Sri Lanka’s economic crisis: A new regime, politics at play?

27 June 2022

As the saying goes, “every crisis is an unexplored opportunity”. But the costs of such opportunities lie in hard-learned lessons, deeper reflections, and warnings that were not heeded in time. The economic system across the world that primarily shapes modern-day societies and cultures is a continuously evolving system, often recrafted from the key learnings of the preceding crisis. The recent economic crisis in Sri Lanka is not new to this phenomenon. Although, the novelty of the crisis lies in its origins: in the country’s political institutions and Chinese “debt-trap diplomacy”, as opposed to the phenomenon of the Asian economic crisis in 1997.

The importance of political economy in mainstream economic outcomes across the world has never been more precisely visible and coordinated than what many developing and developed economies are witnessing today. The unprecedented economic woes and the political destabilisation in Sri Lanka are small yet significant examples of a politics-led economic crisis aggravated by many intermittent regional and global shocks to the system, including the COVID-19 pandemic and the war in Ukraine.

Sri Lanka’s miracle decade and the present crisis

Sri Lanka’s economy enjoyed a decade of growth from 2002 to 2012, reaching a nominal GDP of USD 84 billion in 2019, a year before the COVID-19 pandemic rocked the world. Lifting millions out of poverty, Sri Lanka’s economic growth managed to reap significant demographic dividends, nearly quadrupling its GDP per capita to USD 4,057 by 2019 (relative to 2002 levels). Its average growth rate of approximately 5-6 per cent during this period was considered a miracle among South Asian economies. Sri Lanka used its strategic geographic location and the comparative advantages of cheap labour, attractive investment policies, and its popularity as a tourist destination to sustain its economic growth trajectory. The apparel manufacturing industry, infrastructure projects, and tourism industry witnessed a boom from 2002 onwards.

It is often observed that the dismal performance of a country on socio-economic-political indicators is indicative of the value extracting role of elites in that country and vice versa for the value contributing elites.

However, 20 years later, Sri Lanka’s economic credentials are not only bleak but have reached a crisis, which is worsening every month. The country defaulted on its USD 51 billion foreign debt, with debt service repayments of international sovereign bond (ISB) of approximately USD 1 billion. On top of that, it has other debt repayments amounting to USD 3 billion in 2022. Credit agencies have downgraded the country to a “default status”, cutting Sri Lanka’s access to international capital markets. The dipping of Gross Official Reserves from USD 10 billion in March 2018 to usable foreign exchange reserves standing below USD 50 million, as of May 2022, has made it difficult for Sri Lanka to service its foreign debts. Inflation has been soaring, reaching 29.8 per cent in April 2022, up from 18.7 per cent in March 2002, compounding the country’s inability to pay for essential imports of fuel and food. Coupled with long hours of power cuts, the economic crisis has brought both personal lives and production across key industries to a complete halt.

The twin supply shocks caused by the pandemic and the Ukraine war have not only hiked fuel and food prices across the globe and diminished Sri Lanka’s tea exports, but they also drained the country’s flourishing tourism sector (which was already experiencing a dip after the deadly Easter Day bombings in 2019) that contributes 10 per cent of GDP. Tourism revenues fell from a peak of USD 4.3 billion in 2018 to roughly USD 500 million in 2021 — the lowest level in eleven years.

How is this crisis different?

Sri Lanka’s economic troubles today indicate a systemic crisis, with its roots in a globally coordinated political economy and the rise of China’s “debt-trap diplomacy”. Although Sri Lanka’s ‘unsustainable debt’ and ‘balance of payment crisis’ is reminiscent of the 1997 Asian crisis, its essence is very different. The Thai central bank’s decision to abandon the baht’s fixed exchange rate system to the US dollar, followed immediately by the sudden devaluation of the baht in July 1997 due to the massive capital outflow spree, surprised the Asian markets. It exposed the unregulated and risky banking sector to exchange rate risks, leading to the twin balance-of-payments and banking crisis across Asia. However, the origins of the 1997 Asian contagion were in the US dollar gaining strength due to increasing US interest rates and stronger recovery prospects of the economy after the recession in the 1990s.

In contrast, the roots of the current Sri Lankan crisis lie in, first, President Gotabaya Rajapaksa’s nationalistic and authoritarian policy choices and, second, an inclination towards Chinese lenders that ultimately saw Sri Lanka fall into the Chinese “debt-trap diplomacy”. After winning the presidency in 2019, backed by the dominant Sinhalese Buddhist community votes, Rajapaksa’s administration inherited high levels of debt that rose to unsustainable levels in the wake of authoritarian decisions such as abandoning a debt management plan, announcing tax cuts and 100 per cent organic farming, as well as multiple global supply shocks due to the COVID-19 pandemic, the global decline in tourism, and the Russian invasion of Ukraine. These shocks choked the Sri Lankan economy, leading to massive capital outflows, depletion of foreign exchange reserves by up to 70 per cent, and devaluation of the currency. They prevented the government from servicing its sovereign debt payments.

