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Context

After weeks of economic turmoil, Sri Lanka announced that it would be defaulting on all of its external debt worth $51 billion.
After running out of foreign exchange for imports, Colombo called the move a last resort.
The island nation is grappling with its worst economic downturn since independence, with regular blackouts and acute shortages of food and fuel.

Sri Lankan Crisis: A backgrounder

(1) Fragility of Sri Lankan Economy

Post-independence from the British in 1948, Sri Lanka’s agriculture was dominated by export-oriented crops such as tea, coffee, rubber and spices.
A large share of its gross domestic product came from the foreign exchange earned from exporting these crops. That money was used to import essential food items.
Over the years, the country also began exporting garments, and earning foreign exchange from tourism and remittances (money sent into Sri Lanka from abroad, perhaps by family members).
Any decline in exports would come as an economic shock, and put foreign exchange reserves under strain.

(2) Series of BoP Crises

For this reason, Sri Lanka frequently encountered balance of payments crises.
From 1965 onwards, it obtained 16 loans from the International Monetary Fund (IMF).
Each of these loans came with conditions including that 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 of Sri Lanka, and depreciate the currency.
But usually in periods of economic downturns, good fiscal policy dictates governments should spend more to inject stimulus into the economy. This becomes impossible with the IMF conditions.
Despite this situation, the IMF loans kept coming, and a led the economy soaked up more and more debt.
The last IMF loan to Sri Lanka was in 2016. The country received US$1.5 billion for three years from 2016 to 2019.

The conditions were familiar, and the economy’s health nosedived over this period. Growth, investments, savings and revenues fell, while the debt burden rose.

(3) Terror attack changed the course

A bad situation turned worse with two economic shocks in 2019.
There was a series of bomb blasts in churches and luxury hotels in Colombo in April 2019.
The blasts led to a steep decline in tourist arrivals – with some reports stating up to an 80% drop – and drained foreign exchange reserves.
Second, the new government under President Gotabaya Rajapaksa irrationally cut taxes.
Growth demands stability and stability lies on effective leadership which is totally blurred in Sri lanka which is suffering from ongoing financial crisis.

(4) Pandemic

In March 2020, the COVID-19 pandemic struck.
In April 2021, the Rajapaksa government made another fatal mistake. To prevent the drain of foreign exchange reserves, all fertiliser imports were completely banned.
Sri Lanka was declared a 100% organic farming nation.
This policy, which was withdrawn in November 2021, led to a drastic fall in agricultural production and more imports became necessary.
A fall in the productivity of tea and rubber due to the ban on fertiliser also led to lower export incomes.

(5) Immediate triggers of the crisis

Leadership issues: Another instance that proved detrimental for Sri Lankan leadership is government where few members of the cabinets were immediate relatives of the Prime Minister (Rajapaksas).
Ukraine War: The invasion of Ukraine has further exacerbated the economic calamity of the country as Russia is the second biggest market to Sri Lanka in tea exports and its tourism sector is heavily reliant upon these two nations as most of the tourist arrivals are from Russia and Ukraine.

All these factors led to the implosion of Sri Lankan economy.

Is China the real culprit behind?

Many believe Sri Lanka’s economic relations with China are a main driver behind the crisis. The United States has called this phenomenon “debt-trap diplomacy”.
This is where a creditor country or institution extends debt to a borrowing nation to increase the lender’s political leverage – if the borrower extends itself and cannot pay the money back, they are at the creditor’s mercy.

A reality check

Sri Lanka’s economy, in recent months, started experiencing, what economists refer to as a ‘twin crisis’: in form of a combined balance of payment and sovereign debt crisis.

(1) Debts

The most “burdensome debt” in terms of maturity and rates is typically owed to international sovereign bonds.
Loans from China accounted for only about 10% of Sri Lanka’s total foreign debt in 2020.
The largest portion – about 30% – can be attributed to international sovereign bonds.
Japan actually accounts for a higher proportion of their foreign debt, at 11%.

(2) Losses from Ports

Defaults over China’s infrastructure-related loans to Sri Lanka, especially the financing of the Hambantota port, are being cited as factors contributing to the crisis.
But these facts don’t add up. The construction of the Hambantota port was financed by the Chinese Exim Bank.
The port was running losses, so Sri Lanka leased out the port for 99 years to the Chinese Merchant’s Group, which paid Sri Lanka US$1.12 billion.

Repercussions of the crisis

Sustenance crisis: For Sri Lankans, the crisis has turned their daily lives into an endless cycle of waiting in lines for basic goods, many of which are being rationed.
Energy sources exhausted: Soldiers are stationed at gas stations to calm customers, who line up for hours in the searing heat to fill their tanks. Some people have even died waiting.
Sacking of the public savings: Even members of the middle class with savings are frustrated, fearing they could run out of essentials like medicine or gas.
Public outrage: Meanwhile, Sri Lanka has imposed several curbs on social media and news flow, its stock market and currency is sharply down. Unrest is brewing, so police action, possibly brutal, looks inevitable.

What’s next for Sri Lanka?

In all probability, Sri Lanka will now obtain a 17th IMF loan to tide over the present crisis, which will come with fresh conditions.
Sri Lanka is now seeking financial support from the IMF and turning to regional powers that may be able to help.
Earlier, President Rajapaksa had weighed the pros and cons of working with the IMF and had decided to pursue a bailout from the US.
Sri Lanka has also requested help from China and India, with New Delhi already issuing a credit line of $1 billion in March.

Lessons to be learnt

(1) For India

While the Sri Lankan economic crisis may not directly impact India for now, the crisis itself offers useful political economy lessons for the Indian government.

Populist freebies has a dear cost: A majoritarian government announcing populist measures amidst a low-growth performance cycle creates macroeconomic crisis scenarios over time.
SL had fared better than India: Unlike Sri Lanka, India’s per capita income and performance in social sectors like healthcare, education and social security is worse.
Long term inflation is risky: India’s unemployment and joblessness crisis is far worse – in aggregate. Inflation too has remained high with the RBI struggling to keep consumer prices low.

The idea here is not to compare Sri Lanka with India as like-with-like. They are two different and geographically distinct nation-states with different social, political and economic features.

(2) Other SAARC members

Nations are collapsing: From Afghanistan and Pakistan, and now, Sri Lanka (with Nepal in queue), each nation’s political economy landscape appears to be in a depressing situation.
SAARC has become dysfunctional: Besides India, no other South Asian countries have offered any form of support or assistance to Sri Lanka, which raises alarm over the absence of regional cooperation in South Asia.

Way forward

Fiscal consolidation and discipline: What the Lankan economy would need is a robust path towards revenue based fiscal consolidation.
Near-term monetary policy tightening: It is needed to ensure that the recent breach of the inflation target band is only temporary.
Institution building reforms: such as revamping the fiscal rule, would also help ensure the credibility of the strategy, as the IMF report suggests.
Flexible exchange rate policy: Other (longer-term) reforms would need to include the creation of a flexible exchange rate policy and a medium-to-long-term debt reduction strategy, while ensuring most government spending in targeted social areas continues for developmental objectives.

Conclusion

It is no doubt that the over-dependence on China for economic development could be a miserable option for any country, and the latest examples of it, are Pakistan and Sri Lanka.
Also, Sri Lanka is a prime example of a third world country led by a post-colonial elite on the brisk of collapsing as a nation.