Sri Lankan Crisis: Lessons To Be Learnt

Prof. V.P. Gupta

Director, Rau’s IAS Study Circle, New Delhi – Jaipur – Bengaluru

The recent debt crisis in Sri Lanka has one clear lesson for policymakers across the globe—the common citizens have to pay the price for fiscal profligacy and overlooking of macro-economic stability. Sri Lanka for the first time in its history defaulted on its foreign debt payments as it has forex reserve plummeted to $50 million while it had to pay $7 billion of foreign debt payment obligations in 2022.

Prior to the pandemic Sri Lanka was classified as an upper middle-income country by the World Bank. Today, over half a million people from the country have sunk back into poverty. Soaring inflation and rapidly depreciating currency have forced Sri Lankans to cut down on necessary consumption. The situation of the country is in such a crisis that Sri Lanka does not have enough foreign exchange to import fuel, medicines and other important necessary goods and services. Examinations had to be cancelled as Sri Lanka did not have enough resources to import ink and paper.

The economic instability also resulted in a political storm in the island. The suffering people of Sri Lanka came into the streets against the incumbent government. There were widespread calls for regime change. The coalition government headed by Gotabaya Rajapaksa and Prime Minister Mahinda Rajapaksa seemed to be on backfoot. Prime Minister Mahinda Rajapaksa stepped down and seemed to have escaped the country. The combined political and economic storm does not augur well for Sri Lanka.

Let us look at the reasons for this economic turmoil.

Reasons for financial crisis:

The Present Government headed by President Rajapaksa came into power in 2019. He initiated changes in the economic policy which have led to the present crisis. However, there are also some international reasons such as Covid-19 pandemic and Russian war with Ukraine.

1. Large tax cuts led to fiscal instability: In line with his election promises, President Gotabaya carried on large changes in the fiscal policy. The Value Added Tax (VAT) was reduced to 8% from 15% before that. Other levies such as 2% tax on domestic goods and services for funding infrastructure in the country was also removed. Capital gains tax on stocks was also removed. These tax changes led to Sri Lanka losing 1 million taxpayers from the tax net. Post the tax cuts, international sovereign credit rating agencies downgraded Sri Lanka’s credit rating making it difficult for Sri Lanka to access international financial markets. All this was happening when the global economy was plagued by the Covid-19 pandemic, leading to GDP contraction and increased fiscal expenditure for vaccination and providing economic support to ailing business and people led to zooming of fiscal deficit of Sri Lanka.

2.        Tourism got hit hard: Tourism which was one of the  mainstays of Sri Lanka’s economy got hit hard due to the Covid-19 pandemic. Sri Lanka earned $4.4 billion in foreign exchange from tourism in 2018. However, this figure dropped steeply to $200 million in 2021 due to the Covid-19 pandemic. Also, about 30% of visitors to Sri Lanka are from Russia, Ukraine, Poland and Belarus. The recent Russo-Ukrainian war has resulted in tourism not returning to its full potential even as the impact of Covid-19 has reduced.

3.  Move to Organic farming backfired: President Gotabaya Rajapaksa last year mandated for the island country to shift to organic farming and shunning of chemical fertilisers. This led to steep fall in agricultural production. Sri Lanka, which was self-sufficient in Rice, became a net importer of rice.  Rice production in Sri Lanka reduced by 20% and Sri Lanka was forced to import $450 million worth of rice. Export earnings from globally famous Sri Lanka Tea, which is one of the main export commodities for the country, fell steeply. Good sense has prevailed, and Sri Lanka has decided to step back from this policy.

4.  Russia’s war with Ukraine: The Russian ‘special military operation’ against Ukraine added fuel to the fire and made things worse for Sri Lanka. The conflict led to global rise in crude oil prices, which led to increased foreign exchange outgo for financing oil & gas imports. Also, this has increased the prices of other important commodities such as fertilisers, oilseeds, etc.

5.  Costly infrastructure projects: The Sri Lankan government indulged into a series of costly infrastructure projects, expecting strong revenues and economic growth. The two marquee projects of Hambantota Port and Colombo Port City together costed Sri Lanka $17 billion despite not generating any profits for it. The $15 billion Colombo Port City Project was to house a special economic zone that would attract investments from domestic and foreign companies via tax exemptions. Hambantota Port in the southern part of Sri Lanka is located in the political stronghold of Rajapaksa family. Despite promise, these projects failed to generate any profits for Sri Lanka. Even more, Sri Lanka had to take costly loans to fund them and there is a fear of them falling in the hands of Chinese government.

Lessons from the crisis

1. Abide by the gold standard of spending within our means: This age-old wisdom is true for individuals and countries. Often countries indulge in politics of freebies and large, big-ticket expenditures which do not make economic sense. Politicians who are focused on winning elections promise these not realising the cost future generations will have to pay. The principle of inter-generational equity demands that debt of countries needs to be sustainable and fiscal deficit be in check. Only this will allow and create conditions for long term sustainable growth and development.

2.  Social security net for citizens is an essential: Crises are unpredictable and despite best efforts can come. Be it the Covid-19 pandemic or macroeconomic crises, the worst sufferers are the common people. This calls for countries to develop a robust social security system which takes care of vulnerable in times of need.

3.  Reworking of sovereign debt crises response system: The G20 introduced the Debt Service Suspension Initiative and after its end, the G20 Common Framework for Debt Treatments for Least Developed Countries. The scope of these initiatives needs to be widened. Global institutions such as IMF which is the lender of last resort need to be well capitalised with necessary quota and governance reforms to reflect the increasing weights of developing countries in global economy.

India came to help of Sri Lanka during the crisis giving crucial supplies of fuel and dollar swaps. The support of India has enhanced India’s profile in Sri Lanka as a trusted ally. This has been only possible due to resilience of Indian economy. Going forward too, the principle of fiscal rectitude and inter-generational equity should inform to ensure macro-economic stability as this not only wins us friends in the international arena but also improves lives of our citizens.

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