April 6, 2022
NEW DELHI – The current social and political turmoil in Sri Lanka is once again a stark reminder of what happens when a country indulges in the freebie culture and mismanages its public finances, especially public debt.
Like all countries, the island nation was hit hard by the pandemic which was exacerbated by the Easter Sunday terrorist attacks in April 2019 that killed 269 people. These two had affected its vital tourism sector ~ the third largest and fastest growing source of foreign currency after private remittances and textile exports.
With tourist arrivals dwindling from 2.3 million to only half a million between 2018 and 2020, earnings from tourism nosedived from $4.4 billion, or 4.9 per cent of GDP, to a paltry $682 million or 0.84 per cent of GDP. Long before the pandemic, the import-dependent country was highly vulnerable to external shocks owing to inadequate external buffers and high risks to public debt sustainability.
Then in the November 2019 parliamentary elections, Gotabaya Rajapaksa, who spearheaded the brutal crushing of Tamil Tigers a decade ago, stormed to power on the promise of freebies and massive tax cuts. He reduced the GST rate from 15 to 8 per cent and abolished a 2 per cent Nation Building Tax. While the tax revenues shrank drastically, sweeping loan waivers and subsidies for the farm sector drained the exchequer.
The pandemic contracted the real GDP by 3.6 per cent in 2020 and fiscal deficits soared beyond 10 per cent in FY2020 and FY2021. A ruinous organic farming programme was launched in 2021 with total ban on chemical fertilisers and pesticides which drastically reduced farm output and pushed up prices of foodgrains. It was a completely man-made disaster to which successive governments had contributed equally. At the heart of the problem was fiscal profligacy and unsustainability of public borrowing, especially from external sources.
For the past 15 years, every government had issued sovereign bonds without provisioning for repayment. The country’s foreign exchange reserve thus increased by borrowing in foreign currencies, not through the sensible way of export of goods and services. Unlike IMF loans, these International Sovereign Bonds (ISBs) had no strings attached to them, but came at a price ~ high interest rates, shorter maturity periods, and higher risks. By 2019, commercial borrowings, which were a mere 2.5 per cent of foreign debt in 2004, had ballooned to 56 per cent.
The country thus became extremely vulnerable to market shocks, and it credit rating was downgraded after the sweeping tax cuts and populist measures when it lost access to the ISB market in 2020. With that was gone its ability to roll over its ISBs, and it is now digging into foreign reserves to meet debt servicing obligations. The forex reserves thus plummeted from $8.8 billion in June 2019 to only $2.4 billion in January 2022 ~ equivalent to just one month’s essential imports which precipitated the present crisis.
The country has debt repayment obligations of $4 billion during 2022. A part of the problem was over $5 billion loans from China during the past decade, most of which were invested in lowreturn projects such as construction of ports, airport and coalpowered plants. China had invested $12 billion till 2019 to fund infrastructure projects like the Colombo Port City for reclaiming 269 hectares of land from the sea, being executed by its state-owned China Communications Construction Company at a cost of $1.4 billion.
It is expected to be completed by 2043, and will yield no revenue till then. Even thereafter, 43 per cent of the reclaimed land will be leased to China for 99 years. It recalls the case of Hambantota, for which China gave an estimated $1 billion loan, when every feasibility study advised against it. Indeed, with 36,000 ships, including 4,500 oil-tankers passing along one of the world’s busiest shipping lanes, the port drew only 34 ships in 2012.
The project distinguished itself by failing, and the country, being unable to service the debt, was forced to lease the port and its surrounding 15,000 acres to China for 99 years. This is how China’s BRI works: finance doomed infrastructure projects using Chinese companies and then take over strategic infrastructure. China is also involved in several other infrastructure projects in Sri Lanka like the coal-fired Narocholai power project, Mattala International Airport, Colombo International Container Terminal, etc. Between 2012 and 2018, Sri Lanka’s external debt to China rose from $2.2 billion to $5 billion.
