Foreign Policy
5/1/2022

The Sri Lankan Economic Crisis

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The Sri Lankan economy is currently in the worst economic state it has been in since its independence. This brief explains how ineffective government policy in Sri Lanka has inevitably led to a larger-scale fiscal crisis. It details the political and economic fallout following the initial beginning of the crisis, as well as how international forces have come to Sri Lanka’s aid. Finally, the brief analyzes the current state of the country’s economy and proposes various methods for Sri Lanka’s economic recovery.

Introduction

In September of 2021, Sri Lankan President Gotabaya Rajapaksa declared an economic emergency3 This allowed the Sri Lankan government to take control of the supply of basic food items and set price controls on rising inflation, which spiked to 14.2% in January.3 Since then, the status of the economy has only worsened, and by April 2022, the inflation rate reached near  30%.4 Furthermore,  prices across the country have soared, rendering thousands unable to afford basic necessities. 

Pointed Summary

  • Growth of civilian protests across Sri Lanka 
  • Violence against Sri Lankan protests escalate the conflict 
  • Demands for governmental reform 

Relevance

In response to rising prices and the failing economy, Sri Lanka has been engulfed by protests.31 These protests have appeared all throughout the country, with some taking a violent turn between protestors and Sri Lankan police. Namely, in late April, Sri Lankan police opened fire at protestors in the central town of Rambukkana, ultimately killing one person and injuring 14 others.5 The event only caused greater outrage among Sri Lankans, which grew as the economic crisis continued to worsen. People continue to take to the streets demanding a change in prices, as well as a change in the Sri Lankan government. To understand the views of Sri Lankans, it is important to look at the fiscal policy taken up by the Sri Lankan government over the past two decades. 

History

As hundreds of protestors flock to the streets of Sri Lanka in response to the deepening economic crisis, many point out the decades of economic mismanagement by the Sri Lankan government, specifically the exacerbation of the government’s twin deficit – a deficit encompassing a budget shortfall alongside a deficit in the current account.13 The Asian Development Bank explains that the twin deficit is a clear signal that Sri Lanka’s “national expenditure exceeds its national income,” along with the many inadequacies in the production of goods for trade.13

As such, the deficit has, unfortunately, created a situation where the country now has a public debt that has risen from 94% of Sri Lanka’s GDP in 2019 to 119% in 2021.26 Furthermore, Sri Lanka’s strategy of relying on foreign loans from China and India has resulted in the exponential growth of its debt, which amounted to $56.3 billion in 2020.26 

However, much of the anger from protests in early April was directed at the Rajapaksa family, who has held power in Sri Lanka for over two decades.34 While in power, members of the Rajapaksa family placed a significant burden on the Sri Lankan economy through excessive spending and ineffective fiscal policy. For instance, Mahinda Rajapaksa, who served as president between 2005 and 2015, gave into massive foreign investments from mainly Chinese capital for infrastructure projects, but these investments provided low returns.2 As a result of excessive spending and failed overseas projects, Sri Lanka grew heavily indebted to foreign countries, with nearly $35 billion in foreign debt.39

Although in 2015 President Mathripala Sirisena and Ranil Wickremasinghe took over, the economic state of the country worsened, accompanied by rising corruption in the government. Then, the unraveling of Sri Lanka came with the election of Gotabaya Rajapaksa who was tasked with dealing with tax reforms and fuel prices. Instead of focusing on the accumulating debt of the nation, he leaned on sensitive issues such as “divide ethnonationalism” and passed the 20th amendment to undermine the investigation of corruption and allegations.2 These policies have allowed the government to consolidate its control without any fear of major repercussions, that was until recently. 

Tried Policy 

Following the election of Gotabaya Rajapksa in 2019, as promised during his presidential campaign, Gotabaya announced sweeping tax cuts, which reduced the value-added tax from 15% to 8%.25 However, the finance minister at the time, Mangala Samarawe, emphasized that such an action would devastate the country, as Sri Lanka is a country that has consistently had a budget deficit.25 By cutting taxes, the government has less revenue to spend on necessary goods for Sri Lankans, specifically imported goods. As stated previously, Sri Lanka has both a budget deficit and a trade deficit, meaning a significant portion of goods in Sri Lanka are imported from other countries. Most notably, Sri Lanka imports 25% of its oil and around 85% of its pharmaceuticals.30,10

