Sri Lanka’s Economic Crisis: Is India Repeating the Mistakes Made by Rajapaksas?

India is following the similar explosive formula of populist politics and ad hoc economic policies.

Sri Lankans waiting in a queue to buy kerosene oil in March this year.  

(Photo: The Quint)

Sri Lanka’s default on an overhanging debt of $12.6 billion of overseas bonds has become a flashing warning sign for investors in other developing nations, that is, for those in South Asia and outside, at a time when surging inflation and stagflation (low growth-high inflation-low production-higher unemployment) continue to take a toll.

As I argued a few weeks ago in some detail, Sri Lanka’s passage into darkness needs to be viewed as part of a culmination of consistently pursued poor economics in a populist policymaking environment, where decisions were made without caring for consequences – much like what is being seen in India now.

For example, ahead of the November 2019 election, Sri Lankan presidential challenger Gotabaya Rajapaksa proposed tax cuts so reckless that the incumbent government thought it to be a campaign gimmick.

Samaraweera's Prophetic Warning

Magala Samaraweera, Sri Lanka’s Finance Minister at the time, called the campaign move to be a “dangerous pledge”, whereby reducing the VAT from 15% to 8% would be catastrophic for an economy that already had a low tax-revenue base, high foreign-denominated debt, and large dependence on tourism receipts for financing a high import bill. Samaraweera cautioned:

“If these proposals are implemented like this not only will the entire country go bankrupt…but the entire country will become another Venezuela or another Greece.”

The Rajapaksas went on to pass the populist tax cuts after coming to power and it took less than 30 months for Samaraweera’s prophetic warning – of an economic apocalypse hitting the Lankan economy – to come true.

The Massive GDP Fall in 2020 

Look at the Figures below for studying Sri Lanka’s current state of the economy.

Sri Lanka’s growth was weak even before the COVID-19 pandemic. The International Monetary Fund (IMF) in a recent report explained how COVID-19 severely hit the Sri Lankan economy. The annual GDP growth rate of 2.3% in 2019 fell to -3.6% in 2020.

During the pandemic, the Sri Lankan government promptly announced a series of relief measures through a macroeconomic policy stimulus, an increase in social safety net spending, and loan repayment moratoria for affected businesses. These measures were complemented by a strong vaccination drive that helped restore GDP growth to a recovered rate of 3.6% in 2021, with mobility indicators largely going back to their pre-pandemic levels and tourist arrivals starting to recover in late 2021.

Nevertheless, the pandemic, necessitating several strict lockdowns, caused a colossal loss of tourism receipts, one of the main revenue-generating sectors for the nation.

A Series of Bad Decisions 

The pre-pandemic policy environment added to the economy’s woes, which made it difficult to recover from the pandemic. The Rajapaksa government’s populist tax cuts had limited the government’s revenue options. Foreign remittances from Sri Lankan workers abroad were drying up already (see below).

The adverse impact of COVID-19 and the announced relief-spending measures led to higher government spending (with a weak revenue base); fiscal deficits became larger than 10% of the GDP in 2020 and 2021, while the economy witnessed a rapid increase in terms of public debt to 119% of GDP in 2021.

Subsequently, the low-growth, foreign capital-dependent Sri Lankan economy also lost access to international capital markets in 2020, prompting a decline of international reserves to critically low levels and large-scale direct lending to the government by the Central Bank of Sri Lanka (CBSL). External debt repayments and a widening current account deficit led to foreign exchange (FX) shortages, while the official exchange rate remained de facto fixed since April 2021.

Making matters worse was Rajapaksa’s pivot last year to organic farming, with a ban on chemical fertilizers that triggered farmer protests, leading to a decline in the production of critical tea and rice crops. Imports continued to be higher – amidst a high fuel cost import bill – which further depleted the foreign exchange reserves.

