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An Outcome of Populist Macroeconomics and Family-run Polity?

The Sri Lankan Crisis

Many have argued that the current Sri Lankan crisis was caused by the economic impact of the COVID-19 pandemic and the Ukraine war, and the country’s overdependence on predatory Chinese lending. Sri Lanka’s problems are more deep-rooted and have their origins in economic policy that focused on providing fi scal sops and a family-run political establishment that enabled the government to ignore sound advice.

The recent political and economic crisis in Sri Lanka had attracted quite a bit of attention from the analysts, academia, and media alike. Various hypotheses and questions have been put forward in popular parlance. Has Sri Lanka lived beyond its means and taken its social welfare measures (freebies, acc­ording to some views) beyond the logical extreme? Or, is it in line with the prediction of political instability and civil unrest in emerging economies following the COVID-19 pandemic and the Russian invasion of Ukraine in early 2022 (United Nations 2022; World Bank 2022)? Or, are there some deep stru­ctural issues that have remained unaddressed for long that precipitated this crisis?

The causes of the immediate crisis in the island nation seem clear. The coll­apse of tourism caused by travel restrictions, the consequent draining out of foreign reserves, and rising food and ­energy costs caused by the Ukraine conflict seem to have led to an economic collapse. Food and fuel scarcities forced the citizens of the country out on the streets to remove what they felt was an ineffectual and corrupt government. Prime Minister Mahinda Rajapaksa was forced to resign on 9 May 2022, and his brother Gotabaya Rajapaksa, who was the President, fled the country on 13 July 2022, and resigned from his position the next day. As we write, there does not seem to be much light at the end of a dark tunnel for the newly appointed President Ranil Wickremesinghe, who was sworn in on 21 July 2022.

In this article, we will argue that it would be wrong to attribute the present crisis solely to the pandemic and the consequences of Russia’s actions in Ukraine. Sri Lanka’s economic and political problems predate both, and arguably, the crisis could very well have been avoided if Sri Lanka had an enabling domestic poli­tical environment that supported sound economic policymaking. However, poli­tical power was concentrated in one single family and economic policy seems to have been driven more by populist imp­ulses rather than economic realities. While the crisis might have been precipitated by the pandemic and war, it was inevitable that Sri Lanka would face ­socio-economic difficulties and political unrest, given the direction of government policy since 2009 when the government finally won a long-running civil war against the Liberation Tigers of ­Tamil Eelam (LTTE). But, to begin with, let us turn to the economic dimensions of the crisis.

Fiscal Sops and the Pandemic

Economic crisis is nothing new to Sri Lanka. The country has been taking re­course to International Monetary Fund (IMF) loans for quite some time.1 In fact, the context of the current economic crisis has been succinctly summarised by the IMF’s Article IV Consultation with Sri Lanka Report, 2021 (released on 25 February 2022) as:

In the context of substantial shocks, the programme supported by the IMF during 2016–19 could not resolve all of Sri Lanka’s vulnerabilities. The combination of unbalanced macroeconomic policies and a difficult external environment prompted the authorities to embark on the adjustment programme in 2016, supported under the Extended Fund Facility … by the IMF. Important progress was made through prudent monetary policymaking, earlier fiscal consolidation, and landmark reforms including a new income tax law and an automatic fuel pricing mechanism. However, programme implementation was challenged by large unforeseen shocks including the 2017 drought, the 2018 political crisis, and the 2019 terrorist attack. Inflation was stable but growth was weaker than initially projected. Reserve accumulation was hampered by renewed exchange rate pressures and capital outflows, reflecting both global and domestic factors. Large depreciation in late 2018, a reversal of fiscal consolidation in 2019, and a real interest rate shock resulted in an increase in the public debt to GDP ratio. (IMF 2022: 5)

 

In fact, even before the pandemic, in late 2019, Sri Lanka introduced a number of fiscal sops. In retrospect, it seems that the tax sops came at a most inopportune moment. Various measures were introduced: raising tax-free allowance from Sri Lankan (LKR) `5,00,000 to LKR `3 million; reducing the top marginal tax rate from 24% to 18%; reducing the corporate income tax rate from 28% to 24%; reducing the rate of standard value added tax from 15% to 8%; and elimination of the economic service change and nation-building tax, to name a few. Consequently, the general government revenue suffer­ed. With a rising government exp­endit­ure, such tax sops led to a shooting up of the general government net borrowings, which increased from 5.3% of the gross domestic product (GDP) in 2018 to 12.8% of GDP in 2020 (Figure 1).