With no tax revenue to finance foreign goods or pay off large foreign debts, the Sri Lankan government had to fall back on foreign reserves. However, reliance on foreign reverses would be lost as a result of the 2019 Easter Bombings, in which Islamic terrorists bombed three Sri Lankan churches and luxury hotels.7 The attack killed 290 people, causing fear not only among Sri Lankans but also among prospective tourists. Tourism accounted for nearly 13% of Sri Lanka’s GDP in 2019 but fell to 1.1% after the terror attacks.23,4

While Sri Lanka’s tourism industry was near recovery by the end of 2019, the COVID-19 pandemic shattered all hopes of a revival, as revenue from tourism dropped to only 0.8% of Sri Lanka’s GDP in 2020.20 As such, barely any foreign currency entered the country, and all the while the Sri Lankan government continued to use up the last of its reserves. By April of 2022, the country’s foreign reserves shrank from $6.9 billion in 2018 to $2.2 billion.40 In order to maintain its remaining foreign currency, the government banned the importation of chemical fertilizer,  although Gotabaya attempted to disguise the move as a push toward organic farming. 30

Nevertheless, instead of aiding the economy, the ban disrupted the entire Sri Lankan agricultural chain, which accounts for around a third of the labor force and 8% of its GDP.30 As a result, export revenue from key agricultural goods, such as tea, dried up. In the end, the Sri Lankan economy is in the worst state it has been in over 70 years, as recently the country defaulted on $51 billion dollars of external debt, and inflation reached record highs.14 

Current Stances 

Shortages of food have plagued the country, as the prices have skyrocketed.22 Shortages of necessities like cooking gas, petrol, electricity, and milk powder have also gotten significantly worse. Inflation has also skyrocketed to 30%.4 The Sri Lankan Rupee has depreciated 12%, which has made the currency practically worthless.21 Sri Lanka imports about 85% of its medicine, and due to the economic crisis on hand, doctors and pharmacies are running out of medication.12 Due to rising prices, the poverty rate has risen 2.5% since 2019.28 One of the prime reasons for this rise in poverty is the failures of the Samurdhi program, Sri Lanka’s social safety net, which only is able to help about half of those in the island nation currently experiencing poverty. In reaction to rising poverty, on March 31st, demonstrators attempted to storm the home of Sri Lankan president Gotabaya Rajapaksa.

The Sri Lankan government has been plagued by the chaos following the protests. A State of Emergency was declared on April 1st, but revoked on April 6th.36 The vast majority of the Rajapaksa Cabinet, including Gotabay Rajapaksa's brother, Namal, resigned from their posts in response to the protests.37Troops have been deployed in response to protests.11 To alleviate economic stress, the government of Sri Lanka announced debt restructuring which includes the policy that all creditors will be treated the same. 38

Policy Questions

Problem

Stakeholders 

In light of Sri Lanka’s economic turmoil, several nations have extended economic aid.  After extending a $1.54 billion currency swap and a $700 million loan to Sri Lanka in 2021, China was passive after Sri Lanka asked for further aid. However, after months of silence, China has announced an urgent emergency humanitarian aid of around $31 million.6 Experts speculate the possibility of “debt-trap-diplomacy,” where China would allow Sri Lanka to take out loans despite not being able to pay them fully.8

China has long been accused of using debt traps to coerce dependence from developing nations. For one, Sri Lanka’s past inability to pay debts resulted in a 99-year lease of the Hambantota Port to China, where China ultimately acquired 70% ownership of the port.1 Since January 10, Sri Lanka has sought to delay repayment of $11 billion but has been met with silence from China.

Gulbin Sultana, an associate fellow for Defense Studies and Analyses, comments on China’s refusal to reschedule loans:  "China wants to take advantage of Sri Lanka's inability to repay loans in time. Beijing is waiting for a good time to enter into a debt-to-equity swap and acquire land in Sri Lanka.” Nevertheless, Colombo-based think tank Verité Research states that China has just contributed to 15% of Sri Lanka’s foreign debt, indicating that Chinese debt-trapping may not be the root of Sri Lanka’s struggles.

