Tuesday, April 12, 2022 was a black day in the history of the island nation Sri Lanka, as they defaulted on its $51 billion foreign debt. This move has been increasingly expected by international markets, particularly in recent months. It is Sri Lanka’s first default since its independence in 1948.
The country’s 22 million population is facing crippling 12-hour power cuts, and an extreme scarcity of food, fuel and other essential items such as medicines, as its foreign currency reserves dwindled. Normally, most countries keep foreign currencies in reserves for making payments for these items, but the mismanaging invited a shortage of foreign exchange creating havoc and resulting in sky-high prices.
Currently, inflation is at an all-time high which is 17.5%. The prices of food items such as a kilogram of rice soared to 500 Sri Lankan rupees when it would normally cost around 80 rupees. Amid shortages, one 400g packet of milk powder is reported to cost over 250 rupees, when it usually costs around 60 rupees. This was happening after decades of strong performance on social indicators, which are now at serious risk. From the 1950s to the 1980s, robust tax revenues supported generous subsidies for food, healthcare, and education.
Sri Lanka consistently outperformed its international peers on social indicators. However, from the 1990s, the nation’s tax-to-GDP ratio has declined, from an average of 18.4% in 1990-92 to 12.7% percent in 2017-19 and a low of 8.4 percent in 2020. Surprisingly, the decline in revenues started after Sri Lanka’s civil war, which ended in 2009. Governments began spending substantially less on social goods than they had in the past, with average health and education spending in 2010-19 amounting to 1.8 percent and 1.4 percent of GDP, respectively.
Sri Lanka’s current economic trajectory was predictable, and its impending sovereign default a foregone conclusion. High external debt repayments, a foreign exchange crisis, and above all COVID pandemic push the country to the brink of this unprecedented default. Domestic authorities, including the governor of the central bank, have resisted growing national and international calls for an IMF agreement and debt restructuring, insisting that Sri Lanka will service its debt and keep the interests of foreign creditors at heart.
After 1990, the consecutive Sri Lankan governments had made back-to-back three blunders. Firstly, they have substantially depended on commercial borrowing to finance the budget deficit since the mid-2000s. Secondly, the successive governments failed to widen the tax base resultantly shrinking the revenue. Third and foremost they occasionally missed the opportunities to grow and diversify the export market. Relying on just a few sources for most foreign exchange earnings was disastrous. Due to COVID-19, the current foreign exchange crisis was triggered by the decline in exports and tourism in 2020, and in foreign remittances in 2021. These wrong policies exposed the weak foundations of the economy which is now collapsing inward on itself.
The country’s current crisis has roots in the surge of aid inflows after the economy opened up in 1977. This allowed successive governments to run large fiscal deficits while neglecting revenue collection. Aid and avenues for concessionary borrowing dried up as Sri Lanka rose to lower-middle-income status. This led to a heavy reliance on commercial borrowing to finance the national budget.
These loans, unlike concessionary loans from multilateral institutions, had no strings attached. Most of this debt took the form of international sovereign bonds (ISBs). But this quick and dirty solution came at a price: higher interest rates, shorter maturity periods, and greater risk. By 2019, commercial borrowing reached 56% which was only 2.5% percent of foreign debt in 2004. More than half of government revenue is raised through Import duties which is Sri Lanka’s preferred form of revenue collection.
Rich and poor are taxed equally on the consumption of essential food imports, cooking fuel, and even sanitary pads. Heavy taxes on consumer goods have created a regressive tax system that struggles to collect sufficient revenue to finance public spending. In contrast, progressive taxation has failed to grow since the 1990s, with the number of individual taxpayers not keeping up with the economic expansion.
While Sri Lanka’s higher development status should have resulted in more direct taxation and the growth of the tax-to-GDP ratio, its tax system is highly inequitable, with indirect taxation accounting for an estimated 80–82% of revenue. The falling tax-to-GDP ratio is due in part to the failure to expand the tax base, reliance on indirect taxation, tax policy instability, and an excess of tax concessions and relief.
These unsound policies can be attributed in part to the expansion of the executive presidency’s influence over the treasury and the absence of powerful finance ministers. This was demonstrated in November 2019, when President Gotabaya Rajapaksa fulfilled a campaign promise to slash taxes, which ultimately compounded the revenue losses due to the pandemic. The situation flew out of control when tourism earnings and other sources of foreign exchange took a hit. While remittances from overseas workers actually increased in 2020, they reached a 10-year low in 2021 as the fixed exchange rate led to the increased use of informal channels to repatriate earnings.
