The Deep Roots of Sri Lanka’s Economic Crisis

As Sri Lanka faces its worst economic crisis since independence, it is high time – not just for the Sri Lankan political elite, but the world at large – to reflect upon how the country got here. President Gotabaya Rajapaksa’s resignation and subsequent exit from the country has put Sri Lanka back in global headlines. To make sense of the current political and governance crisis, however, we must examine the crisis’ economic origins.

The immediate crisis is the persistent shortages of fuel, gas, and other essential items in Sri Lanka, due to a shortage of foreign exchange. The country and its people have scant options to address the issue. An IMF bailout has become a must, as currency swaps with India and China alike have been insufficient in ameliorating the foreign-exchange crisis. Yet the IMF will set strict conditions, including a necessary consensus from the creditors regarding debt restructuring. That looks unlikely at the moment, with one of the major bond-holders of the government filing a lawsuit against the Sri Lankan state for a bond payment due in July 2022. Sri Lanka can neither get more foreign exchange, nor more debt relief, without substantial and shocking readjustments to its domestic economy.

The ongoing economic crisis is thus two-fold. The first constitutes the foreign exchange crisis – the Sri Lankan economy’s foreign reserves were decimated as a result of the ongoing pandemic and travel restrictions, but also substantial uncertainty over consumer confidence and the state of the economy. The second is the debt crisis – the Sri Lankan state is fundamentally incapable of repaying the vast loans it has taken out, from countries including, but not limited to, China, but also from international markets.

So how did Sri Lanka get here?

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A Short Economic History of Contemporary Sri Lanka

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Some might argue that much of Sri Lanka’s current fiscal malaise began with the tax cuts given in 2019. Prior to the tax cuts, Sri Lanka had achieved its first primary budget surplus in decades and had largely been on track to resume its status as an upper-middle-income country per World Bank standards. The tax cuts increased fiscal deficits, culminating in international rating agencies downgrading Sri Lanka’s credit rating, and thus shutting the country off from much of the international capital market.

In a stroke of truly atrocious timing, this was followed by a historic pandemic that further weakened the tourism industry, which was just recovering from the Easter attacks of May 2019. The pandemic’s spillover implications on Sri Lankan workers working abroad also precipitated a fall in expatriate remittances – a major source of foreign currency for the country. In addition, the decision of the government to ban chemical fertilizers and shift to organic farming overnight led to a 50 percent drop in agricultural output. This adversely affected the tea industry hard, which had been another major source of foreign exchange.

Yet to concentrate on only the past five years would be a fundamental error. The Sri Lankan economic crisis cannot be attributed to governmental undertakings and blunders across the past few years alone. It behooves us to reach for structural explanations. Macro risk factors, such as a 26-year-long civil war, the persistence of terrorism and violent incursions by fringe groups, public skepticism toward competitiveness-oriented privatization, and a cultural predisposition against FDI and raised taxes, have all engendered what we term “systemic fragilities” within Sri Lanka, awaiting triggers that would ignite the flashpoints.

Let’s delve into some of these factors in turn, staring with the nature of Sri Lanka’s indebtedness. From the 1970s to the mid-2000s, Sri Lankan debt had predominantly consisted of low-interest-rate loans from multilaterals. Yet much of this changed during the mid-2000s, which saw the country reorient itself to foreign investors and lenders alike. Sri Lanka issued its first international sovereign bond in 2007 – one with higher interest rates, designed to draw investors. Unfortunately the money was used to fund, under governmental directives, projects with limited to no national utility, pursued largely for the sake of political vanity, such as the Colombo Lotus Tower.

Certain decisions undertaken by the Mahinda Rajapaksa (the older brother of recently resigned President Gotabaya) government in the 2000s paved the way for the demanding debt conditions that Sri Lanka finds itself in today, whether it be in relation to the Chinese government (10 percent or so of the country’s debt), or, indeed, European and American financial institutions (over 80 percent). While some rightly note that Chinese involvement in Sri Lanka had steadily increased over recent years, talk of China of instigating “debt trap diplomacy” in Sri Lanka is overblown, as per the persuasive deconstruction done by academics such as Deborah Brautigam. In Sri Lanka, as elsewhere, domestic economic problems have domestic origins.

The second factor is the populist macroeconomic policies pursued by political parties. Sri Lanka has had a long history of political parties winning elections on claims of sweeping, unrealizable promises. The public had often been promised many things before an election, such as low priced bread, subsidized rice, free fertilizer, public sector salary increases, and tax cuts. Voters expecting these promises to be fulfilled – without questioning them substantively, given the low-information and oft-opaque media environment – become ostensible evidence for the credibility and legitimacy of successive governments that underdeliver upon their economic commitments.