Meanwhile, Bangladesh has extended a $200 million loan to Sri Lanka, while India has committed financial aid of $2.4 billion for necessities such as food and oil.29 Within a week, 16,000 Megatonnes of rice have been supplied under India’s support package. Yet given continuing predicaments, Colombo has continued to seek further aid from its neighbors.18 

Nonpartisan Reasoning

At first, Sri Lanka dodged negotiations with the IMF due to conditions attached to the relief package, instead of leaning on countries such as China and India.  In March, however, Sri Lanka’s central bank devalued the rupee by up to 15%, which analysts interpret as a step to obtain an IMF loan to help debt restructuring and bolster currency reserves.19 On the brink of bankruptcy, Sri Lanka began talks with the IMF in April for Rapid Financing aid to mitigate supply chain issues.35 The IMF, though initially hesitant, has now pledged to “support Sri Lanka’s efforts to overcome the current economic crisis”.16 

Policy Options

As Sri Lanka fails to make an economic recovery and the government faces increasing political pressure from angered citizens, a policy shift is imminent. There are three primary ways this change may manifest, including a hybrid option of the policies outlined: 1) a comprehensive bailout from the International Monetary Fund (IMF); 2) significant alternative foreign assistance from non-Western nations; and 3) structural government reform. 

IMF Bailout

The IMF has a long, controversial history of bailing out debt-ridden countries, and, despite initial hesitancy, the Sri Lankan government appears to now be taking steps to partner with the fund. After pausing external debt payments in early April, Colombo announced it would be refinancing and restructuring these obligations following the economic advice and counseling of the IMF.24 

This, necessarily, means the government will be obligated to undergo severe austerity measures as demanded by the IMF, including a tighter monetary policy and higher taxes. Such measures are just the baseline, as the IMF’s vagueness regarding certain “structural issues” in Sri Lanka opens the door for more strict measures – “privatizing [ . . . ] state-owned enterprises, increasing charges for utility services such as water and electricity, and slashing subsidies on essential goods.” 

These austerity measures will push the limits of Colombo’s political legitimacy. Social unrest stemming from accusations of the government’s economic mismanagement is already straining Rajapaksa’s political control, and policies that limit government assistance and risk increasing the price of common goods and utilities may cause escalation. Lacking trust and political legitimacy, implementing such measures while minimizing the risk of social upheaval stands to be a large challenge for the administration. 

Even in the case where Rajapaksa is able to enforce the austerity measures that the IMF requests, it is unclear whether this will lead to the long-standing stability of the Sri Lankan economy. The IMF’s bailout system has long been criticized for allowing problematic governments to remain in power while the structural and systemic issues that lead to the crisis the country faces are met with surface-level solutions in the form of large influxes in foreign dollars.27 There also exists substantial critiques of the neoliberal system that the IMF promotes, prioritizing growth over all else and allowing for unsustainable economic inequality to manifest.9 k,

Alternative Foreign Assistance

Up to this point, there have been two primary actors in Sri Lanka’s attempt to receive alternative forms of foreign assistance – India, and China. Most recently, India increased its commitment to Sri Lanka by $500M, extending its $1.5B credit line to the country significantly.17 China, on the other hand, has been more hesitant to offer its support for Colombo. Beijing has provided the country with some funds, $31M, serving more as a diplomatic smoothing-over than genuine financial support. China’s hesitancy to engage with Sri Lanka represents a shifting philosophy in Beijing whereby the government is refining the aims of its Belt and Road Initiative in an attempt to minimize its involvement in messy domestic political affairs.15 

Despite its newfound willingness to engage with the IMF, Sri Lankan government officials have expressed a desire to avoid interactions with the IMF unless forced to do so.32 There is, in the case of sourcing external funding, a binary to be had: either China and/or India move to pull out the checkbook, or Sri Lanka is coerced by economic and political pressure to continue pursuing relief from the IMF.

Structural Governmental Reform

Even if the money exists, being provided by the IMF or China/India, substantial government reform is needed to ensure a) the measures demanded by the IMF are able to be effectively implemented and/or b) the funds provided are effectively allocated by the Sri Lankan government. 

Sri Lanka’s present struggles are, at least in part, a function of economic mismanagement, and reforms to the system that created the crisis are prerequisites to its resolution. The acquisition of large amounts of debt in order to finance popular infrastructure projects initiated Sri Lanka’s debt struggles, encouraging irresponsible finances motivated by political ambitions.33 Reducing the power of the Sri Lankan executive to pursue populist policies and create a nepotistic government is a first step in distributing control and enforce stability through a more parliamentary system – rebuilding the political legitimacy needed to convince prospective financiers that reform is being taken seriously.

Conclusion

While the specifics and actors regarding Sri Lanka’s debt restructuring and refinancing may be up for contention, government reform is necessary. The IMF and China/India may be able to motivate some reform by conditioning financial assistance, but lasting efforts will start on the streets. Maintaining and increasing domestic and international pressure on the administration represents the fundamental first step in resolving the economic crisis via political mechanisms.

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