Over the six months, inflation rates continued to climb up, reaching double digits in December 2021, while simultaneously reflecting the cascading effects of imported inflation from rising oil-food import prices, supply shocks, and a pickup in domestic consumer demand, amidst a loose monetary policy. The unemployment rate (seen below) also continued to peak, which only angered citizens, who ultimately took to the streets to protest the government’s ill-thought economic policy moves.

What Next for Sri Lanka?

Going forward, from a macroeconomic standpoint, what the Sri Lankan economy would need is a robust path towards a medium-to-long term, revenue-based fiscal consolidation strategy. Economic and political reforms must focus on strengthening the tax system through VAT, income and corporate (direct) taxes through gradual rate increases and base-broadening measures.

The fiscal adjustment would also need to be accompanied by energy pricing reforms to reduce the risks from loss-making public enterprises. Near-term monetary policy tightening is needed to ensure that the recent breach of the inflation target band is only temporary. Institution-building reforms, such as revamping the fiscal rule, would also help ensure the credibility of the strategy.

Other (longer-term) reforms would need to include the creation of a flexible exchange rate policy and a medium-to-long-term debt reduction strategy, while ensuring that most government spending in targeted social areas continues, such as in areas of healthcare, education and social security goals.

Sri Lanka's Is a Unique Case, But There Are Uneasy Parallels, Too

Sri Lanka’s situation is unique in the way all debt crises are. The characteristic features include an unpopular government run by an all-powerful family ruling the nation-state as a neo-patrimonial state, after the unresolved aftermath of a 30-year-old civil war and violent street protests.

Still, the island’s saga may be seen as a ‘bellwether’ for emerging markets, particularly those in South Asia, where populist measures, excessive dependence on foreign debt-owed capital, and a consequentially independent economic policymaking environment may lead to shortages further exacerbated by inflation.

This, as an ‘invisible tax’ on poorer sections of society, may have the potential to roil national economies.

A populist government pursuing majoritarian politics to consolidate ‘power’ while destroying public institutions and pursuing ad-hoc economic policy measures is bound to enter into a vicious, irreversible economic trap, which directly impacts its own citizens, first through a low growth, low production, low employment cycle, and then by exacerbating the effect of these from the ills of sustained inflation. All this will trigger a full-blown crisis.

Populism Meets Shoddy Economic Decisions

Much before opposition leader Rahul Gandhi’s recent posts on Twitter comparing India and Sri Lanka’s economic plight, a few of us had argued why, despite the tempting need to see India and Sri Lanka as like comparisons (which they are not), there are still some lessons for India.

The nature of the social policy direction of Sri Lanka – before the crisis – was closely aligned with improving the ‘quality of life’ for its people, especially in the context of ensuring access to affordable healthcare. India, on an aggregate, and in relative comparison to policy direction, performed miserably in this regard (see India’s performance on healthcare and nutritional outcomes in comparison to Sri Lanka prior to 2016).

A comparative table is republished below and is based on the World Economic Forums’ Global Competitive Report 2015/16 and the World Bank Group’s Doing Business Report 2016, providing a brief overview of these two countries:

A lot changed for Sri Lanka after 2016, as it did for India post-2014.

Rajapaksa’s politics, style of governance, and gross disregard for democratic procedures (as was evident from the constitutional amendment passed in 2020) resemble the way Modi has led India post-2014.

Centralised ad hoc policy measures, cutting taxes for populist reasons (prior to the pandemic), the inability to collect estimated revenue for the government’s spending needs, seeing a rise in government debt, offering limited autonomy to the central bank for targeting inflation, while banning chemical fertilizers – all strike a worrying resemblance to the troubling state of affairs being observed in India’s own (macro) politico-economic scenario.

(Deepanshu Mohan is Associate Professor and Director, Centre for New Economics Studies, Jindal School of Liberal Arts and Humanities, OP Jindal Global University. He is Visiting Professor of Economics to Department of Economics, Carleton University, Ottawa, Canada. This is an opinion piece and the views expressed are the author's own. The Quint neither endorses nor is responsible for them.)