SRI LANKA’S ECONOMIC CRISIS

As Sri Lanka faces its worst economic crisis since independence, it is high time –
not just for the Sri Lankan political elite, but the world at large – to reflect upon how
the country got here. President Gotabaya Rajapaksa’s resignation and subsequent
exit from the country has put Sri Lanka back in global headlines.

The immediate crisis is the persistent shortages of fuel, gas, and other essential
items in Sri Lanka, due to a shortage of foreign exchange. The country and its
people have scant options to address the issue. An IMF bailout has become a must,
as currency swaps with India and China alike have been insufficient in ameliorating
the foreign-exchange crisis. Yet the IMF will set strict conditions, including a
necessary consensus from the creditors regarding debt restructuring. That looks
unlikely at the moment, with one of the major bond-holders of the government filing
a lawsuit against the Sri Lankan state for a bond payment due in July 2022. Sri
Lanka can neither get more foreign exchange, nor more debt relief, without
substantial and shocking readjustments to its domestic economy.

The ongoing economic crisis is thus two-fold. The first constitutes the foreign
exchange crisis – the Sri Lankan economy’s foreign reserves were decimated as a
result of the ongoing pandemic and travel restrictions, but also substantial
uncertainty over consumer confidence and the state of the economy. The second is
the debt crisis – the Sri Lankan state is fundamentally incapable of repaying the vast
loans it has taken out, from countries including, but not limited to, China, but also
from international markets.

So how did Sri Lanka get here?

Some might argue that much of Sri Lanka’s current fiscal malaise began with the tax
cuts given in 2019. Prior to the tax cuts, Sri Lanka had achieved its first primary budget
surplus in decades and had largely been on track to resume its status as an upper-
middle-income country per World Bank standards. The tax cuts increased fiscal deficits,
culminating in international rating agencies downgrading Sri Lanka’s credit rating, and
thus shutting the country off from much of the international capital market.

In a stroke of truly atrocious timing, this was followed by a historic pandemic

that further weakened the tourism industry, which was just recovering from the
Easter attacks of May 2019. The pandemic’s spill over implications on Sri Lankan
workers working abroad also precipitated a fall in expatriate remittances – a
major source of foreign currency for the country. In addition, the decision of the
government to ban chemical fertilizers and shift to organic farming overnight
led to a 50 percent drop in agricultural output. This adversely affected the tea
industry hard, which had been another major source of foreign exchange.

POLITICAL BACKGROUND
The Sri Lanka Podujana Peramuna (SLPP) recorded a landslide victory with a
majority during the 2020 Sri Lankan parliamentary election. The SLPP gained the
support of the majority Sinhala Buddhists, which was part of the election manifesto
by the party during its election campaign. The SLPP government also gained
majority support thanks to its handling of the first wave of the COVID-19
pandemic. Gotabaya was elected as the 7th executive President of Sri Lanka during
the 2019 presidential election, who won with a majority of 6.9 million votes. He
cemented his popularity as a strongman due to his military background and also due
to his role as defence secretary in ending the 26-year Sri Lankan Civil War in May
2009.

MR. GOTABAYA RAJAPAKSA

REASONS BEHIND THE CRISIS
The year 2021 marked the plummeting of the popularity of the Gotabaya Rajapaksa-
led government which gained widespread opposition from various stakeholders due
to the inability and incompetence of the government when implementing
policy. Although the government was credited for its successful handling of the first
wave of the pandemic and for its successful vaccination drives amid misinformation
about vaccines, the popularity of the Rajapaksa-led government began diminishing
from 2021 due to its poor handling of the economy.

