SRI LANKA – BAD POLICIES, BAD FRIENDS AND BAD LUCK

Sri Lanka, an island nation of 22 million, is facing an economic and political crisis of unprecedented nature. Prices of essential commodities have sky-rocketed as their currency has devalued and there is crippling inflation. A mad rush at organic farming has ruined their agriculture and an economy which was already challenged by bad loans, too many subsidies and too few taxes is now falling apart. With protesters taking to the streets in defiance of curfews and government ministers stepping down en masse there is disorder and chaos and virtual anarchy. A 60 per cent drop in the Sri Lankan rupee’s value since mid-March have made even basic commodities unaffordable for many families.

 

Bad friends

Sri Lanka’s economic disaster has deep roots: the country has long lived beyond its means – borrowing too much and taxing too little – and produced below its potential. Sri Lanka’s international debt obligations have steadily grown, in part because of costly infrastructure projects financed with Chinese loans that must be repaid even though the projects have yet to pay economic dividends. China with its infamous Belt and Road Initiative holds a significant portion of Sri Lanka's total foreign debt, nearly 10%, with more held by Japan, the World Bank and the Asian Development Bank. India holds nearly 3%. Besides repaying these loans the country also needs to finance its chronic budget deficits generated by a large public sector and low taxation rates. Sri Lanka has requested China for debt restructuring but China is yet to grant this request. Instead China provided relief to Sri Lanka by providing a Yuan swap of 10 billion Yuan, so a new loan to service the old loans! India however has already done debt restructuring and extended a new line of credit to a friend in need.

 

Too much borrowing

Over the past decade, the Sri Lankan government has borrowed vast sums of money from foreign lenders to fund public services. Sri Lanka then had to fall back on its foreign exchange reserves to pay off government debt, shrinking its reserves from $6.9 billion in 2018 to $2.2 billion this year. This impacted imports of fuel and other essentials, which sent prices soaring. Its foreign debt obligations for this year exceed $7 billion. But the country's foreign exchange reserves as of March 2022 were just $1.6 billion! Obviously they had to declare a default on their debt repayment.

 

Since graduating into a lower middle-income country in the early 2000s, successive Sri Lankan governments have been increasingly borrowing from private international capital markets through the issuance of sovereign bonds, seriously contributing to the precarious nature of the balance-of-payments of the country. This capital-market borrowing is unconditional, with relatively high interest rates and much shorter durations of repayment. These Sovereign Bonds account for nearly half of the country's total outstanding external debt. A sharp decline in the market prices of these bonds followed Sri Lanka's announcement of a per-emptive default on its foreign debt.

 

Populist Tax cuts

Sri Lanka's government recently offered unsolicited value-added and income tax cuts to taxpayers. President Gotabaya Rajapaksa slashed taxes in a doomed attempt to stimulate the economy. This move however backfired and instead led to an extreme loss of government revenue. That prompted rating agencies to downgrade Sri Lanka to near default levels, meaning the country lost access to overseas markets. As a consequence, the Sri Lankan Rupee started to slip. Without the necessary cash reserves in place, in early March Sri Lanka had to allow the rupee to free fall. If instead of slashing personal income tax and corporate tax the President would have opted for a reduction in indirect consumption taxes such as the VAT , that could have been beneficial to the common people, but it seems the President had other ideas. So you see the economic crisis is home-made and long-running and the COVID pandemic and the war in Ukraine only worsened it.

 

Too little production

Sri Lanka produces very little and relies mostly on imports. It imports almost everything including much of their food and medicine, and all of their fuel. The primary form of agriculture in Sri Lanka is rice production. Rice is cultivated during Maha and Yala seasons. Tea is cultivated in the central highlands and is a major source of foreign exchange. Vegetables, fruits and oilseed crops are also cultivated in the country but still what they produce is not enough. Besides tea, which is their main export, they also export coffee, knitted and non-knitted clothing, fish and crustaceans, pearls and precious stones.

 

The bright idea of organic farming

In organic agriculture, yields for most crops are likely to be lower than those that are given fertilisers. If the natural resource endowment of the country cannot feed the entire population through organic produce, it should be ready to import. That's the problem with Sri Lanka. Tea, rubber, cashew, coconut, sugarcane and oil palm cannot be substituted for food. Agricultural activities are carried out on 41.63 % of the total land in Sri Lanka. Of this, 23.45 % is used to grow paddy and other field crops; 10.32 per cent land is devoted to plantations. Considering a consistently lower yield of paddy in Sri Lanka compared to international averages, would this land be sufficient to stockpile supplies for a primarily rice-eating nation? Was this factor considered in the decision when they suddenly switched to organic farming? Their tea production, the crop which earns maximum foreign exchange, fell by 40%, so was organic farming a good idea? As generations of farmers have adopted green revolution farming, the skills and knowledge required for organic farming are scarce today. Can Sri Lankan farmers make the right choices regarding seeds? Do they have access to seed banks? Are they aware of organic soil nutrients and bio-pesticides? Obviously not, and as a result, agricultural yields plummeted, farmers got poorer and the government was forced to import more food.

 

Bad luck

This borrowing spree has coincided with a series of hammer blows to the Sri Lankan economy, from both natural disasters such as heavy monsoons to man-made catastrophes, including terrorist attacks and stopping of remittances from Non Resident Lankans staying and working overseas. The Easter bombings of April 2019, along with the rise of the Covid-19 pandemic, led to a fall in tourism revenues. In absolute terms, tourism earnings fell from $4.4 billion in 2018 to just $682.4 million in 2020 and $506.9 million in 2021. Tourism revenues contributed 4.98% to GDP in 2018, but below 1% now.

 

Undemocratic and headstrong leadership

The President’s authoritarian, centralised and non-transparent decision-making along with a coterie of cronies is central to the crisis. Oblivious to criticism, his administration rejected repeated calls for a course correction as the crisis deepened. Defying expert opinion, the president and his Central Bank governor initially refused to enter into negotiations with the IMF to arrange a financial package that could win international creditors’ confidence and allow for the restructuring, and reduction, of Sri Lanka’s debt. Instead, throughout 2021 and the first quarter of 2022, the government arranged a series of short-term currency swaps and credit lines from China, India, Bangladesh and others. These were merely Band-Aids for the bullet holes which the economy suffered.

 

The prescription

Sri Lanka urgently needs the International Monetary Fund (IMF) to bail it out of insolvency. IMF had issued a statement outlining the reforms needed to win its financial support. These include a long series of austerity measures, from budget cuts to income tax and VAT increases, an end to inflationary money printing by the Central Bank, phasing out import restrictions, stopping government interventions aimed at stabilising the rupee, and “growth-enhancing structural reforms”, which will likely include the sale or partial privatisation of state-owned companies.

 

Lessons for India

There is a lot to learn from the Sri Lankan crisis. The most important thing is that we have to produce more and import less and Atmanirbhar Bharat should not remain merely a slogan. We should cut our coat according to our cloth and not indulge in careless borrowing. We should be fiscally responsible and for that election gimmicks like loan waivers, free electricity, free water should all be either budgeted or absent. Before the Green Revolution in the 1960s during which agriculture in India was converted into a modern industrial system by the adoption of technology, such as the use of high yielding variety seeds, mechanized farm tools, irrigation facilities, pesticides and fertilizers, we were not producing enough food grains to feed our own people and today despite having twice the population we are exporting food grains; we must not lose this edge by indulging mindlessly in organic farming. The government must listen to multiple domain experts before deciding economic and fiscal policies and must still remain open to coarse correction if the Geo-political situations change.