lanka’s tourism sector suffered a major setback following the Easter Sunday Bombings in April 2019, with tourist footfall dropping by 70 per cent as reported by authorities. To make matters worse, there was a fall in revenue from tourism by US $3 billion in the first eight months of 2021 as compared to the same period in 2018 as a result of the COVID pandemic. Furthermore, the remittances also decreased by US $100 million withina month’s period (October to November 2021). Thus, a fall in the revenues from tourism and remittances have caused the economy to nosedive especially in the times of global economic winds blowing in the opposite direction.
Government decisions gone wrong
The economic perils of the country trace their genesis to a variety of factors such as the Easter bombings of 2019, pandemic, flawed economic policies and the disruptions in supply chains as a result of Ukrainian crises, being the latest. Among these the faulty policy decisions taken by the government need to be highlighted in order for history to not repeat itself.
Sri Lanka emerged from a civil war spanning 26 years in 2009 with high budget deficit levels. The global financial crisis of 2008 further drained it of its foreign reserves thereby causing it to raise a loan of US $2.6 billion from IMF in 2009. The post 2013 period saw a fall in global commodity prices, slow down in exports and rise in imports, pushing the government to further seek assistance from the IMF to the tune of US $1.5 billion in 2016.Instead of following a counter-cyclical fiscal policy in times of low economic growth wherein the government increases its spending to boost demand and thus production, the country bound by IMF conditionalities bore the brunt of some wrong policy choices.
Firstly, in December 2019 the Value Added Tax (VAT) rates were slashed from 15 to 8 per cent, corporate tax rates were reduced by 4 per cent 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.
Secondly, the government completely banned fertiliser imports from May 2021 onwards to prevent drain of foreign exchange reserves, declaring Sri Lanka a 100 percent organic farming nation. This resulted in a fall in agricultural production, especially of rice and tea and rise in food inflation. While foreign exchange reserves earned from export of tea sank, the need for currency to import rice rose drastically. Despite economists warning against the negative fallouts of this miscalculated decision, the irrigation minister Chamal Rajapaksa said that the country should not listen to “chemical fertilizer mafia”.
Thirdly, Mahinda Rajapaksa’s insistence on laying the foundation of the Hambantota port has cost Sri Lanka heavily. China has become a top source of foreign investment in Sri Lanka and holds the largest amount of Sri Lankan debt (around 10.8 per cent of its total debt). While the government may perceive China to be posturing benevolence, the Chinese investments in Sri Lanka are largely driven by its strategic interests.
Fourthly, the government’s failure to gauge the gravity of the situation and choosing to wait instead of seeking IMF’s help sooner has caused the economic crisis to worsen. Former Central Bank Governor, Weligamage Don Lakshman, resorted to printing currency in order to “increase the proportion of domestic debt”. As a result, the money supply increased by 42 per cent between December 2019 and August 2021 and inflation rates were at record high by the end of 2021.
Lastly, the government has spent money on unproductive projects such as Mattala Rajapaksa International Airport (world’s emptiest international airport) and the Lotus Tower, to name a few.
Thus, the economic mismanagement by successive governments fetched Sri Lanka the title of a “twin deficits economy” according to the 2019 Asian Development Bank working paper, which still holds water. The twin deficits include national expenditure exceeding national income and inadequate production of tradable goods and services.
India’s assistance to Sri Lanka and negative fallouts of crises on India
In 2019, Sri Lanka’s outstanding debt to India, out of its total debt, was around 2 per cent. This figure might not appear very significant when seen in percentage terms, but does amount to a lot for Sri Lanka especially when it is short on money to pay back. Within the last three months, India has extended a support of US $2.5 billion to Sri Lanka. In kind support has been in the form of 400,000 metric tonnes of fuel and 40,000 tonnes of rice under the credit facility. In November 2021, India also supplied 100 tonnes of nano nitrogen liquid fertilizers to Sri Lanka in the wake of the Sri Lankan government banning import of chemical fertilizers.
In January 2022, India extended US $400 million currency swap to Sri Lanka and allowed deferred payment of several hundred million dollars by the Central Bank of Sri Lanka to RBI under the Asian Clearance Union. India also provided a US $500 million short-term loan to purchase petroleum products from Indian suppliers in February 2022and has agreed on another US $500 million credit line for fuel imports lately. Additionally, India sent vegetables, daily ration items and shipments of sugar, rice and wheat to Colombo in April 2022. Tamil Nadu Chief Minister M K Stalin, on his three-day visit to Delhi, appealed to the Centre to permit the state government to provide humanitarian aid to Sri Lankan Tamils.
On the sidelines of the IMF-World Bank Spring Meetings in Washington D.C on April 19, 2022, India’s Finance Minister, Nirmala Sitharaman, met with her Sri Lankan counterpart and assured Sri Lanka of India’s cooperation and assistance during this period of unprecedented crises. India further pressed on categorising Sri Lanka as a “low income” country for the purpose of debt restructuring.
However, the crisis has started holding out ramifications for India. Sri Lanka has already announced that it will default on repayment of its external debt worth US $51 billion. There has been an impact on commodity exports from India to Sri Lanka,as has been witnessed in the case of onions and also exports to the world since Colombo ports act as trans-shipment hubs for 60 percent of India’s global trade. Furthermore, India’s projects in Sri Lanka shall face delays and cost overruns and the threat of refugee influx looms over India from the neighbouring nation, with 16 having arrived in Tamil Nadu last month.
Thus, the crisis in Sri Lanka is a culmination of interplay of several factors ranging from faulty economic policies, global volatilities and domestic security challenges. The country is trapped in a vicious debt cycle wherein to avail IMF assistance it has to fulfil certain conditionalities. At the same time these conditionalities straitjacket the government from making necessary expenditures, thereby bringing the economy down and further necessitating IMF assistance. For instance, the government lately devalued the currency by 15 per cent in March in line with the IMF guidelines and an intention to boost exports. However, this rendered the Sri Lankan Rupees the world’s worst performing currency and raised inflation levels in the economy.
The IMF declared the Sri Lankan debt as ‘unsustainable’ making it all the more necessary for the country to take steps to restore debt sustainability. The World Bank has agreed to provide an aid package to Sri Lanka of US $300 million to $600 million in the next four months to buy medicines and other essential items. The IMF also termed the discussions with the Sri Lankan Finance Minister during the Spring Meetings “fruitful”. While cash and in-kind help from global institutions and neighbouring countries will be a blessing in the short run, the long run demands for economics to take precedence over political interests. Policies aimed at restructuring the tax system, reducing wasteful expenditures and methods to earn foreign exchange are the only ways to stir the whirlwind.
(The author has done her Masters in Economics from University of Warwick, United Kingdom. Views expressed are personal and do not reflect the official position or policy of Financial Express Online. Reproducing this content without permission is prohibited)