During the pandemic, the Sri Lankan government took a broad set of relief measures, such as (i) macroeconomic policy stimulus; (ii) an increase in social safety net spending; (iii) loan repayment moratoria for affected businesses; and (iv) a strong vaccination drive (IMF 2022). Per se, all these are fairly standard measures adopted worldwide; however, in the Sri Lankan case, the fiscal deficit almost became unsustainable bec­ause of the near-absence of fiscal space triggered by the tax sops introduced earlier. The 2019 tax cuts coupled with the COVID-19 impact on revenues, and the expenditure measures widened fiscal deficits to 12.8% of GDP in 2020 and 11.4% of GDP in 2021. Such increases in fiscal deficit raised public debt above 100% of GDP (Figure 2). Due to their timing, the tax sops coupled with the pandemic-related fiscal stimulus turned out to be a recipe for a macroeconomic disaster. Meanwhile, with the drying up of tourism during the pandemic, Sri Lanka’s current account deficit also became unmanageable. While the current acc­ount deficit shot up after the global fin­ancial crisis, it improved till about 2019. The pandemic caused a substantial deterioration in the current account deficit; it is projected to go as high as 7.1% of GDP in 2022 (Figure 3).

With the emergence of such twin defi­cits came a rating downgrade and eventually Sri Lanka lost access to the international capital market. Consequently, its foreign exchange reserves became critically low.2 Sri Lanka’s bond spread over the emerging markets bond index (EMBI) also increased recently to more than 25%, making the cost of borrowing prohibitively high.3 While financial support from neighbouring countries relieved the stress to some extent, such assistance is clearly not enough. Speci­fically, Sri Lanka received assistance from Bangladesh ($200 million), China ($2.8 billion), and India ($1.4 billion) during the pandemic. It also received new special drawing right (SDR) allocations from the IMF in August 2021 amounting $780 million, “85% of which had been converted and used for debt ­repayment and forex intervention as of end–2021” (IMF 2022). Effectively, its net international reserves have become negative since November 2021. In May 2022, Sri Lanka defaulted on its debt and despite the negotiations with the IMF, any bailout package is yet to emerge (Senanayake 2022). Thus, in the short run, the crisis seems to have stemmed from the twin deficits in the fiscal acc­ount and the current account. But there is an influential view that there are structural factors behind a crisis and

Macro risk factors, such as a 26-year-long civil war, the persistence of terrorism and violent incursions by fringe groups, public skepticism toward competitiveness-oriented privatisation, and a cultural predisposition against FDI and raised taxes, have all engendered … “systemic fragilities” within Sri Lanka, awaiting triggers that would ignite the flashpoints. (Rafi and Wong 2022)

Dependence on China

Two other aspects of Sri Lanka’s government action seem to have contributed to the crisis breaking out in 2022—an increasing reliance on Chinese loans to fund investment, particularly in infrastructure, and the concentration of political power in the hands of the members of the Rajapaksa family. To what extent did these contribute to the crisis?

 

China’s role in the current crisis: China’s relationship with Sri Lanka stren­gthened considerably when Mahinda Rajapaksa was President from 2005 to 2015. Chinese financial assistance was $12.4 billion between 2005 and 2014 (Hein 2020). Sri Lanka’s economic relationship with China deepened after 2013 when the Chinese President Xi Jinping launched the Belt and Road Initiative (BRI), also known as the One Belt, One Road Initiative (OBOR). During President Xi’s visit to Sri Lanka in 2014, the two countries signed a development cooperation agreement, which envisaged the development of the capital city of Colombo as a business hub and the port of Hambantota as a trans-shipment port, with a highway connecting the two cities. For China, the port of Hambantota was strategically significant since Chinese imports of West Asian oil passed through the Indian Ocean and China had concerns regarding the security of its sea lanes of communications (SLOCs).

