Economic and Strategic Dimensions of the Crisis in Sri Lanka

Sub Title : Sri Lanka will find it difficult to extract itself from this economic quicksand

Issues Details : Vol 16 Issue 2 May – Jun 2022

Author : Dr RajanKatoch

Page No. : 50

Category : Geostrategy

: June 1, 2022

The current situation is dire. Sri Lanka will find it difficult to extract itself from the economic quicksand it is currently in. India will have to be part of the solution. The strategic dimension to India’s economic outreach is now very important. India will also have to be politically non-judgmental

Lost in the midst of global attention on the Ukraine conflict, the crisis in Sri Lanka over the past few months has not grabbed the kind of headlines that its gravity warrants. Trouble has been brewing and escalating for quite some time. Matters are now coming to a head with rioting, arson, violence and street protests against the Government over the past month. The Government is on the back foot, and President Gotabaya Rajapaksa is at the centre of the storm. The chants in the street protests “Go Home Gota” and “Go, Gota, Go” say it all!

Though the President has declined to step down, these protests have forced him to get all his Ministers, (including strongman Prime Minister Mahinda Rajapaksa) to resign. He has imposed repeated curfews and ordered a crackdown on protesters. Not only this, but a national emergency has also been declared twice in around one month. The first one declared on 01 Apr was lifted on 05 Apr and the second one was declared  on 06 May. It has since been lifted (lasted two weeks). None of this seems to have helped dampen the unrest. The crisis is a classic example of how major economic policy failures can eventually have drastic political consequences. In an effort to improve the state of affairs  and bring stability the President has appointed Ranil Wickremesinghe as the Prime Minister. This is the sixth time that Wickremesinghe has become the Prime Minister of the country.

On 25 May Wickremesinghe was also  sworn in  as Minister of Finance, Economic Stabilisation, and National Policies. After assuming charge, he said that he would drastically reduce infrastructure projects to divert funds  for relief. The new Prime Minister’s  focus so far has been on seeking external assistance. He is also proposing constitutional reforms  wherein the powers of the president will be reduced and those of parliament strengthened.

So, what is the crisis?

In brief, Sri Lanka is virtually bankrupt. Foreign exchange reserves have fallen from US $ 7.5 billion in 2019 to US $ 1.6 billion in April 2022. Of this just US $ 50 million is “usable” or liquid reserves now, according to the Finance Minister. Against this, its external debt is about US $ 51 billion with repayments alone of around $ 7 billion due this year. This has compelled Sri Lanka to declare a first ever default on external debt repayments.

Sri Lankans are facing severe shortages of food, fuel and medicines.  Domestic availability is falling short of the requirement, and there isn’t enough foreign exchange available to be able to import and fill the gaps. Food inflation has reportedly hit 25% and is still rising, causing widespread distress all over. To deal with the situation, the President had imposed price controls last year. These didn’t work. The suffering of the people continues.

What led to this crisis?

There are many reasons, but four economic factors are significant.

The first is the disruption caused by covid pandemic, and prolonged nationwide lockdowns. The tourism sector crashed. Tourism had brought in about 20% of export earnings in the pre-pandemic period.

Many tourism dependent countries are similarly impacted, some more than others. Till tourism revives, this factor will remain and drag down the Sri Lankan economy.

The second is the spectacularly ill-timed decision of the present Government to make sweeping tax cuts upon assuming office in 2019. This hobbled the capability of the government to ramp up spending to tackle any unforeseen crisis. And unfortunately a crisis was around the corner, in the form of the pandemic.

The third (strangely) was a new farming initiative. In April 2021, the Government suddenly decided that Sri Lankan farming would go 100% organic. One would have thought that going organic farming would be a good thing. But this decision was made applicable with immediate effect. All fertilizer and pesticide imports were totally banned.

Hard hit by this drastic new policy were the major crops of tea, rubber and paddy. These crops were earlier heavily reliant on chemical fertilizers and pesticides. Tea exports declined, and production of the staple food crop paddy declined. Rice shortages resulted, and prices shot up. Suddenly a country that was earlier almost self-sufficient had to rely on imports of rice! The initiative has since been partially rolled back, but the damage has been done.

