Context

On 31 August 2021, Sri Lanka declared a state of economic emergency, as it is running out of foreign exchange reserves for essential imports like food.

Economic cooperation with Sri Lanka

• India is Sri Lanka’s third-largest export destination, after the US and UK.
• More than 60% of Sri Lanka’s exports enjoy the benefits of the India-Sri Lanka Free Trade Agreement, which came into effect in March 2000.
•  India is also a major investor in Sri Lanka.
•  Foreign direct investment (FDI) from India amounted to around $ 1.7 billion over the years from 2005 to 2019.
• Concessional financing of about $ 2 billion has been provided to Sri Lanka through various Indian government-supported Lines of Credit across sectors like railways, infrastructure and security.
• India’s development partnership with Sri Lanka has always been demand-driven, with projects covering social infrastructure like education, health, housing etc.
• The Reserve Bank of India (RBI) had signed a currency-swap agreement with the Central Bank of Sri Lanka (CBSL) under the Saarc Currency Swap Framework 2019-22.

Factors responsible for economic emergency in Sri Lanka

• Tourism: Tourism, a big dollar earner for Sri Lanka, has suffered since the Easter Sunday terror attacks of 2019, followed by the pandemic.
• Declining FDI: Earnings fell from $3.6 billion in 2019 to $0.7 billion in 2020, even as FDI inflows halved from $1.2 billion to $670 million over the same period.
• Debt distress: Its public debt-to-GDP ratio was at 109.7% in 2020, and its gross financing needs remain high at 18% of GDP, higher than most of its emerging economy peers.
•  The external debt-to-GDP ratio stood at 62% in 2020 and is predominantly owed by its public sector.
• More than $2.7 billion of foreign currency debt will be due in the next two years.

How economic crisis may push Sri Lanka to align its policies with China

• Reliance on Chinese credit: Sri Lanka has increasingly relied on Chinese credit to address its foreign debt burden.
• Unable to service its debt, in 2017, Sri Lanka lost the unviable Hambantota port to China for a 99-year lease.
• Increasing bilateral trade: China’s exports to Sri Lanka surpassed those of India in 2020 and stood at $3.8 billion (India’s exports were $3.2 billion).
• Strategic investment by China: Owing to Sri Lanka’s strategic location at the intersection of major shipping routes, China has heavily invested in its infrastructure (estimated at $12 billion between 2006 and 2019).
• In May, Sri Lanka passed the Colombo Port City Economic Commission Act, which provides for establishing a special economic zone around the port and also a new economic commission, to be funded by China.

Implications for India

• Relations between India and Sri Lanka seem to have plummeted since the beginning of this year.
• In February, Sri Lanka backed out from a tripartite partnership with India and Japan for its East Container Terminal Project at the Colombo Port, citing domestic issues.
• Sri Lanka’s economic crisis may further push it to align its policies with Beijing’s interests.
• India is already on a diplomatic tightrope with Afghanistan and Myanmar.
• Other South Asian nations like Bangladesh, Nepal and the Maldives have also been turning to China to finance large-scale infrastructure projects.

Way forward

• Nurturing the Neighbourhood First policy with Sri Lanka will be important for India.
• Explore possibility through regional platforms: The BIMSTEC and the Indian Ocean Rim Association could be leveraged to foster cooperation in common areas of interest like technology-driven agriculture and marine sector, IT, renewable energy, and transport and connectivity.
• Cooperation on private sector investment: Both countries could also cooperate on enhancing private sector investments to create economic resilience.

Consider the question “How economic troubles in Sri Lanka could impact India? Suggest the way forward.”

Conclusion

With its economy in deep trouble, Sri Lanka may get further pushed towards China, India has to deliver on its Neighbourhood First policy to protects itself from the adverse fallout.

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