What led to the economic crisis in Sri Lanka and how can it be tackled?

What is happening in Sri Lanka?

It is deep in debt. Its public debt is estimated to be 119 percent of the GDP.

Is that a lot?

It means that it has borrowed more than it can produce. It’s a lot but Japan’s worse. Japan’s debt was 259 percent of GDP in 2021.

What?

Yes, what makes all the difference is who they have borrowed from.

Did Sri Lanka borrow from the mafia? How can it be worse than 259 percent of GDP?

Sri Lanka has borrowed heavily from foreign markets, while Japan’s borrowing has been largely funded by its central bank and conservative domestic investors.

Who are Sri Lanka’s creditors?

It’s foreign creditors. The largest slice of the borrowing has been done in international sovereign bonds, which is 36.4 percent of all the foreign debt. Its second-largest lender is the Asian Development Bank (ADB), which gave 14.6 percent of the total. Then Japan and China, which gave 10.9 and 10.8 percent, respectively.

But why did Sri Lanka have to borrow so much?

The coronavirus pandemic was bad for its tourism sector but the borrowing goes way back… to the mid noughties.

Why then?

After the 2004 tsunami, the government started rebuilding on a large scale. Public expenditure became the main driver of investment growth from 2006, according to an ADB report.

Is that a bad thing?

In a way, yes-it was masking a fall in private investment, which stemmed from an uncertain economic and political climate. This meant that the share of taxes to GDP kept falling. The government began financing its investments through foreign borrowings. In 2007, Sri Lanka issued its first international sovereign bond and it was for $500 million.

And then it went downhill…

Well, then there was also the reconstruction effort after the civil war. Around that time the government had started its final, aggressive push against the Tamil militancy and finally ended a three-decade-long civil war in 2009.

Oh, so the war was expensive?

No, after the war the government started spending massively on reconstruction and in real estate. There were prime properties that had been lying dormant. How can that go wrong? Seems like smart thinking. They did too much of it and didn’t exactly work on diversifying the export basket, which is what brings in forex, which the country desperately needed to pay off foreign debt. KG Sahadevan, professor of economics at IIM-L, says that countries such as Malaysia and Indonesia learnt from their experience of the dangers that come from relying too heavily on one sector or commodity. Sri Lanka did try to diversify from its tea-and-tourism export basket to increase the share of garments but then didn’t diversify further. There were other slip-ups by the government as well.

Seriously?

Yes. In 2021, the PM implemented another poll promise, of promoting organic farming by banning the import and use of chemical fertilisers and pesticides. It led to panic about shortages and food prices rocketed. According to some observers, this was done also to conserve forex because fertilisers were costing the country $300 million to $400 million every year. But six months after that announcement, the government revoked the ban. This January, the government announced $200 million in compensation to rice farmers who had to take losses because of the ban.

If a country were a pile-up… So, what has happened now for the country to grab everyone’s attention? Inflation has been rising, forex reserves fell to $2.36 billion in January, when their import bill had come to $20.6 billion in 2021 and they have a $1 billion bond repayment due in July. The country is running out of fuel. There are long queues at banks and food shortage is forcing people to flee. Refugees have started arriving in Tamil Nadu.

How will this end?

IMF does not sound too optimistic. The debt and poor ability to manage public finances will limit growth and even jeopardise macroeconomic stability in the near and medium term, it has said.

The government has no plans?

It does. It hopes to tide over the forex shortages in the near-term with government-to-government loans, currency swaps with foreign central banks…

Currency swaps?

Yes, in which Sri Lanka could give its local currency in exchange for foreign currency it needs to repay debt.

Oh okay, and?

The government also plans to generate more revenueeither by sale or through more efficient operationsfrom underutilised public assets and temporary export surrender requirements, which is basically pushing exporters to bring the forex they have earned into Sri Lanka and convert the earnings into the local currency so that the banks can distribute the foreign currency to people who need it for imports and other payments.

Will these be enough?

The IMF isn’t very confident. In the latest note, it said, “The authorities have presented plans to tackle the crisis but these are unlikely to put the economy back on a stable and sustainable path.”

What does the IMF advise?

First, to protect the vulnerable and the poor through policy. “In addition to creating fiscal space for higher social safety net spending, the coverage, targeting, and per-family benefit needs to be strengthened to provide adequate protection for vulnerable groups,” it has said. Then to improve revenue generation and collection. “Fiscal consolidation should be primarily revenuebased, given Sri Lanka’s very low tax-to-gdp ratio. The needed revenue should be mobilized from CIT, PIT, and VAT, by raising rates, minimizing exemptions, and ensuring greater contributions from high-income earners,” the note said.

So raise taxes and expand the tax base?

Also, improve the tax collection mechanism. Then spend more efficiently, ensure that fuel pricing is based on market forces and isn’t fixed by the government… this will help reduce the fiscal burden on state-owned enterprises, which were otherwise footing the bill. Also, allow market forces to determine the exchange rate of Sri Lankan rupee instead of the “current unsustainable policy to fix the official exchange rate”. Then some reforms in improving its labour force, exports diversification, governance…

Such as?

Liberalise exports and remove import restrictions to diversify the basket, and encourage investment with a coherent policy.

What about its habit of borrowing?

Yes, the Central Bank of Sri Lanka (CBSL) has been asked to monitor loans under moratorium and to identify vulnerabilities through stress testing.

Stress testing?

Having simulations to check how the loan will be serviced if there is a stressful financial or economic event.

Oh okay.

It has also asked the country to adopt a new banking act, which will give the central bank more regulatory powers and improve the country’s debt resolution process.