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Inefficient Fiscal Management, Extreme Populism and Increasing Dictatorial Powers: The Making of the Sri Lankan Economic Crisis

By Sashank Rajaram

The lush green tea plantations, stunning landscape, clear blue sky, golden beaches, and verdant hills make Sri Lanka virally infectious with allure. But none of these adjectives would bring succour to the economic crisis in the country. 

On 12th April 2022, the island nation declared that it is defaulting on its entire $51 billion external debt as a “last resort to prevent a further deterioration of the republic’s financial position”. Grappling with its most severe financial crisis since independence, Sri Lanka’s finance ministry said that creditors were given a choice to either capitalise on any interest payments due to them or opt for payback in Sri Lankan rupees. 

Unable to put up any longer with such an economic brunt, hundreds of Sri Lankans have taken to protest over major power cuts, the soaring cost of food and fuel, and demanded the resignation of the Sri Lankan President Gotabaya Rajapaksa. 

Given the problem of ‘twin deficit’– a budget shortfall as well as a current account deficit – it is natural to ponder how a country that consistently performed better than its neighbours in terms of various social indicators dug itself deep into this bottomless hole?

Economic Crisis- What Went Wrong? 

To get a comprehensive overview of the current situation, one needs to rewind the clock to the end of the 20th century. Since the 1990s, Sri Lankan governments have continued to commit three key macroeconomic errors: extreme reliance on commercial borrowing to finance the government’s budget deficit; failure to strengthen the tax system and widen tax brackets, resulting in declining government revenues; and unwillingness to diversify exports, resulting in an over-reliance on few sectors as a source of foreign exchange. 

All these weak foundations gave rise to a precarious economy that could collapse on itself at any time. 

Despite such gaping holes, the economy seemed to be on a smooth ride until the first domino fell that ballooned into the present-day crisis. 

In April 2019, the world woke up to the shocking ‘Easter Day Bombing’ wherein an Islamic militia group bombed 3 churches and 3 hotels, killing close to 300 people. As expected, the news did not resonate well and deterred any potential tourists. In 2020, the Covid-19 pandemic and subsequent lockdowns exacerbated the vital tourism industry (which had previously contributed to 12% of the country’s GDP), stalled the recovery, and further drained the economy. 

However, the pandemic and its effect on the tourism sector is not the sole reason for the crisis. Every economic crisis is a political crisis and so is this. 

Under the Rajapaksa family, the president, Gotabaya, and his brother Mahinda – who is the Prime Minister – (until recently, the other brother Basil Rajapaksa was the finance minister), the country has been dogged by bungling political and financial management, one after the other.  

Once voted to power in 2019, President Rajapaksa slashed Value Added Tax (VAT) from 15% to 8%. The rationale behind this ‘masterstroke’ was simple. A tax cut would increase the disposable income in the hands of the people which would induce households to increase their consumption. 

This, in turn, would lead to an increase in demand, thereby finally renewing the economic growth. Though this idea is not entirely new and has even been successfully implemented in times of economic hardship, thorough planning and execution are paramount. Riddled with uncertainty and lockdowns during the pandemic, people saved more than they consumed. As a result, the tax slash hardly helped in recovering demand. It yielded the opposite effect of starving the government of much-needed revenue to override the pandemic. 

If this isn’t enough, a bigger blow came on 29th August 2021, when Rajapaksa imposed a blanket ban on the import of chemical fertilisers and pesticides to promote ‘organic farming’. The argument given by Rajapaksa was that Sri Lanka was spending a vast sum of the foreign exchange on the import of fertilisers, whose market, as so he claimed, had turned into an oligopoly. 

He stated that this move would benefit Sri Lankan fertiliser companies and would also improve the health of the population as it shifts towards ‘natural farming’. Since then, crop yields of cinnamon, pepper, tea, cloves, and cardamom, of which Sri Lanka is a major exporter, have dropped by 30% – 40%, causing severe food inflation in the country. 

The crisis worsened when the government announced an economic emergency later in that month amidst rising prices and issued a ‘Public Security Ordinance’ that allowed government officials to seize food stock hoarded by traders and sell them at the government-mandated price. 

Former Central Bank Deputy Governor, W.A. Wijewardena, said that the organic plan was a “dream with unimaginable social, political and economic costs.” What about institutions that limit the power of the President? Could they not do something? Rajapaksa got that covered too. 

In 2020, the Sri Lankan Government passed the 20th Constitution Amendment that directly contradicted democratic doctrines by empowering the president to appoint and dismiss ministers, dissolve the parliament after 1 year from the general elections, and make him immune from legal proceedings.  

