Sri Lankan Financial Crisis: A Tale of Riches to Rags

Written By: Nayeema Nusrat Arora

Sri Lanka is living the ultimate nightmare of every sovereign country- shortage of food and medicine, successive blackouts due to energy crisis, mass protest and a failed government. The situation has worsened to such a scale that on April 12, the government had to announce sovereign debt default for the first time since its independence, in order to ensure essential goods. 

In the eyes of the general public, this crisis came as somewhat of a shock, as everything seemed to work in favor of Sri Lanka. After all, it had become an upper-middle income country in 2019 and was witnessing exponential growth. However, critics could sense the deteriorating fiscal policies, bad policy-decisions, lack of a strong export performance and rising inequality, and warned about the upcoming catastrophe. The Covid-19 Pandemic just accelerated the prophecy and pushed Sri Lanka to the recent abyss.   

There seem to be a lot of myths surrounding the root causes of the crisis. The ‘Chinese Debt Trap’ seems to be a favorite narrative of the anti-Chinese cluster. Some blame the government’s commitment towards the green revolution. Even though these incidents add up to the crisis, the reality is more complicated than this. A set of complex events and tangled decisions resulted in the current situation. And so, to understand the cause it is important to analyze those events and decisions simultaneously. 

During the first decade after its independence in 1948, Sri Lanka was a widely open-trading nation with minor restrictions. However, the change in the thought-process behind state development combined with the political shift in leadership and balance of payment difficulties in the late 1950s transformed the country into one of the most inward-oriented economies. Until the 1960s, Sri Lanka’s per capita income was much higher than that of South Korea and Thailand. But from then on Sri Lanka started to gradually decline to the position of a ‘low-income’ category classified by the World Bank. Frustrated by the dismal economic outcome of the inward-looking policy, the right-wing United Nation Party that came to power in 1997 initiated the journey of extensive economic liberalization to move forward the reform that had started in 1977-79. The reform had lost some momentum in 1983 due to the ethnic conflict that evolved into a prolonged civil war. Still the country did not shift from its determination to liberalize the economy. In the 1990s a second wave of liberalization was implemented. However, it was getting harder to reap benefits from this policy transition because of the massive military expenditure— one which the civil war had thrust on to the already unstable macroeconomy.   

In 2009, the nearly three decades long civil war came to an end and with that one of the most influential political families in Sri Lanka came into the spotlight— the Rajapaksa family. After the 2019 Easter Sunday attacks, the Rajapaksa brothers started to mobilize the fear of minorities and leverage the fact that they are the only ones to restore national security as they did back in 2009 by ending the civil war. They voiced their resentment against the tax reforms taken by the Sirisena government which were crucial for economic stabilization and made it one of the agenda on their election manifesto to reduce taxes. When Gotabaya Rajapaksa came in power in 2019, he stayed true to his promise and slashed value added tax to 8% from 15%. He also reduced the income tax of the construction industry from 28% to 14% and abolished the Pay As You Earn (PAYE) taxes from all inclusive monthly income of Rs 250,000 instead of the previous mark of Rs 125,000 per month for all member of public and private sectors (Jayasinghe, 2019). This tax-relief package adopted by the Rajapaksa government further reduced Sri Lanka’s already low tax to GDP ratio. While many ministers hailed it to be first of the many victories for the public, a lot of people viewed the decision to be a step forward to consolidate crony capitalism in Sri Lanka.   

The allegations against the Rajapaksa government of being protectionists ignited when President Gotabaya Rajapaksa announced a halt in importing chemical fertilizers in May 2021. The government represented the decision by green-washing their agenda and promoting the benefit of using organic fertilizers that are produced in the island, even though farmers continued to protest against this abrupt policy change. The authority justified their move by citing President Gotabaya’s poll pledge taken in 2019 and the urgent need of reducing the country’s import bill under the impact of the pandemic. Until 2021, Sri Lanka spent an estimated 300-400 million dollars annually on importing fertilizers. A “Presidential Task Force” was responsible to look into the policy implication, however most of the members of the task force were private sector representatives and no farmer’s organization were a part of it. The result of this abrupt and ill-advised policy was catastrophic. Sri-Lanka, a long self-sufficient nation in rice production, had to import about 450 million dollars’ worth of rice. The drop in production of the country’s essential cash crops, such as tea and rubber, forced the government to partially lift the ban. However, the damage was already done. Sri Lanka’s already weak export system was on the verge of collapse. In the 2000s, Sri Lanka may have survived through exporting textiles, garments, tea and rubber. But with the emergence of lower-income countries like Bangladesh and Kenya in similar sectors, that was not possible anymore. And due to that its foreign exchange inflow is way low compared to its outflow. This one fact seems to be ignored by all administrations and Sri Lanka has failed to diversify its exports time and again. 

Apart from exporting tea and rubber, Sri Lanka’s excessive dependency on its tourism and remittance for earning foreign currency is another flawed policy preference. The reason for calling it a ‘flawed policy preference’ is made crystal clear by the recent pandemic. The tourism was already badly affected by the Easter Sunday attacks; the pandemic just doubled it. On the other hand, remittance was not as badly affected as the tourism sector, but the lockdowns did force some expatriates to return to the island. In such a scenario, the government resorted to the easy option in hand, borrowing money from foreign sources. Even with a low foreign exchange reserve, the government resorted to taking loans and building heavy infrastructural projects that were not taken upon out of necessity, but rather for showy demonstration of development. One such public investment project is the Hambantota Port that was taken up by Chinese investors. This project is infamous for blaming the current crisis on the Chinese debt trap. However, the reality is far beyond that. First of all, the Sri Lankan government leased the Hambantota Port to the CM Port in hopes of increasing the foreign exchange inflow. And secondly, China is not the one that owes the largest portion of Sri Lanka’s foreign debt. Instead, the largest portion is held by international sovereign bonds or market borrowings, about 47% of the total foreign debt. This year alone Sri Lanka is obligated to pay more than 7 billion dollars of debt whereas its total forex reserve as of March 2022 amounts to 1.6 billion dollars. 

All these issues along with the Rajapaksa government’s tilt towards ethnonationalism which failed to incorporate productive minority citizens in nation-building projects were hinting at the recent crisis way before it took such an aggressive form. The government has asked for an IMF bailout, and Ranil Wickremesinghe’s appointment as the new PM and Finance Minister suggests that President Gotabaya is looking forward to creating a coalition government. However, his resignation as the President of Sri Lanka may not become a reality soon, as many of the protestors are demanding. Because Gotabaya Rajapaksa’s resignation may lead to his trial and possible execution of the war crimes that he has committed in the Civil War. However, with the growing empathy towards the victims who had to endure the injustice of the Rajapaksa government, outrage is also growing among the protestors. Only time can tell how long can the current President survive the wrath of the masses


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Featured Image Courtesy:  Reuters


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