Sri Lanka’s national economic crisis and its impact on foreign relations with China

10 March 2022

Sri Lanka’s latest national economic crisis is also triggering a crisis in its foreign policy. The country’s government is compelled to diversify its foreign policy engagement in order to manage (among other issues) the problem of paying off its relatively large foreign debt amidst alarmingly low foreign currency reserves. The government needs to service a total of USD 7.3 billion in 2022 or default on its debt. This high foreign debt is largely a result of the country’s reliance on high-interest commercial borrowings to finance its long-running twin deficits. By the end of 2021, the country’s foreign reserves fell to as low as USD 1.6 billion.

In Sri Lanka’s post-independence history, efforts to charter a non-aligned foreign policy have been invariably checked by domestic political and economic volatility. In the post-civil war context, the Mahinda Rajapaksa government leant closer to China for economic, political, and strategic reasons. Regional tensions ensued — for instance, India twice opposed the docking of Chinese submarines in 2014, claiming that Sri Lanka would become a strategic base for China. Ruling politicians tout China’s model of authoritarian development as one worth emulating, using this model to legitimise increasing militarisation under the current government’s authoritarian populism.

Government response to the economic crisis at the domestic level

Domestically, the economic crisis disproportionately impacts marginalised communities, mainly the urban and rural poor. The import restrictions imposed by the government since 2021, geared to restrict foreign currency outflows, critically affects the import and availability of essential food and medical items. The Central Bank recorded a rise in inflation rates from 12.1 per cent in December 2021 to 14.2 per cent in January 2022. The World Bank estimates that around 500,000 people in Sri Lanka have been pushed below the poverty line since the beginning of the pandemic.

The government frames the economic crisis as a result of the COVID-19 pandemic and the previous government’s rule. Admittedly, the pandemic had a significantly negative impact on foreign remittances as well as the tourism and manufacturing sectors. The present economic crisis is also largely a result of long-term structurally poor governance going back to the 1980s.

The import restrictions imposed by the government since 2021 critically affects the import and availability of essential food and medical items.

Nevertheless, these factors are exacerbated by the present government’s weak public finance management and lack of visionary and sustainable economic policymaking. The latter is evident in the recent organic fertiliser debacle. The government’s ad hoc decision in May 2021 to ban chemical fertiliser products towards a 100 per cent organic farming system resulted in reduced crop yields and negatively impacted national food security.

This lack of visionary and sustainable economic policymaking is also evident in how accessing foreign currency reserves has dominated the government response at both economic and foreign policy levels. This has precluded a much-needed dialogue and action plan on economic and public sector reform at a structural level.

At the national level, stop-gap measures include selling half the country’s gold reserves worth USD 382 million in January 2022. The government also ordered licensed commercial banks to sell 25 per cent of all foreign exchange receipts to the Central Bank every week. It imposed capital controls limiting outgoing foreign currency by the Central Bank and placed import restrictions on goods ranging from motor vehicles to electrical goods to consumer durables.

Managing the economic crisis at the foreign policy level

The preoccupation with obtaining foreign currency reserves has also resulted in a foreign policy that is reactive and short-term. The government pursued several credit lines and currency swaps with different countries. In January 2022, a USD 400 million currency swap was finalised with the Reserve Bank of India, and a two-month deferment of repaying USD 500 million to a group of central banks in the region was obtained. A USD 1 billion credit line was also provided by India for essential food and medicine. Currency swaps were also finalised with South Korea and Bangladesh in 2021.

As expected, China is among the countries that Sri Lanka has approached for assistance. In January this year, in a meeting with visiting Foreign Minister Wang Yi, the Sri Lankan President Gotabhaya Rajapaksa requested restructuring Sri Lanka’s debt to China (Sri Lanka’s fourth-largest creditor), which accounts for around 10 per cent of the country’s total USD 35 billion foreign debt. This included a request for China to provide “concessional terms” for exports to Sri Lanka, with an offer to relax COVID related restrictions for Chinese tourists in Sri Lanka in return. In December 2021, Sri Lanka had finalised a USD 1.5 billion currency swap with China.

However, Sri Lanka’s request for debt restructuring comes against a backdrop of increasing strains in its relations with China. Bilateral relations took a downturn in the latter half of 2021, when the government of Sri Lanka rejected a Chinese shipment of organic fertiliser, quoting bacterial infections within that consignment. This claim was contested by the involved Chinese fertiliser company, and the Chinese Embassy in Colombo subsequently blacklisted Sri Lanka’s state-owned People’s Bank for refusing to honour its payment. The Sri Lankan authorities eventually agreed to pay 70 per cent (USD 6.7 million) for the fertiliser shipment.

The episode contributed to growing public scrutiny of China’s presence in Sri Lanka. In January 2022, a member of the ruling party, MP Wijeyedasa Rajapakshe (not a relation of President Rajapaksa), wrote a 45-point letter to Chinese President Xi Jinping. In it, MP Rajapakshe described China’s behaviour around the fertiliser episode as “cruel, inhuman”, and “brutal”. In addition, the letter identified the One Belt-One Road (OBOR) initiative as a “debt trap”, and as a means for China to become a world power while dismantling regional peace. OBOR therefore allegedly makes Sri Lanka vulnerable to major power rivalry. The letter also portrays development projects between Sri Lanka and China as corrupt and warns that, after the next national elections, development agreements that were disadvantageous to Sri Lanka would be restructured or cancelled.

No strings attached?

Controversy over the economic (as well as social and environmental) unsustainability of several large-scale Chinese-financed infrastructure development projects is not new. In fact, addressing the economic irregularities and development priorities with regard to such projects formed a key agenda of the previous government’s election manifesto in 2015. That coalition government subsequently faced much criticism for its 99-year lease of the Hambantota port to China Merchant Port Holdings Company in return for USD 1.1 billion. Although the funds eased Sri Lanka’s difficulty in paying foreign debt, the country’s debt to China was not written off and merely reclassified.

More recently, in April 2021, the China-funded Colombo Port City project came under attack by sections of civil society and the political opposition. The Colombo Port City Economic Commission Bill was opposed on grounds that it violated Sri Lanka’s sovereignty, as it provided the Economic Commission immunity from Sri Lankan law.

Significantly, the present government is also resisting pressure to go to the International Monetary Fund (IMF) for a relief package. The government justified its anti-neoliberal ideological stance by framing the IMF as an instrument of Western neo-colonialism that undermines national sovereignty. Such arguments align broadly with the government’s economic and political nationalist rhetoric. Increasingly, however, China too appears to be open to operating within global initiatives on international debt management, including with the G20 and IMF.

The present economic crisis is at its core political, and the Sri Lankan government appears to be groping blindly in the dark. This political crisis is evident in the country’s foreign policy as well, which remains largely reactive and short-term and inflected with domestic nationalist ideology. The urgent need for foreign reserves may make the country’s foreign policy look more balanced and diversified when in reality it is making the country more vulnerable in an increasingly unequal relationship with its bilateral partners.

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

Author biography

Rajni Gamage is an independent researcher based in Colombo, Sri Lanka, with a PhD in Political Science and International Relations at the University of Queensland, Australia. Image credit: Flickr/Mahinda Rajapaksa.