Moreover, the decision to ban chemical fertilisers overnight created a huge

backlash, especially from farmers who were critical of the government's decision to
ban chemical fertilizers without proper planning. The decision was allegedly taken
by Gotabaya, who had consulted Vandana Shiva, an Indian scholar and anti-GMO
activist, instead of listening to experts on agriculture who repeatedly urged him to
avoid such an ill-fated move. Gotabaya intended to make Sri Lanka the first country
in the world to follow 100% organic farming. The chemical fertilizer ban turned out to
be costly as harvest was severely hampered, triggering acute food shortages
throughout the country. The impact of a sudden chemical fertiliser ban was felt with
the purchasing behaviour of public as Sri Lanka witnessed lengthy queues to buy
important essential food items and other stuff including sugar, milk powder,
kerosene oil and cooking gas.
In September 2021, the government declared an economic emergency, as the
situation was further aggravated by the falling national currency exchange rate,
inflation rising as result of high food prices, and pandemic restrictions in tourism
which further decreased the country's income. The government invoked emergency
regulations to control prices of essential food items. The government accused the
traders and businesses for hoarding essential food items such as sugar and milk
powder, which according to government led to massive food shortages. The
government also accused the Sri Lankan media of stoking unnecessary fears
among the public and denied any shortages. It was reported that the national
emergency was declared on 30 August 2021 and the Parliament of Sri Lanka
approved it on 6 September 2021. In November 2021, Sri Lanka abandoned its plan
to become the world's first organic farming nation following rising food prices and
weeks of protests against the plan.

The change in composition of gas cylinders which led to explosions in houses and
hotels also caused negative publicity to the government as many people started to
use electric cookers and ovens due to fear of using biogas. The government also
failed to preserve the crucial foreign reserves, which led to a curtailing of imports.
The first part of the import ban was imposed on motor vehicles, which angered the
vehicle importers as it severely affected their livelihoods. The threat of the Delta
variant also further dampened any hopes of recovery for the tourism industry. In
addition, foreign remittances to Sri Lanka also began declining in 2021, which
further dented the country's GDP. The government also faced continuous strikes by
school teachers, demanding higher salaries, with the teachers also carrying out
online education strikes, which affected the education of school children who were
already deprived of a physical education.

Yet to concentrate on only the past five years would be a fundamental error. The Sri
Lankan economic crisis cannot be attributed to governmental undertakings and
blunders across the past few years alone. It behoves us to reach for structural
explanations. Macro risk factors, such as a 26-year-long civil war, the persistence of
terrorism and violent incursions by fringe groups, public scepticism toward
competitiveness-oriented privatization, and a cultural predisposition against FDI and
raised taxes, have all engendered what we term “systemic fragilities” within Sri
Lanka, awaiting triggers that would ignite the flashpoints.

Let’s delve into some of these factors in turn, staring with the nature of Sri Lanka’s
indebtedness. From the 1970s to the mid-2000s, Sri Lankan debt had predominantly
consisted of low-interest-rate loans from multilaterals. Yet much of this changed
during the mid-2000s, which saw the country reorient itself to foreign investors and
lenders alike. Sri Lanka issued its first international sovereign bond in 2007 – one
with higher interest rates, designed to draw investors. Unfortunately, the money was
used to fund, under governmental directives, projects with limited to no national
utility, pursued largely for the sake of political vanity, such as the Colombo Lotus
Tower.

Certain decisions undertaken by the Mahinda Rajapaksa government in the 2000s

paved the way for the demanding debt conditions that Sri Lanka finds itself in today,
whether it be in relation to the Chinese government (10 percent or so of the
country’s debt), or, indeed, European and American financial institutions (over 80
percent). While some rightly note that Chinese involvement in Sri Lanka had steadily
increased over recent years, talk of China of instigating “debt trap diplomacy” in Sri
Lanka is overblown, as per the persuasive deconstruction done by academics such
as Deborah Brautigam. In Sri Lanka, as elsewhere, domestic economic problems

have domestic origins.

Source: The Diplomat

The second factor is the populist macroeconomic policies pursued by political

parties. Sri Lanka has had a long history of political parties winning elections on
claims of sweeping, unrealizable promises. The public had often been promised
many things before an election, such as low-priced bread, subsidized rice, free
fertilizer, public sector salary increases, and tax cuts. Voters expecting these
promises to be fulfilled – without questioning them substantively, given the low-
information and oft-opaque media environment – become ostensible evidence for
the credibility and legitimacy of successive governments that underdeliver upon their
economic commitments.