Sri Lanka’s debt now stands at a dangerous level of 119 per cent of its GDP, with 64 per cent of its outstanding debt stock owed to external debtors. Over 10 per cent of its total debt stock is owed to China, but unlike other external debtors like Japan, ADB, World Bank etc., most of its Chinese loans are non-concessional commercial loans commanding interest rates of 6.5 per cent as against 2.5 to 3 per cent for other loans. In fiscal year 2021, its interest payments alone consumed over 95 per cent of its total revenues.
With a highly regressive tax system where indirect taxation accounts for over 80 per cent of revenue, over 50 per cent coming from import duties alone, it is sure recipe for disaster. Lack of an equitable tax policy coupled with irrational tax concessions has kept the tax base small, leaving no option for the government but to resort to increasing commercial borrowings. Its tax to GDP ratio has fallen continuously since 2016 from 14.1 per cent to only 8.4 per cent in 2020.
The tax cuts in 2019 were the proverbial straw that broke the camel’s back, plunging the country into an inevitable and irrevocable financial catastrophe, the heavy price of which is being paid by the people today. Sri Lanka’s is an overwhelmingly import-dependent economy ~ now it has no forex reserves to buy most essential goods like petrol, diesel, food, sugar, lentils, paper, medicines etc. that it imports. Such is the crisis that it had to cancel exams of students due to a crippling shortage of paper.
Newspapers have stopped publishing print editions due to shortage of newsprint. Operations at oil refineries have been suspended due to shortage of crude oil. Power cuts have been imposed for 13 hours a day due to shortage of fuel like coal and oil which have to be imported.
Queues at petrol pumps and for cooking gas cylinders are more than a kilometre long, with people queueing each day from 4 a.m. Limited availability of external financing forced the Central Bank of Sri Lanka (CBSL) to directly finance the huge budget deficits fuelling inflation. In March 2022, the retail inflation rate was 18.7 per cent ~ way above the target band of 4-6 per cent.
Food prices have risen by 30 per cent ~ one cup of tea now costs Sri Lankan Rupee (SLR) 100, up from SLR 25 in October 2021. One kilogram of rice costs Rs 500, one kilogram of milk powder costs Rs 800. By the time this article gets to print, the prices will have risen further. Sri Lanka also had a fixed exchange rate with the SLR pegged to the US dollar; the fixed exchange rate led to the increased use of informal channels to repatriate the earnings of non-residents.
The current account deficit widened from 1.3 per cent of GDP in 2020 to 3.8 per cent in 2022, and soaring inflation coupled with low forex reserves forced the CBSL to devalue the SLR, which depreciated from 201 to a dollar on 7 March to 298 on 3 April.
Devaluation of currency has increased the cost of imports and consequently rise in prices of goods, with consequent effects on inflation which recorded a new peak during each of the last six months, and is likely to remain in double digits, unless the government rolls back its tax cuts and curtails welfare expenditure, which will trigger further social and political chaos.
But the only possible way out of this quagmire is to restore macroeconomic stability and debt sustainability, while protecting vulnerable groups through well-targeted social safety nets. It will have to phase out the central bank’s direct financing of budget deficits, besides a gradual return to a market-determined exchange rate to rebuild international reserves. These are the conditions the IMF will certainly impose for bailing the country out of the crisis which will exact political costs, the reason why the government was so far unwilling to approach the IMF, preferring instead friendly countries like China and India.
China had provided a currency swap of $1.5 billion in 2021. India has provided a total assistance of $2.4 billion, including $400 million swap to help boost its reserves. The challenges the country faces are formidable, and the government seems to have no clue at all.
The capital is under indefinite curfew in the wake of the violence by protesters demanding Mr Gotabaya’s resignation. His entire cabinet except his brother Mahinda who is the PM has already resigned. When populism and recklessness in spending get the better of prudence in managing public finance, this is what happens. The world has witnessed this turmoil many times ~ in Venezuela, Argentina, Greece and elsewhere.
Some Indian states seem to be going the same way, Punjab, for example, after the elections. The AAP government should heed the warning signals emanating from Punjab’s precarious financial position and desist from indulging in further populism to avert a bigger disaster.
(The writer is a commentator, author and academic. Opinions expressed are personal)