Debt and Foreign Exchange

But how does all this tie to the debt and the low forex reserves that Sri Lanka is presently facing? After the Sri Lankan civil war ended in 2009, the country desperately wanted to leave behind its bloodied past and pave the way for modernization. But being a small island without many resources, the Sri Lankan government borrowed huge loans from China in an attempt to boost its infrastructure. 

However, poor monetary management drove the country to a dire situation wherein it had to hand over the newly built Hambantota port to the Chinese in 2017 after it failed to repay $1.4 billion. In 2020, the country’s debt was at 101% of its GDP

So, with mounting debt and a lack of inflows, the foreign exchange reserves depleted drastically. And when it was needed the most, as in the case of the food inflation, Sri Lanka simply had very little forex reserves, as little as $2.8 billion. 

Having exhausted all other options, Sri Lanka printed excess currency to pay off its loans as a last resort. As expected, the printing frenzy weakened the Sri Lankan Rupee and caused high inflation in an already stressed economy that still has to pay over $3billion

The situation has deteriorated since then, with debt amounting to 111% of GDP and forex reserves now lingering at a paltry $1.6 billion.

It must be cautioned that this debt crisis was not something out of the blue. It was always present, just not visible. One of the fundamental problems relating to Sri Lanka’s debt burden is that it faces an information problem: The available published data does not accurately reflect Sri Lanka’s debt burden and its distribution among foreign lenders. Thus, Sri Lanka is limited to reporting on only that portion of external debt held directly by the central government and does not report on external debt held by State-Owned Enterprises (SOEs). 

Using this glaring loophole, the debt statistics can be manipulated by moving the debt from the government to SOE books. To provide a clearer picture, in 2019, Sri Lanka’s total debt to China was $3.3 million. However, this figure only includes the debt of the central government and not the debt the SOEs owe to Chinese firms which stood at $2 million as of 31st December 2019. 

As one might imagine, the failure to properly report public debt owed by the SOEs leads to a significant underestimation of Sri Lanka’s actual debt crisis. 

India & China- The Rivalry Intensifies  

Considering its present scenario, Sri Lanka has sought help from India, China as well as the International Monetary Fund (IMF) to help it overcome its current crisis. It is at this point that geopolitics becomes relevant. 

Ever since the end of the civil war, Indo-Sri Lankan ties have weakened significantly. In recent times, New Delhi is also irked by the increasing dependence of Sri Lanka on China and the sell-out of strategically significant ports. 

For instance, in the case of Hambantota and Colombo, these ports are developed by Chinese construction companies. They are strategically located and are significant points for maritime trade in the Indian ocean as various shipments from the Middle East pass through them. 

The proximity of these ports poses huge security concerns for the Indian peninsula. The construction of renewable energy power plants in Jaffna reinforces the fears among Indian diplomats. Moreover, the recent veiled dig by Rajapaksa on the Quad Agreement is viewed as Sri Lanka’s intent to ignore the concerns of New Delhi and candidly welcome Beijing as a ‘genuine friend.’ 

Furthermore, The Military Assistance Protocol signed between the two countries has amplified India’s worries. Even now, as the nation battles the economic crisis, China was the first country Sri Lanka approached for a $500 million loan and $1.5 billion currency swap as a way of pandemic time support. 

With the situation getting worse, China once again extended a $2.5 billion credit line to weather the crisis. 

Hence, all these circumstances forced the Indian government to intervene and prevent the fast-growing foothold of China in Sri Lanka. One such move was the $400 million currency swap and deferment of loan repayment that was announced in January 2022. Since then, India has extended a $500 million credit line for the purchase of fuel and another credit line worth $1 billion was signed between the 2 countries. 

The Indian Oil Corporation (IOC) also announced that it would release 6000 MT of diesel to help the island nation mitigate its power cuts. The two countries signed the deal to jointly develop the Trincomalee oil tank farm along the North-Eastern coast of the island. 

The strategically positioned tank farm provides India with some traction in Sri Lanka and is a clear stand against the growing Chinese investment. 

What Lies Ahead?

In such a deteriorating situation, Sri Lanka faces tumultuous days ahead. If we take a decades-long view, Sri Lanka’s economic trajectory was obvious, and its impending sovereign default a foregone conclusion. 

Attributing the high external debt repayments, inflation, and the forex crisis, the Covid-19 pandemic alone would be ghastly inaccurate. The poor, brash and inefficient fiscal management by the Sri Lankan government, fueled by extreme populism and increasing dictatorial power are some of the primary reasons why Sri Lanka is in its present state. 

Despite all the help around from its neighbors and perhaps, even an IMF bailout, there seems to be no light at the end of the tunnel for Sri Lanka as of now. 

Sashank Rajaram is a 1st-year Undergraduate student at Ashoka University, pursuing an Economics Major and Political Science Minor.

Image credits – CNBC

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