Structurally, the centrality of rural populations to Sri Lankan elections has produced
economic policies aimed at stifling, as opposed to promoting, competition. This also
explains Sri Lanka’s repeated failures to liberalize its economy – with significant
tariffs imposed on imports, and a broader focus on import substitution, modern Sri
Lanka had struggled with its export industry, mainly because the beneficiaries of
exports are unlikely to hold as much political sway or influence as their anti-
establishment opponents. With a perennially hamstrung export sector, the country
has come to rely heavily on expat worker remittances, the apparel industry, and tea
exports for its foreign exchange – all industries that were heavily hit by the raging
pandemic.

Finally, the Sri Lankan state’s overbearing transfer payments and subsidies are
fundamentally rendered futile under the double whammy of over-bureaucratization
and inefficient deployment of state subsidies. For a country of 22 million people, Sri
Lanka has a public sector workforce of 1.4 million employees. In 2019, a full 36
percent of government revenue went to pay for the salaries and pensions of present
and past state sector employees. This is not only unsustainable but hardly leaves
any money for development in the education and health sectors, which collectively
receive less than 1 percent of GDP in government spending.

WHAT IMPACT HAS THE CRISIS HAD ON SRI LANKA?

The economic crisis has had a crippling effect on the country, with shortages of
essential goods, high inflation, and more, leading to mass protests and resignations
from the president’s cabinet.

 Shortages of essential goods | Sri Lanka has faced acute shortages of

essential items such as fuel and medicines as it struggles to import goods due
to its precarious foreign exchange reserves and mounting debt. This has had a
compounding impact on the island nation as tourists have stayed away from
 the country amidst the fallout from the situation. Since tourism accounts for
approximately 12 percent of Sri Lanka’s GDP, the failure to see an uptick in
tourism following the easing of the Covid-19 pandemic has hit the country
hard.
 High inflation | The country has struggled with high inflation owing to the
vicious debt trap that it has found itself in. As a result, the interest payments
on sovereign debt and the cost of imports have been rising steadily. The
increase in inflation has hit every stratum of society hard, but has hit those
with the lowest incomes the hardest.
 Fuel Shortages | in Sri Lanka are a major operational constraint for the
humanitarian response, as they affect effective programme implementation
and monitoring.

HIGHLIGHTS
 It is estimated that 5.7 million people are in need of humanitarian assistance,
of whom 1.7 million are prioritized through the Humanitarian Needs and
Priorities (HNP) Plan launched on 9 June 2022.

 The HNP Plan calls for US$47.2 million to implement responses to lifesaving
priorities between June and September 2022, with a particular emphasis on
 averting a further deterioration of needs and thus prevent a full-scale
humanitarian crisis.

 The Central Emergency Response Fund (CERF) has approved a US$5-million

rapid response allocation to address urgent needs on food assistance, basic
agricultural and livelihoods support, vital and essential medicines and
supplies, child protection, nutrition, safe water and education in priority
districts.

KEY DEVELOPMENTS IN THE CRISIS:

 March 31, 2022: Demonstrators march to President Gotabaya Rajapaksa's
private residence to protest over worsening economic conditions.
 April 3: Rajapaksa dissolves the cabinet, which includes his younger brother
Basil Rajapaksa as finance minister, but elder brother Mahinda Rajapaksa
continues as prime minister.
 April 9: Protests escalate, with sit-in demonstrations outside Rajapaksa's office
calling for the removal of the president to pave the way for political reforms.
 May 9: Following widespread clashes between pro- and anti-government
protesters, Prime Minister Mahinda Rajapaksa resigns. Countrywide violence
leaves nine dead and about 300 injured.
 July 9: President Gotabaya Rajapaksa informs the parliamentary speaker that
he plans to step down on July 13, after protesters storm into the official
presidential residence. Prime Minister Ranil Wickremesinghe says he is willing
to resign too.
 July 13: President Gotabaya Rajapaksa flees Sri Lanka, initially going to
Maldives, before moving on to Singapore.
 July 14: Rajapaksa submits a letter of resignation hours after arriving in

Singapore, becoming the first Sri Lankan president to quit while in office.
 July 15: Parliament accepts Rajapaksa's resignation. Ranil Wickremesinghe, a
six-time prime minister, is sworn in as acting president.