After sweeping tax cuts in 2019 led to a downgrade of the nation’s credit rating in 2020, Sri Lanka lost access to international financial markets and with it the ability to roll over its ISBs. While some of the repayments were supplemented by increased multilateral and bilateral borrowing, Sri Lanka started dipping into its foreign reserves to meet its debt obligations. This resulted in foreign reserves plummeting from a healthy level of USD 8,864 million in June 2019 to USD 2,361 million in January 2022, out of which only USD 792 million were usable. Unable to bring its foreign earnings back to pre-pandemic levels, Sri Lanka now faces a dire foreign exchange crisis.
Sri Lanka has the unique problem of consistently outperforming its peers on development indicators while contending with dangerously low government revenues. Its economic decline is a cautionary tale of short-sighted policies and weak management of public finances. Rather than being a victim of predatory lending practices, Sri Lanka is a victim of its own crumbling and politicized institutional foundations. Its trifecta of sins has brought it to the brink of default and could undo decades of progress and years of post-conflict stability. The government insists that “Sri Lanka always pays its debts.” But while this may be an admirable stance, how long will the Sri Lankan people have to bear the cost?
Many believe Sri Lanka’s economic relations with China are a main driver behind the crisis. The United States has called this phenomenon “debt-trap diplomacy”. This is where a creditor country or institution extends debt to a borrowing nation to increase the lender’s political leverage – if the borrower extends itself and cannot pay the money back, they are at the creditor’s mercy. The Chinese-owned debt (including public debt and publicly guaranteed debt) represented only 17.2 percent of foreign debt in 2019. But the real devil lies in the effective interest rates of the ISBs, which are more than double those of Chinese loans. Sri Lanka’s interest payments alone took up 95.4 percent of government revenue in 2021. For comparison, its credit-rating peers Ethiopia and Laos have rates of 11.8 percent and 6.6 percent, respectively.
However, loans from China accounted for only about 10% of Sri Lanka’s total foreign debt in 2020. About 30% can be attributed to international sovereign bonds. Japan actually accounts for a higher proportion of their foreign debt, at 11%. Defaults over China’s infrastructure-related loans to Sri Lanka, especially the financing of the Hambantota port, are being cited as factors contributing to the crisis. The construction of the Hambantota port was financed by the Chinese Exim Bank. The port was running losses, so Sri Lanka leased out the port for 99 years to the Chinese Merchant’s Group, which paid Sri Lanka US$1.12 billion. So the Hambantota port fiasco did not lead to a balance of payments crisis (where more money or exports are going out than coming in), it actually bolstered Sri Lanka’s foreign exchange reserves by US$1.12 billion.
In all probability, Sri Lanka will now obtain a 17th IMF loan to tide over the present crisis, which will come with fresh conditions. A deflationary fiscal policy will be followed, which will further limit the prospects of economic revival and exacerbate the sufferings of the Sri Lankan people.
Though Sri Lanka had handled the public health emergency well but the economic fallout from the pandemic would be significant. Sri Lanka’s growth could be less than the 2.3% recorded in 2019 and possibly the worst rate in its recent development history. Much will depend on the US-China dynamics and supply chains getting relocated from a manufacturing point of view. However, it is important to note that the Port City is a services hub not an industrial one. To be competitive Sri Lanka needs to have a tax and policy regime to position itself as a business-friendly nation. He further stated that a ranking of 99th position on the World Bank’s Doing Business Index is low by the standards of other upper-middle-income economies in Asia and that Sri Lanka should ideally target being in the top 35 or 40 in the world by 2025, which requires a major effort in cutting red tape affecting business and digitizing all government services.
Despite a possible reversal of the brain drain, there are urgent issues to be addressed in the university system including a skill mismatch. The government has recognized this problem and underlined the need to move towards a curricula that suits the Port City (that includes STEM subjects, IT skills, and foreign languages). Raging has been outlawed but better enforcement is needed.
This Port City should be seen not as an enclave but as a vehicle to drive modern services sector developed which is linked to the rest of the Sri Lankan economy. Since the government needs the support of businesses including the port city to achieve a high growth trajectory it needs to create an overall environment that is conducive to do business and foster economic growth in the future.
The author, Nazir Ahmed Shaikh, is a freelance columnist. He is an academician by profession and writes articles on diversified topics. Mr. Shaikh could be reached at [email protected]