While the initiative seemed to be bold, visionary, and potentially capable of transforming Sri Lanka’s economy into a high-growth economy, there were two primary concerns with how the project evolved. The first was the debt burden taken on by Sri Lanka to fund these projects, which sharply increased Sri Lanka’s dependence on China and the second was the environmental damage caused by these investments (Ruwanpura et al 2020). However, while the dependency on China increased since 2005, it should be noted in the context of the present crisis that high levels of Chinese debt were not a major factor that contributed to the crisis. Of Sri Lanka’s total debt of $38.6 billion, China’s share was only 10%, the same level as its level of indebtedness to Japan, and lesser than that of other foreign creditors such as sovereign bondholders and the Asian Development Bank (Macan-Markar 2022).

It appears that it is not the level of ­indebtedness, but rather China’s failure to continue to provide standby assistance to Sri Lanka since early 2022 that seems to have precipitated the crisis. This refusal to help seems surprising, espe­cially given the close relationship that the two Rajapaksas who held the posts of President and Prime Minister, deve­loped with the Chinese government, particularly President Xi. The reluctance to bail out Sri Lanka could perhaps be att­ributed to a growing realisation in China that continued support would, in effect, be “throwing good money after bad.” Some have argued that Chinese policy can be compared to those of colonial powers, and Chinese policy could be designed to force a Sri Lankan default to enable it to take control of its strategic investments in that country (Basu 2022).

This Chinese approach to solving Sri Lanka’s economic problems is reflected in Chinese official media which has called on the IMF and other international institutions to help countries such as Sri Lanka overcome the present economic crisis. A commentary for Global Times, a newspaper which is often used by the Chinese government to communicate its official position of global issues, said,

Professional finance organisations, such as the International Monetary Fund and World Bank, should be largely responsible for addressing the crisis based on effective coordination with all creditors.4

Family-run Politics

 

Democracy, ethnocracy, and the failure of governance: A civil war that pitted the Sri Lankan government, dominated by the majority Sinhalese, and the LTTE, claiming to represent the minority Tamil community’s interests, lasted over two-and-a-half decades and caused lasting damage to Sri Lanka’s democratic traditions and institutions. Once the Sri Lankan government emer­ged victorious, the country moved rapidly towards an authoritarian government. Although governments were democratically elected, they primarily protected majorita­rian interests and moved to quell any opposition (DeVotta 2021).

The domination of the Rajapaksa family over Sri Lankan politics since 2005 was based on the critical role that the members of the family played in defeating the LTTE. Mahinda Rajapaksa, who was the President when the civil war was won in 2009, had given his two brothers, Gotabaya Rajapaksa and Basil Rajapaksa important positions in government. Gotabaya Rajapaksa was put in charge of defence and Basil Rajapaksa as the minister in charge of the economy. Though his government subsequently became unpopular, and he lost power in 2015 to Maithripala Sirisena, the general secretary of another Sinhala-dominated party, the Sri Lanka Freedom Party, this interregnum was short-lived. Corruption scandals and the 2019 Easter Day terrorist bombings once again saw issues of national security emerging as a major concern, and the Rajapaksa family returned to power. In the presidential election of November 2019, Gotabaya Rajapaksa was elected as President. In the parliamentary elections held in ­August 2020, a new party formed by the Rajapaksa family, the Sri Lanka Podujana Peramuna (SLPP), won 60% of the vote and got a supermajority in Parliament. Mahinda Rajapaksa was appointed the Prime Minister.

The family’s almost total control of the institutions of state had a policy imp­act as well. Family members and their close associates were appointed in the government. Professional bureaucrats who spoke out against different government policies were either removed or left the government in protest (Klem and Samararatne 2021). Agricultural output was hit by a ban on use of chemical fertilisers, a measure taken without consultation with farmers, and without arrangements to make sufficient organic fertiliser available. The familiar pattern of authoritarian and populist governments ignoring sensible advice seems to have been repeated in Sri Lanka as well.