The fourth factor is the Government’s policy on external financing. In particular, there was an increasing reliance over the years on Chinese financing for vanity development projects to the exclusion of other available options. Notably, Chinese loans were provided on relatively stiff terms. Sri Lanka now owes more than $ 5 billion to China, about 10% of its total external debt.

There were always multilateral funding alternatives for Sri Lanka e.g. International Monetary Fund (IMF) lends funds to countries on easy terms to overcome short run balance of payments difficulties. The World Bank and other development banks provide development project financing on better terms than the market. However, the Sri Lankan Government was steadfastly opposed to IMF funding, preferring instead higher cost Chinese loans. Only last month, with default around the corner and imminent bankruptcy forcing its hand, did it reluctantly seek support from the IMF/Bank.

Sri Lanka has already paid dearly for its preference for usurious Chinese support. A prominent example is the case of Hambantota Port, which was originally financed with a Chinese loan. Just seven years after it was inaugurated, Sri Lanka found itself unable to pay back or service the Chinese loan. It had to settle the debt by handing over the port to a Chinese controlled company on a 99-year lease!

All these factors compounded each other, making the situation unsustainable. On top of all these preexisting crises, the Ukraine conflict is also hitting Sri Lanka hard. The cost of essential imports, particularly oil, is zooming up day by day. There were a few days last month when diesel pumps ran dry. Further, Russia and Ukraine had together historically accounted for a significant chunk of foreign tourist arrivals. They were also an important market for Sri Lankan tea. Both these foreign exchange earnings prospects have dried up.

What does this mean for India?

As it seems, although the pandemic did hit the island hard, the bigger economic mess it is in is largely of its own making. It has made conscious policy choices that have accelerated the slide.

Further, the Sri Lankan Government appears to have encouraged Chinese involvement in the economy. Partly due to this, Sri Lanka is caught in an external debt trap.

Should India then leave Sri Lanka to sort out the crisis by itself?

Leaving Sri Lanka to deal with its crisis on its own is not really an option for India. Sri Lanka is a close neighbour that it needs to remain engaged with. Longstanding civilizational, cultural and economic linkages and the immutable logic of geopolitics means that India is the country most invested in the well being of Sri Lanka. India needs a stable and prosperous Sri Lanka. Instability there is not in India’s interest. Ethnic Tamil linkages are also a factor in the equation.

The increased Chinese involvement has resulted in the strategic dimension of the relationship becoming more important. This may be a time for India to wrest back the strategic initiative that had earlier seemed to be slipping away. India has to stay in the game with investments and financial support, particularly at this time when Sri Lanka desperately needs immediate outside help to alleviate the suffering of its people and to get out of the mess it has got into.

Fortunately, that does indeed seem to be the effort. High-level exchanges have taken place between the two countries. There has been a fairly prompt response to requests for assistance from India. Official reports indicate that over the past few months about $ 3.5 billion of assistance has been committed by India. This includes a $ 1 billion line of credit to Sri Lanka for fuel, food, medicines etc. Under this line of credit, already 270,000 tonnes of diesel/petrol and 40,000 tonnes of rice have been physically shipped for immediate relief. India has got $ 1.5 billion of payments owed by Sri Lanka to the Asian Clearing Union deferred, and also extended a $ 400 million currency swap given in January this year.

India has another indirect mechanism of support. New Finance Minister Ali Sabry is reported to have stated that they are seeking $ 3-4 billion bridge financing from IMF to tide over the forex crunch, and another $ 500 million loan from the World Bank to support cash transfers to the poor. This IMF/Bank support too will be championed by India. Few know that India represents on the Boards of the Fund and the Bank a “constituency” that includes Bangladesh, Sri Lanka and Bhutan. Anything concerning Sri Lanka on these multilateral institutions accordingly concerns India. So when the proposal for support comes up for consideration to the Board, it will be the Indian Executive Director on the Board who will be lobbying for its clearance. It is unfortunate that despite this favourable configuration in the Fund/Bank, the Sri Lanka Government shunned financing from these institutions for so long, accentuating the crisis situation.

How about China and Pakistan?

Apart from India, two of the parties considerably involved in Sri Lanka are China and Pakistan. On its part, the Sri Lankan Government has consciously courted both China and Pakistan in the past. However, neither of these countries has any vital stake in the welfare of Sri Lanka; they only see it in terms of its strategic anti-India potential. In line with its long-standing approach of seeking to keep the rise of India in check, China has lapped up the opportunities offered by the Sri Lankan Government. Riding on the back of its growing financial strength, China liberally advanced funds to Sri Lanka. Over the years, it has now become the largest foreign creditor in Sri Lanka.

