Our neighboring Island nation, Sri Lanka is presently wrestling its worst economic and political crisis. We at Avaaz24, tried to analyze the cause for this downfall of the island nation.
Post independence history of Sri Lanka:
Even though, Sri Lanka got independence from British in 1948, it remained a dominion of the British Empire until 1972.
In 1972 it assumed the status of a Democratic Socialist Republic. A constitution came into force in 1978. It made Executive President the head of the state.
In 1983, a Civil War because of ethnic conflict between majority Sinhalese and minority Tamils broke out in Sri Lanka. It finally ended in 2009.
Past economic status of Sri Lanka:
Post Independent Sri Lanka’s agriculture is dominated by export oriented crops like tea, coffee, rubber and spices.
A larger share of its GDP came from foreign exchange earned from exploiting these crops. That money was used to import essential food items.
As per Asian Development Bank’s 2019 working paper, Sri Lanka is a classic twin deficits economy. Twin deficits signal that a country’s national expenditure exceeds its national income and that its production of tradable goods and services is inadequate.
For this reason, it frequently encountered Balance of Payment crises. From 1965 onwards, it obtained 16 International Monetary Fund loans.
These loans came with conditions like- once Sri Lanka received the loan they had to reduce their budget deficit, maintain a tight monetary policy, cut government subsidies for food for the people and depreciate the currency.
Last IMF loan to Sri Lanka was in 2016. Country received USD $15 billion for three years from 2016-2019.
Present economic status of Sri Lanka:
As of Feb, country has left with only $2.31 billion in its reserves but faces debt repayments of around $ 4 billion in 2022, including $ 1 billion International Sovereign Bond maturity in July.
The country’s external debt repayments doubled from $2.1 Billion in 2017 to $3.3-4.2 Billion in 2019-2022. 28.3% of country’s total population is food insecure.
Reasons for the present economic crisis of Sri Lanka
A combination of Internal [Domestic] and External factors had driven Sri Lankan economy from bad to worse.
External Factors
COVID 19 pandemic:
The pandemic of COVID 19, had massively hit economies of many countries. In Sri Lanka tourism used to generate 10% of country’s GDP. The lucrative tourism industry had a blow by the pandemic. Additionally foreign remittances lowered. As a result, its forex reserves soared.
2. US- raise in interest rates:
US abruptly raising its interest rates lead to drastic changes in international financial market.
3. Russia- Ukraine conflict:
Russia’s invasion of Ukraine has made fuel and other imports more expensive. Sri Lanka imports 45% of its wheat and more than 50% of its Soybeans from the above two countries. The above countries also key buyers of Sri Lankan Tea and are important sources of tourists.
Internal [Domestic] Factors:
2019 Easter Sunday bombings:
Easter Sunday bombings by Islamic State linked militants in 2019 brought country’s tourism to a near stop. Tourist fall reduced by about 80%.
2. Tax cuts:
In 2019, Rajapaksa’s government in a hope of reviving the fragile economy launched country’s largest tax cuts in the history.
Value Added Tax (VAT) was slashed from 15% to 8 % and corporate tax was reduced from 28% to 24%. Additionally, Indirect taxes like nation building tax, pay-as-you-earn tax and economic service charges are abolished.
About 2% of GDP is lost in revenue due to these tax cuts. This move prompted creditors to downgrade Sri Lanka’s rating. Consequently, forex reserves further shank as it prevented the country from borrowing more money.
3. Ban on Chemical Fertilizers- promoting Organic Farming:
In April 2021, Rajapaksa announced that Sri Lanka would allow only organic farming. Hence, importing chemical fertilizers was banned. This move was to prevent drain of forex reserves.
Government claimed it would increase the production of manure and other organic fertilizers in place of imported synthetic fertilizers.
Against claims that organic methods can produce comparable yields than conventional farming, this budge went catastrophically wrong.
As a result, domestic rice production fell down by 20% in just 6 months, forcing the country to import $450 million of rice to meet supply needs. The surging rice prices rose nearly by 50%.
Drop in tea production alone resulted in economic losses of $425 million. Owing to low export income, less money became available to import food and food shortages arose.
The experiment was ill conceived. Lack of organic fertilizer production capacity, coupled with absence of a formalized plan to import organic fertilizers raised food insecurity and drained forex reserves.
4. Failed Infrastructure Projects
i) Hambantota Port:
In 1970’s Mahinda’s father Don Alwin Rajapaksa had called for a port to be built in his home district, Hambantota. It promised 100,000 jobs.
In 2003, Sri Lanka had rejected proposals by the Canadian engineering firm SNC Lavian to explore this idea.
Only regime linked cronies have profited from the Hambantota Port. It did little for Sri Lanka.The port never achieved targeted traffic projections. It couldn’t generate the jobs as promised.
To help its increasing debt payments, Sri Lanka found itself compelled to grant Hambantota Port on a 99 year lease to China Merchants Port in 2017, in return for a $1.1 billion.
ii) Colombo Port City Project
Even Hambantita floundered, China announced Colombo Port City Project in 2014 as a part of its Belt Road Initiative.
For a 99year old lease on 43% of land, China Harbour Engineering Corporation needed 1.4 billion $ to build the project.
China- Sri Lanka’s ties :
They are started during Sri Lanka’s Civil War, when China was one of the few reliable arms suppliers to the government.
It also provided political cover, using its veto to stop UN resolutions targeting Sri Lanka.
5. China’s Debt Trap Diplomacy
China accounted 30% of all Foreign Direct Investment in Sri Lanka from 2012-2016 (Four times of FDI from India). Today, China is the top source for Sri Lanka’s imports displacing India. China’s debt and equity are funding more than 50 projects worth more than $11 billion.
Sri Lanka borrowed heavily from China to plug years of budget shortfalls. But it wasted large amounts on building expensive and unviable aviation, shipping highway and hospitality.
Interest rates on some of the Chinese loans are as high as 6.5% per annum. On the contrary, loans of Asian Development Bank or World Bank are cheaper (2.5% – 3% interest per annum)
Since both financiers and contractors are owned by Chinese government, there is a possibility of project costs being padded, exacerbating the debt load.
Thus China employed its debt trap diplomacy to gain a strategic edge over Sri Lanka.
6. Foreign Debt
China ranks only third among Sri Lanka’s creditors after Japan and Asian Development Bank.
Large foreign loans, contracted at high interest rates have pushed the country into a debt trap.
7. Market Flaws
Sri Lanka focussed on domestic markets instead of selling good abroad. So export incomes remained low, import bills kept on growing.
How Sri Lanka can get out of this economic crisis now?
- Getting another loan from International Monetary Fund. But, with stricter guidelines.
- Restructuring the present economic model. Food subsidies should be abolished. Taxation policies have to be restructured.
- Accepting the credit line made by India. It’s time to differentiate between friends and foes.
- Promoting food crops in the island nation. A partial shift from plantation and cash crops towards food crops will make the country not only food secure, but also reduce the import bill.
- Nevertheless, it’s not too late to stop all the commercial unviable infrastructure projects which dragged the country’s economy to downfall.
