The neighbouring island nation- Sri Lanka is caught in a downward spiral as it faces an economic crisis fuelled by depleting foreign exchange reserves, deteriorating currency and soaring inflation. The forex reserves of the nation have nearly halved to USD 2.8 billion in a year, resulting in a depreciating currency that crossed a historical high of Rs. 201 to USD. As an import dependent nation, this translates into higher food and fuel prices. In an attempt to contain the rising inflation, the Sri Lankan President Gotbaya Rajapaksha declared an economic emergency to seize the stock of food and regulate their prices.
The crisis however, is not an overnight development but a result of decades of historic disregard to debt sustainability. This has manifested through frequent balance of payment crisis and instability evident by the fact that in a period of around 50 years, Sri Lanka has been part of 16 macroeconomic stabilisation programmes with the IMF. While COVID-19 outbreak has been a contributing factor to the downturn, a significant cause of the stress stems from the government’s unsustainable budgetary operations, populist politics and policy short-sightedness.
Srilanka is a classic twin-deficit economy i.e., the country’s national expenditure exceeds its national income (Budget Deficit), at the same time, the production of tradable goods and services is insufficient (Current Account Deficit). The underlying cause of the budget deficit has been the drastic reduction in collection of government revenues while the expenditure remaining high, more so in a pandemic year. A lack of public expenditure management is equally to be blamed for this fiscal fiasco.
Price of Populism
In a populist move, the Rajapaksha government introduced a new tax regime in 2019 which abolished PAYE (Pay as You Earn) Taxes, reduced corporate tax, and value added services tax, etc. This resulted in a significant decline in government revenues. Collection further deteriorated due to the shortfall in revenue from tourism triggered by the pandemic.
Similarly, the government also announced creation of one lakh employment opportunities in the public sector annually. The increase in public sector recruitments and upward revisions in salary and pension payments have contributed to high revenue expenditure. As per statistics, the expenditure on salaries and wages alone utilised about 36 per cent of government revenue in 2019 while expenditure on subsidies and transfers including pension payments, accounted for 26.7 per cent of government revenue in 2019. This leaves limited leg room for other financial obligations. Faced with fiscal constraints, the government continued to resort to borrowings through sovereign bonds and international bilateral commercial loans, generally at high-interest rates and short payback periods. The expansionary fiscal stance has also negatively influenced private investment decisions.
This lack of expenditure rationalisation has snowballed into a crisis largely due to these populist sentiments prevailing over sound economic logic in Sri Lanka. The primary challenge now is to improve the quality of public expenditure and enhance revenue by adjusting the fiscal deficit in a financially sustainable way.
On the current account side, there has been a structural deficit owing to the anti-export policies. As a strategy to manage foreign debt, the country placed prohibitive barriers to trade on a broad range of items.
With more than 57% of imports being either intermediary or capital goods, the restrictions have put businesses in jeopardy due to increased cost of domestic production.
Another short-sightedness in policy is reflected in the government’s decision to transition to 100 percent organic farming coupled with an import ban on chemical fertilizers. The mammoth switch to organic farming serves two important lessons.
Firstly, a policy should give a reasonable timeframe for the economic agents to adjust. The lack thereof has put the agricultural sector of the country in complete disarray. Secondly, a policy should be cognisant of the cost of transition. A productivity drop that is projected at 25 percent has serious ramifications on agricultural yield and potential exports revenues.
Tea has been one of the top exports of Sri Lanka which generated $811M worth revenues in 2019. The move misses out on boosting exports- a key policy lever that could have been leveraged, given the depreciating currency. Since Sri Lanka imports approximately $400 million worth of fruits and vegetables per year to meet its total domestic demand, any restrictive policies preventing domestic production may result in food shortages and a higher import bill.
Sri Lanka has now course-corrected this policy by lifting the ban. However, in a major turn of events, a recent dispute occurred with China over contaminated fertilizer that Sri Lanka refused to accept. Following this, China slapped a ban on Sri Lankan Bank for defaulting on payments. With China constituting over 10 percent of Sri Lanka’s debt, the changing power dynamics are reflected in this economic and political milieu. The retaliation by China highlights how the economic sovereignty of a country diminishes when it wrestles with excess debt.
Consequence of Coercion
With the government wielding the power to control food prices and seize stock supplies, there is a risk of drop in supplies. The State’s rogue decisions can discourage traders when supplies are seized and penalties are charged. The decision of the Sri Lankan central bank to ban forward contracts and the spot trading of rupees at above 200 rupees to an American dollar may also do the unintended, by causing greater volatility in food price. The inadvertent consequence of this decision apprises us that in many contexts, not-doing-anything at all proves to be optimal policy response than having to do-something.
Sri Lanka’s descent into crisis is a cautionary tale on the implications of fiscal excess on the overall economy. While much of the domestic policies have now been reversed lately, it leaves lessons for South Asian counterparts traversing through similar trajectories. They are summed up below –
Views expressed by the author are personal and need not reflect or represent the views of Centre for Public Policy Research.