Through its Belt and Road Initiative, China stepped in aggressively with billions of dollars of loans to Sri Lanka for huge infrastructure projects such as the Colombo Port City, Mattala International Airport, and Hambantota Port. Many of these projects are white elephants, but have potential strategic significance for China to further its aim of “encircling” India. Inability of the Sri Lankan authorities to repay the loans has already resulted in China taking over control of one port. It is a possible indication of the direction the other important infrastructure projects may head towards.

Sri Lanka has reportedly sought $ 4 billion in assistance from China to tide over its current crisis. So far, apart from solemn assurances of “firm support” from China, the funds have yet to come. If and when they do, most of the money is expected to come in the form of loans to enable Sri Lanka to roll over repayments due to China on past loans!

With Pakistan, Sri Lanka has of late actively engaged with India’s hostile neighbor to strengthen both the economic and defence relationship. Pakistan is one of just three countries with which Sri Lanka has a Free Trade Agreement (FTA), the other two being India and Singapore. In the midst of the economic crisis, Pakistan has also offered a $ 50 million line of credit to Sri Lanka – not for emergency relief  – but for defence assistance! Notably, this is despite Pakistan’s own economic morass that in no small way contributed to the downfall of the Imran Khan government.

But then, with Pakistan, every policy is defined by its perennial hostility to India, and seeking to build defence cooperation with Sri Lanka is a part of this. Unlike Sri Lanka, it does not fear bankruptcy or default. Pakistan is secure in the knowledge that regardless of the hole that it is in, it will continue to be able to access timely external funding support, as it is perceived to be too dangerous to the world for it to be allowed to fail.

Finally, to whom does this crisis matter?

It matters, foremost, to Sri Lanka itself. Its people are in deep distress, for no apparent fault of theirs. The Government is seen as being responsible, and is under extreme domestic pressure to get its act together, or go.

Many of the causes of the crisis appear to be policy related, should not have happened, and can be addressed in the medium term by sensible policy measures. The Sri Lankan Government will now need to make the hard economic choices that have been avoided so far. The IMF/World Bank financing being sought will help in this regard. Entering into an arrangement with them will help restore Sri Lanka’s credibility amongst foreign creditors and open the tap to access essential imports. The Fund/Bank provide funding with “conditionalities” attached; these are basically the steps needed for the receiving country to stabilize the economic fundamentals, and boost revenues and forex earnings. Tough decisions on taxes, tariffs, exchange rates may be required.

For Sri Lanka to sustainably overcome the crisis, such decisions would have to be taken. In every such crisis there is also an opportunity for reform. All parties will have to be kept on board, for the steps to be taken successfully. It is possible that a different political dispensation may be needed to be able to credibly take such steps.

Sri Lanka will also need to take a political call on the countries whose support it has been relying upon. In the recent past, Sri Lanka has been tempted to court China and Pakistan perhaps to assert its independence and balance what a section of opinion may have perceived to be an excessive reliance on India. As a sovereign nation, Sri Lanka is entitled to its choices. However, for these countries that are essentially inimical to India, Sri Lanka is seen as just a pawn in the global scheme of things whose main usefulness to them is to needle India. It is not a pressing concern to them whether Sri Lanka succeeds or fails; they are merely fishing in troubled waters. The outcome of such initiatives, if pursued with, will inevitably lead to greater friction between Sri Lanka and India.

Governments in India and Sri Lanka have to appreciate geopolitical realities. India is the only country that has a vested interest in the long-term stability and well being of Sri Lanka, and likewise Sri Lanka’s best prospects of durable peace and prosperity is in a close and special relationship with India. Neither can afford to ever take this relationship for granted; they need to keep working at it.

The current situation is dire. Sri Lanka will find it difficult to extract itself from the economic quicksand it is currently in. India will have to be part of the solution, regardless. It will also have to be politically non-judgmental. By virtue of its geography, Sri Lanka is always going to be important for India. A stop-go approach as adopted at times in the past isn’t wise in the current context. The strategic dimension to the economic outreach is now very important. And it is in this backdrop that efforts are being made and need to consistently be made.