Concluding Observations

Sri Lanka is often cited as a state with impressive social indicators in South Asia (Drèze and Sen 2013). Hence, in the context of the current crisis, people have wondered whether such impressive social achievements have come at the cost of populist macroeconomics. Purely going by the timing of the trigger, that does not seem to be the case. The reality seems more nuanced. We find that given the emergence of family-dominated politics, placating the citizens with sops, and relying on China to provide investment and financial assistance, were means of ensuring the legitimacy of the government. Given the onslaught of the pandemic, such fiscal lenience backfired badly. In public policy literature, the success of a government is often attributed to good policy and good luck. Sri Lanka’s current crisis seems to have emanated from bad policy and bad luck.

Notes

1 History of lending commitments as of 30 September 2018 is as follows:

The IMF (2022) has estimated that Sri Lanka’s foreign exchange reserves would continue to remain “critically low at around one month of imports over 2022–26.”

3 The emerging markets bond index (EMBI) is “a benchmark index for measuring the total ­return performance of international government and corporate bonds issued by emerging market countries that meet specific liquidity and structural requirements” (https://www.investopedia.com).

4 See https://www.globaltimes.cn/page/202207/1270278.shtml. Last viewed on 22 July 2022.

References

Basu, Kaushik (2022): “Why Sri Lanka Imploded: Project Syndicate,” 22 July, https://www.project-syndicate.org/commentary/sri-lanka-why-it-has-collapsed-by-kaushik-basu-2022-07.

DeVotta, Neil (2021): “Sri Lanka: The Return to Ethnocracy,” Journal of Democracy, Vol 32, No 1, pp 96–110.

Drèze, Jean and Amartya Sen (2013): An Uncertain Glory: India and Its Contradictions, Princeton: Princeton University Press.

Hein, Patrick (2020): “The Patterns of Chinese Aut­horitarian Patronage and Implications for Foreign Policy: Lessons from Sri Lanka, Myanmar and Cambodia,” Asian Journal of Comparative Politics, Vol 5, No 4, pp 385–99.

IMF (2022): “Sri Lanka—2021 Article IV Consultation,” IMF Country Report No 22/91, March, https://www.imf.org/en/Publications/CR/Issues/2022/03/25/Sri-Lanka-2021-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-the-515737.

Klem, Bart and Dinesha Samararatne (2021): “Sri Lanka in 2021: Vistas on the Brink,” Asian Survey, Vol 62, No 1, pp 201–10.

Macan-Markar, Marwaan (2022): “Sri Lanka Meltdown Exposes China Loan Policy: Five Things to Know,” Nikkei Asia, 13 May, https://asia.nikkei.com/Spotlight/Sri-Lanka-crisis/Sri-Lanka-meltdown-exposes-China-loan-policy-5-things-to-know.

Rafi, Talal and Brian Wong (2022): “The Deep Roots of Sri Lanka’s Economic Crisis,” Diplomat, 15 July, https://thediplomat.com/2022/07/the-deep-roots-of-sri-lankas-economic-crisis/.

Ruwanpura, Kanchana N, Peter Rowe and Loritta Chan (2020): “Of Bombs and Belts: Exploring Potential Ruptures within China’s Belt and Road Initiative in Sri Lanka,” Geographical Journal, Vol 186, pp 339–45.

Senanayake, Devana (2022): “Inside Sri Lanka’s Devastating Economic Crisis,” Foreign Policy, FP Dispatch, 18 July, https://foreignpolicy.com/ 2022/07/18/sri-lanka-economic-fuel-crisis-mass-protests-wickremesinghe-rajapaksa-politics/.

United Nations (2022): Global Impact of War in Ukraine on Food, Energy and Finance Systems, Brief No 1, 13 April.

World Bank (2022): World Bank Group Response to Global Impacts of the War in Ukraine Proposed Roadmap, World Bank Group, 13 April.

 

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Updated On : 8th Aug, 2022
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