Cautionary

Sri Lanka has now been declared in default after failing to make interest payments on its outstanding debts. There has been widespread rioting in this country of 22 million. The population is angered by shortages of food and fuel. Inflation is expected to hit 40 percent.

This is the first time in Sri Lanka’s history that it defaults on its debt obligations. The default complicates everything. It will raise interest rates on new borrowings, should that even be available.

After refusing to do so for years, Colombo is now asking the IMF for bridge financing as it restructures its debt. The country needs $4 billion to update its debt service. The World Bank agreed to lend the country $600 million. The IMF insists the country raise interest rates as a condition for further financing.

India has come to the island nation’s rescue, offering about $1.9 billion in financing. New Delhi is rushing deliveries of food and fuel to help calm the explosive political situation there. This will not be enough.

The government of Prime Minister Ranil Wickremesinghe and President Gotayaba Rajapaksa blames the pandemic for the country’s difficulties. This is not true.

Although the pandemic cut Sri Lanka’s income from tourism, the international consensus is that the present crisis is the outcome of years of sheer incompetence in economic and fiscal management.

The crisis may be traced back to the government’s decision in 2009 to focus its production on the domestic market. Since then, the country’s foreign reserves began to dwindle. Sri Lanka imports $3 billion more than it exports.

At the end of 2019, the country had $7.6 billion in foreign currency reserves. By March 2020, this had gone down to $1.93 billion. The latest government numbers indicate the country’s current foreign reserves were just $50 million.

Shortly after becoming president, Rajapaksa introduced large tax cuts. While this won him short-term popularity, it undermined government’s fiscal stability.

In 2021, when the country’s foreign reserves were seriously depleting, Rajapaksa banned chemical fertilizer imports, telling farmers to use organic fertilizers. There was widespread crop failure – including major exports tea and rubber.

In response, Rajapaksa tried to supplement the country’s food stocks through importation. This depleted foreign currency reserves even more.

Today, Sri Lanka cannot pay its debt, cannot buy fuel and cannot import enough food for its people. This is why public anger has spilled into the streets. The country has entered a long tunnel and no one knows when it could reemerge.

The pandemic simply aggravated a rapidly deteriorating fiscal position. The first step towards disaster was to look inward, neglecting exports to offset necessary imports. An economic crisis as serious as this one eventually expresses in political turmoil.

The Sri Lankan government made one bad decision after another. Now it is privatizing everything in sight to pay down its indebtedness.

Lessons

The crisis in Sri Lanka is instructive for us. First, it should warn us against adopting an inwardlooking economic strategy. Many developing economies – ours included – cannot avoid importing vital goods such as fuel and chemical fertilizers. We need to grow our exports to balance our trade, especially as the current fuel price regime continues to push upward.

Second, fiscal prudence must be of primary importance in any economic strategy. The nation’s debt must be kept sustainable, even under extreme conditions such a pandemic. Revenue flows too must be reliable. Our tax system must keep up with best practices elsewhere.

Third, importation of agricultural products is not necessarily bad. What is important is to continue modernizing our farm systems so that cost of production matches those in our neighboring economies. There are enough protectionist groups here who want to ban agricultural imports while holding our consumers captive to inefficient farm production. This penalizes consumers and keeps our farmers poor in the long run because protectionism keeps them from improving our own agricultural efficiency.

Fourth, we need to invite investments into our farms. Our entire agricultural framework, including breaking up landholdings into small and unsustainable plots of land, is protectionist. It inclines us to remain within subsistence farming resistant to mechanization. The real economic revolution of this time is in consolidating our farm production and rapidly improving our logistics system.

Fifth, government needs to resist that constant demand to subsidize everything in sight. When the war in Ukraine caused prices to spike, militant groups demanded excise taxes on fuel products be suspended. If they got their way, we would have been on the road Sri Lanka took. When the pandemic struck, the protest industry demanded that government give bottomless cash support for nearly everyone. That would have bankrupted us.

The protest industry demands free tuition, free health care and free irrigation. They want power and food subsidized. If they get their way, we would have fallen into the hole ahead of Sri Lanka.

Sixth, our social security institutions are mainly benefits-driven. People want to contribute as little as possible and receive as much benefits as politically possible. This is the reason why the actuarial lives of our social security agencies tend to be short and why government last year provided billions to save the retirement fund for uniformed personnel.

Institutions such as PhilHealth are designed to be financial failures. A universal health care system is good; but it should be supported by enough contributions from its members to enable financial viability.

In a word, we should always keep a close eye on the deficits (budgetary as well as trade). They are the canaries in the mine.