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Is struggling Sri Lanka salvageable?

Bangkok Post (Bangkok)
Syed Munir Khasru
April 08, 2022


Last Sunday -- with two notable exceptions -- Sri Lanka's cabinet resigned en masse in protest against the government's handling of the worst economic crisis to hit the island in decades, which has sparked widespread rioting, unrest, and arson attacks on police property.

The two men stayed put were President Gotabaya Rajapaksa and Prime Minister Mahinda Rajapaksa, scions and brothers of the powerful Rajapaksa clan.

The prime minister's son, Namal Rajapaksa, was among those who resigned, however, explaining via Twitter that the move would "help the President and PM to establish stability for the people and the government". President Gotabaya imposed a 36-hour curfew on Friday, a day after protesters clashed near his residence.

The economic downfall started with a changeover from an international trade strategy to focusing on domestic economy development. It resulted in shrinking trade as exports declined as a percentage of GDP -- 26% in 2005, 15% in 2010, 13% in 2015; and by 2020 at 12%. The domestic economy could not create demand to stimulate economic growth, which fell from 9% in 2012 to 2.3% in 2019.

Income tax concessions led to significant revenue loss of Rs 500 billion (55.8 billion baht; or 4% GDP). A ban on chemical fertiliser imports to promote organic farming led to crop failure and the country ended up importing staples such as rice, draining foreign reserves. By December 2019, the borrowing had shot up by Rs 4.2 trillion (173%) within two years. This is the country's worst economic crisis with rolling power blackouts, shortage of cooking gas and essential goods including food.

Borrowings from China to finance infrastructure projects such as a $1.4-billion port construction project left a hole in the reserves. Sri Lanka owes $35 billion (10% of its foreign debt) to China, by April 2021. Foreign reserves fell to $2.3 billion by 2022 and after removing illiquid balances from China, Sri Lanka is left with only $400 million. The government imposed an import ban in 2020 shooting up food prices up by 25% as overall inflation touched 17.5%. Rising prices coupled with high debt concretised the lack of essentials, with staples like rice, milk and sugar being rationed, and a ripple effect followed for most food items.

The economy remained vulnerable to external shocks as foreign reserves were based on foreign borrowings rather than export earnings. The government spent forex on debt repayment, depleting central reserves and drying up funds for food imports. Other external shocks affected the volatile economy, primarily the Covid-19 pandemic that contracted the economy by 3.6% in 2020. Foreign migrant worker remittances also declined, adding to the woes.

The pandemic was a blow to the country's tourism-dependent economy which has been on pause since 2020. Some 30% of Sri Lankan tourism depends on visitors from Russia, Ukraine, Poland and Belarus, which is now at an additional risk due to the Ukraine war. Petroleum products accounted for 20% of Sri Lanka's imports in December --having risen 88% compared to a year earlier. The Russia-Ukraine conflict is worsening fuel prices; adding to an already fragile economy that has only $2 billion in reserves, but $7 billion in debt payments.

High unemployment and skyrocketing inflation have prompted some Tamils to flee northern Sri Lanka to Tamil Nadu in India. Some refugees ended up stranded and later rescued by the Indian Coast Guard. Critical foreign currency shortages have left traders unable to finance imports as banks remain unable to finance the imports of food, fuel and medicines.

Sri Lankans have resorted to kerosene and firewood for cooking. Exams were cancelled for millions of students due to a printing paper shortage. The situation is dire with food being rationed at supermarkets and a shortage of essential goods. The price of food has increased more than 30%, and the price of some vegetables have quintupled. Poor availability and a price hike of milk powder has made young children's nutrition difficult. People have cut down their meals, with some sacrificing their meals to feed their children.

Sri Lanka's public debt increased from 94% in 2019 to 119% of GDP in 2021. Neighbours like China, India and Bangladesh have come to assist. In 2021, China swapped $1.5 billion to help reduce fluctuating exchange rates. India announced a credit of $1 billion for procuring food, medicines and essentials; $500 million was extended for petroleum purchase. Bangladesh offered a credit of $200 million to Sri Lanka in 2021. Pakistan and Qatar have also offered support.

The government took additional policy measures to reduce capital outflow; increasing investors' confidence by not defaulting debt-servicing; introducing import restrictions on luxury vehicles, fertilisers and food items to prevent currency outflows; restrictions on forward contracts foreign exchange; policies for improving foreign remittance inflow, such as diversifying foreign employment market, introducing a contributory pension and pay remittances above the normal exchange rate; boosting investors' confidence by offering provisions for Special Deposit Accounts. Although the country had earlier been sceptical of an IMF bail-out, it will now discuss an IMF rescue plan in addition to seeking World Bank support.

As an alternative to borrowing by way of increasing taxes and investments in healthcare and education, social protection can improve public financing and boost the economy for a lower-middle-income country like Sri Lanka. Strengthening offshore financial centres and addressing tax evasion should go hand in hand. However, collections from tax may not suffice as the current income levels may only yield proportionately low taxes.

A comprehensive policy is required for the country to bail itself out. Firstly, management of borrowings must be bettered. This includes addressing demand side issues, improving accountability and political commitment. Options such as diversifying and divestments may be explored in addressing issues that require immediate resolution. It is important to strengthen accountability of borrowers and lenders by bringing transparency in debt, so citizens and other civil bodies can collaborate for contingent liabilities management.

Debt reframing is a possible policy option that may be used in combination. Debt restructuring and rescheduling may be pursued by the renegotiation and modification of contract terms with lenders, while requesting concessions and extensions for tackling debt pay-outs. Renegotiations may also consolidate many debts into few.

Debt conversion is another way to ensure that local currency pay-out is not large -- this can be achieved through conversions of assets (such as debt for equity swaps) in place of cash and increase domestic money supply. It can be managed through schemes involving issuance of government bonds to strengthen domestic capital markets.

Sri Lanka must strengthen its shock and crisis management, and make the economy resilient to external shocks by introducing permanent mechanisms. The road ahead will be rocky but not insurmountable with some belt tightening, economic reforms and most importantly -- prudent political leadership.

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