Domestic front: The national policies

Disregarding a 2019 debt management plan focused on narrowing the fiscal deficit, in 2019 Rajapaksa’s government not only introduced deep tax cuts (such as decreasing VAT from 15 to 8 per cent across all income cohorts) but also imposed an overnight ban on imports of chemical fertilisers in 2021 to make agriculture 100 per cent organic. This led to a decline in rice production by 25 per cent in 2021, forcing the country to import more rice and affecting the livelihoods of farmers. Both the tax cuts and the introduction of organic farming were a part of Rajapaksa’s 2019 election campaign. Also, the ban on luxury goods like perfumes, automobiles, and electrical appliances in 2021 (carried out to halt the outflow of foreign exchange reserves) indicated an ailing economy. This move halted the operations of many small businesses that were completely reliant on imported goods.

The tax cut sent the economy into a downward spiral. Instead of boosting investment and opening spending channels, it catered to the extractive business models of the Sri Lankan elites. The Elite Quality Index (EQx) 2022 ranks Sri Lankan elites at 116 out of 151 countries included in the Index. EQx 2022 is a political-economy index that uses 120 indicators to measure how the choice of business models undertaken by elites (political and economic) either contributes value-driven resources or value-extractive resources in a particular society. It is often observed that the dismal performance of a country on socio-economic-political indicators is indicative of the value extracting role of elites in that country and vice versa for the value contributing elites. Hence, a country’s elite play an important role in shaping its society and economy. The quality of Sri Lankan elites ranked poorly and with a score of 43.9 indicates that the country’s business elite are of ‘middle quality’. ‘Economic power’ which measures the dominance of elites in the economy, is even more concentrated than political power in Sri Lanka. Paradoxically, the economic elite is more extractive than the political elite. For example, the degree of firm dominance (ranked 145/151), which measures the concentration of power in the hands of Sri Lanka’s leading firms is pathological.

The dismal performance on multiple social indicators — from social/religious hostilities and human rights to economic indicators, including the proportion of women in senior management positions and R&D — reflects the value extracting character of Sri Lankan elites. The female labour force participation at 31 per cent is less than half that of the males (73 per cent). With half of society excluded from the workforce to such a high degree, Sri Lanka’s GDP is one-third lower than it could be in a more balanced economy. A more female-inclusive labour force expands the labour income pool base, and further creates more avenues of employment and services. Moreover, a balanced labour force also reflects the ‘social equilibrium’ aspect of the GDP. Despite the indications of mounting external debt, the need for controlling fiscal deficit by the Asian Development Bank in 2019 and a series of downgrades by rating agencies in 2020, politically-motivated economic policies pushed Sri Lanka to its first-ever default.

International front: Chinese debt-trap diplomacy

Since 2007, a crucial part of Sri Lanka’s ‘unsustainable debt’ lies in its involvement with massive high-yielding, sovereign debt-backed infrastructure projects. Of significant importance is the country’s enthusiastic participation in Beijing’s Belt and Road Initiative (BRI). Of the total USD 51 billion debt, sovereign bonds alone constituted a USD 12.55 billion debt in May 2022. Chinese lenders, with 10 per cent of this total debt portfolio and tricky payback conditions upon default, has and will turn out to be costly and dangerous to the economy. A prime example of Chinese “debt-trap diplomacy” has been the leasing out of the Hambantota port to a Chinese company for 99 years in 2017 after a loan default. Further potential defaults will not only ensure losing other infrastructure but will also give China undue political leverage in South Asia.

Lessons for the way forward

Despite all this, a series of opportunities lie ahead, apart from debt restructuring plans and IMF bail-out packages. Sri Lanka should implement reforms to ensure greater political accountability and inclusiveness in political decision-making. It should turn away from the authoritarian way of politics and revise tax regimes (especially to the benefit of elites) and adopt a more export-driven growth strategy to embrace the true benefits of globalisation and prepare for automation shocks in the future. On the political and regional front, Sri Lanka should take steps to renew its ties with India and initiate a robust effort to revive the South Asian Association for Regional Cooperation (SAARC) to address the need of the hour. True regional cooperation will ensure social peace, greater regional stability, and political strength to the benefit of all the member countries.

DISCLAIMER: All views expressed are those of the writer and do not necessarily represent that of the 9DASHLINE.com platform.

Author biography

Dr Neha Gupta is a Lecturer of economics and Visualization Manager at EQx at the University of St. Gallen. Prof. Guido Cozzi is Professor of Macroeconomics at the University of St. Gallen Image credit: Flickr/Department of Foreign Affairs and Trade.