MR. RANIL WICKREMESINGHE

 July 18: Wickremesinghe declares state of emergency.

  July 20: Wickremesinghe wins vote in parliament to become new president. A
large section of the public remains unhappy with parliament's choice, because
of Wickremesinghe's past association with Rajapaksa.
 July 22: Sri Lankan security forces raid a protest camp occupying government
ground in the main city of Colombo and cleared out a section of it, arresting
nine people. Later the same day, Dinesh Gunawardena is sworn in as prime
minister, although he too has been perceived as an ally of Rajapaksa

CHANGE MUST COME THROUGH RADICAL ECONOMIC

REFORM
Liberalization – not further entrenchment – of the national economy, is the only way
out of the current conundrum. Sri Lanka is in dire need of radical economic reforms,
ones that liberate and emancipate, as opposed to entrapping its population under
the shackles of bureaucratic ineptitude and kleptocratic governance.

First, tax reforms are needed. Less than 2 percent of government revenue comes
through direct taxes and only 1 percent of the population come under the
requirement to pay income taxes. An increase in direct taxes and widening of the tax
base are long overdue. Sri Lanka currently has a very low tax-to-GDP ratio – just
above 8 percent at this time. It was 12 percent to GDP prior to the aforementioned
cuts. Not only is the tax revenue low, but direct taxes amount to a dismal 2 percent
of GDP.

With the bulk of government revenue coming from indirect taxes, it is the ordinary
consumers, as opposed to the biggest earners, who end up paying the most. The
taxation system is both inadequate and regressive. Sri Lanka needs a more
progressive and effective taxation system that makes the wealthy pay their due
share. To pre-empt concerns pertaining to capital flight, the government must
implement more transparency-centric regulations that ensure the property rights and
business interests of the burgeoning upper-middle and middle classes – the bulwark
of the Sri Lankan economy’s growth in the future.

Second, politicians must stop taking people’s preferences for granted – or, worse
yet, as tools to be used to get elected – without paying heed to the underlying social
dynamics. The Sri Lankan people deserve a real and proper say. Educating people
on how the government runs financially in accessible language and with full access
to information is needed to make people understand that populist policies will be
detrimental to long-term recovery. The people are not to blame, but those who wield
cultural and media influence are. A drive to encourage entrepreneurship among the
population is needed, given that Sri Lanka has a very low percentage of
entrepreneurs, accounting for less than 3 percent of the population. Other countries
in the region have much higher figures, with Bangladesh, for instance, at 12 percent.

Third, Sri Lanka must shrink the state – within reason and with pragmatic
prerogatives in mind. A restructuring and overhaul of state-owned enterprises
(SOEs) is needed for the administration to achieve fiscal discipline. The Sri Lankan
government spends far too much on catering to those who are supposed to work for
the people, and not enough on the people themselves. Many SOEs can be
privatized, specifically in areas where natural monopolies, paired with market
incentives and regulatory mechanisms, would yield far better results than state-
sponsored monopolies and oligopolies. A good example would be Sri Lanka
Telecom, which was privatized in 1997, with 35 percent of its shares sold to a
Japanese investor. Sri Lanka Telecom is one of the best performing corporations
that remains partially, but not fully, owned by the government. This model of
privatization can be emulated across other SOEs.

Fourth and most fundamentally, Sri Lanka needs to shift toward an export-oriented
economy and this requires proactive changes on many angles. To begin with, Sri
Lanka must reduce its import tariffs to make raw materials cheaper for export-based
companies. Free trade agreements with regional partners – including but not limited
to the Gulf countries, Bangladesh, and Thailand – are needed; Sri Lanka is only
party to 3 FTAs at the moment. In the long run, Sri Lanka must look to improving
consumer and investor confidence, through introducing powerful, thorough
regulatory changes. Much of this can be done – but it must be done swiftly, in
conjunction with political and structural reforms. Otherwise, it will be too late for the
economy to be genuinely salvaged.