Structurally, the centrality of rural populations to Sri Lankan elections has produced economic policies aimed at stifling, as opposed to promoting, competition. This also explains Sri Lanka’s repeated failures to liberalize its economy – with significant tariffs imposed on imports, and a broader focus on import substitution, modern Sri Lanka had struggled with its export industry, mainly because the beneficiaries of exports are unlikely to hold as much political sway or influence as their anti-establishment opponents. With a perennially hamstrung export sector, the country has come to rely heavily on expat worker remittances, the apparel industry, and tea exports for its foreign exchange – all industries that were heavily hit by the raging pandemic.

Finally, the Sri Lankan state’s overbearing transfer payments and subsidies are fundamentally rendered futile under the double whammy of over-bureaucratization and inefficient deployment of state subsidies. For a country of 22 million people, Sri Lanka has a public sector workforce of 1.4 million employees. In 2019, a full 36 percent of government revenue went to pay for the salaries and pensions of present and past state sector employees. This is not only unsustainable but hardly leaves any money for development in the education and health sectors, which collectively receive less than 1 percent of GDP in government spending.

Systemically, generations of pork-barrel politics and short-term economic thinking have seen Sri Lankans offered rice, electricity, fuel, and gas at lower rates than the market price. Removing or reducing these subsidies has remained politically unpopular. As a result, governments have shied away from structural reforms to state-owned enterprises – which would render, through cost-cutting and efficiency-improving measures, price-raising nigh-impossible to avoid. With these embedded incentives, firms such as the Ceylon Petroleum Corporation and the Ceylon Electricity Board have suffered vast deficits and losses at the hand of an ineffectual state.

Change Must Come Through Radical Economic Reform

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Liberalization – not further entrenchment – of the national economy, is the only way out of the current conundrum. Sri Lanka is in dire need of radical economic reforms, ones that liberate and emancipate, as opposed to entrapping its population under the shackles of bureaucratic ineptitude and kleptocratic governance.

First, tax reforms are needed. Less than 2 percent of government revenue comes through direct taxes and only 1 percent of the population come under the requirement to pay income taxes. An increase in direct taxes and widening of the tax base are long overdue. Sri Lanka currently has a very low tax-to-GDP ratio – just above 8 percent at this time. It was 12 percent to GDP prior to the aforementioned cuts. Not only is the tax revenue low, but direct taxes amount to a dismal 2 percent of GDP.

With the bulk of government revenue coming from indirect taxes, it is the ordinary consumers, as opposed to the biggest earners, who end up paying the most. The taxation system is both inadequate and regressive. Sri Lanka needs a more progressive and effective taxation system that makes the wealthy pay their due share. To preempt concerns pertaining to capital flight, the government must implement more transparency-centric regulations that ensure the property rights and business interests of the burgeoning upper-middle and middle classes – the bulwark of the Sri Lankan economy’s growth in the future.

Second, politicians must stop taking people’s preferences for granted – or, worse yet, as tools to be used to get elected – without paying heed to the underlying social dynamics. The Sri Lankan people deserve a real and proper say. Educating people on how the government runs financially in accessible language and with full access to information is needed to make people understand that populist policies will be detrimental to long-term recovery. The people are not to blame, but those who wield cultural and media influence are. A drive to encourage entrepreneurship among the population is needed, given that Sri Lanka has a very low percentage of entrepreneurs, accounting for less than 3 percent of the population. Other countries in the region have much higher figures, with Bangladesh, for instance, at 12 percent.

Third, Sri Lanka must shrink the state – within reason and with pragmatic prerogatives in mind. A restructuring and overhaul of state-owned enterprises (SOEs) is needed for the administration to achieve fiscal discipline. The Sri Lankan government spends far too much on catering to those who are supposed to work for the people, and not enough on the people themselves. Many SOEs can be privatized, specifically in areas where natural monopolies, paired with market incentives and regulatory mechanisms, would yield far better results than state-sponsored monopolies and oligopolies. A good example would be Sri Lanka Telecom, which was privatized in 1997, with 35 percent of its shares sold to a Japanese investor. Sri Lanka Telecom is one of the best performing corporations that remains partially, but not fully, owned by the government. This model of privatization can be emulated across other SOEs.

Fourth and most fundamentally, Sri Lanka needs to shift toward an export-oriented economy and this requires proactive changes on many angles. To begin with, Sri Lanka must reduce its import tariffs to make raw materials cheaper for export-based companies. Free trade agreements with regional partners – including but not limited to the Gulf countries, Bangladesh, and Thailand – are needed; Sri Lanka is only party to 3 FTAs at the moment. In the long run, Sri Lanka must look to improving consumer and investor confidence, through introducing powerful, thorough regulatory changes. Much of this can be done – but it must be done swiftly, in conjunction with political and structural reforms. Otherwise, it will be too late for the economy to be genuinely salvaged.

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