- Mudita Mishra and Hardik Narayan Shukla
Bailing Out the Burdens of a Sinking Economy: Sri Lankan Crisis
Sri Lanka, our closest maritime neighbour, is reeling under an unprecedented crisis since the start of the pandemic. Since 2007, the island nation has consistently been borrowing through a myriad of sources including capital markets, foreign governments and international organisations.
The tourism sector that generates maximum revenue for the island nation has been hit hard due to the pandemic. Inflation is at an all-time high and the value of the Sri Lankan Rupee is undergoing a steep decline. Food and fuel shortages have worsened and added to the already depleting foreign reserve crisis. In sum, Lanka is witnessing the worst economic crisis in its history. Such an environment has raised serious concerns over the country’s ability to repay the whopping $ 4.5 Billion of debt it is expected to dispense this year. Will Sri Lanka be able to survive its first default in history?
The COVID-19 pandemic has led to a global slump with supply chains getting disrupted and an increase in oil prices in international markets. Countries like Sri Lanka have to suffer incongruous consequences due to the rise in global food prices given their reliance on imports to sustain themselves.
Sri Lanka’s foreign reserves fell to $1.8 bn at the end of November 2021 from $7.5 bn in November 2019. According to the Sri Lankan Central Bank, the economy is estimated to have contracted by 1.5% in July-September 2021. After the latest payment of $500 mn, Sri Lanka has foreign debt obligations exceeding $7 billion in 2022, including repayment of another bond worth $1 billion in July.
Sri Lanka has all the emerging signs of bankruptcy. The Petroleum Minister has said 200 million are missing to pay for oil which has led to power cuts as Sri Lanka is unable to import oil to run the power stations.
Bankruptcy is when a country does not have reserves left to meet its immediate needs like food, pharmaceuticals, oil, and all other essential commodities. Default is when you decide to delay a debt payment unilaterally by over 30 days.
As Sri Lanka holds on to the dollars in the reserves and does not release it for the essential needs of the economy it might approach bankruptcy. The more Sri Lanka restricts dollars from entering the local economy the more it will approach bankruptcy.
Sri Lanka is in a dilemma and needs to choose between delaying the debt payments or barricading bankruptcy. Debt suspension might help avoid bankruptcy.
Usable reserves are down to under one month of imports which is about 1.5 billion. 500 mn has recently flown out of the country for debt payments leaving the country stranded in a critical position. For the year 2021, Sri Lanka’s debt to GDP ratio was 109.25%. The problem is not in having debt but the cost of debt which is at a remarkably high price.
Sri Lanka also does not have sufficient government revenue which is one of the key parameters indicating the fall of SL in global ratings like S&P, Moody’s and Fitch.
Debt service payment, that is, interest payment as a percentage of government revenue was 70 per cent that is around 6% of GDP. It means that Sri Lanka pays more than 6% of GDP on interest on its debt.
This has been around for many years but the problem arises when global ratings go down. American rating agency Fitch downgraded the island nation to a ‘CC’ rating which is the lowest rating before sovereign default. Sri Lanka is now stuck in a vicious cycle where they are not able to borrow from international markets due to low ratings, which lowers their forex reserves and hence cannot pay debts which further decreases the confidence of investors and lenders.
Amidst the pandemic, the country has witnessed increased unemployment and rising prices of essential commodities like rice, milk powder and oil. The government should be sympathetic to the needs of the people and spread the relief package in a way that is beneficial to the low-income bracket. The daily wage workers were the most affected during the lockdowns as people working in the government sector did not have to worry about their job safety.
The IMF can help Sri Lanka repay its debt but there are two fundamental problems: One, Sri Lanka does not have a robust business plan to pull itself out of the current economic turmoil. Without a plan, that is implementable and can win the confidence of the bank, it is very cumbersome to get a loan from the IMF. Secondly, since the IMF has a high ground in the situation, no bank wants to bail out the current debt holders. Sri Lanka would want to suspend the current debt payments and only then it would be in a better bargaining position.
Severe Blow to Tourism, Exports and Remittances
The three most pivotal sources of foreign revenue for Sri Lanka are tourism, export of agricultural goods and personal remittances from overseas. All these sources were severely hit by the pandemic, which exacerbated the depletion of the country’s foreign reserves.
Being the third-largest source of foreign exchange earnings, Sri Lanka’s tourism industry contributes to about 5 per cent of its GDP. Following the detection of its first COVID case in mid-March, Sri Lanka imposed lockdown in March 2020 which led to a decline in international tourist arrivals by 70.8 per cent in comparison to the previous year. Over 1 million people who were directly or indirectly dependent on this sector were left unemployed. However, the island is trying to recoup its tourism sector. The fact that Sri Lanka has attracted nearly 59000 tourists during the first 22 days of the new year reflects that the industry is pacing towards revival.
At the same time, the earnings from the export of textiles and cash crops including tea and spices dwindled. The barrier on imports imposed by Sri Lanka to prevent the outflow of dollars is a major factor for the decline in exports.
Finally, remittances from Sri Lankan expatriates contribute to about one-fourth of the country’s forex earnings (nearly 10 per cent of GDP). Reflecting serious concern towards the same, the Sri Lankan government took action against informal payment of remittances (money laundering) and encouraged people to use formal means. However, the remittances recorded a marginal increase of 2.6 per cent in the last year.
A policy failure of organic farming
A major part of the problem can be credited to the policy failure of implementing organic farming intertwined with staunch and hasty decisions and the non-cognizance of the scientists and experts in the matter.
Over the last few decades, Sri Lanka has become a self-sufficient country with an adequate food supply. This has become possible due to the Green Revolution policies that started in the 1960s. Chemical fertiliser is one of the chief drivers of the Green Revolution, and the subsidy — promoted especially by the earlier Rajapaksa administrations from 2005 to 2014 — made it easily accessible to them.
There was a complete ban imposed on the import of commercial chemical fertilisers on May 6 2021, to embrace the promise made in his manifesto of organic farming. The sudden ban and transition to organic farming came with no plans, discussion or consultation and only brought with itself a devastating impact on local agriculture.
In the face of criticism, government spokespersons have sought to justify the move for more than one reason. They pitch it as a necessary step to prevent a chronic kidney condition – loosely attributed by non-scientists to chemicals in the soil – and to save dollars spent on fertiliser import [about $300 million annually] for the country that is in dire forex and economic crisis.
President Gottabaya has defended his ambitious policy locally and at international fora. “We need a new agricultural revolution that is not against nature,” he said in the United Nations Climate Change Conference (COP26) in Glasgow held in October-November. Acknowledging the criticism and resistance to his government’s ‘organic only’ policy, he told the summit: “In addition to chemical fertiliser lobby groups, this resistance has come from farmers who have grown accustomed to overusing fertilisers as an easy means of increasing yields.” He disregarded Sri Lankan scientists' opinion, who have slammed the initiative, terming it “ill-advised” and “a catastrophe” in the making.
Sri Lanka’s $1.3-billion tea industry will be impacted negatively which is a vital foreign exchange earner for the country. The local planters anticipate a 40-50% slash in production, despite the government relaxing the chemical fertiliser ban for the sector in October after their repeated appeals.
The Government almost entirely holds the pandemic responsible for the current crisis. Though it is true that all major revenue earning sectors of Sri Lanka – exports, tourism, and inward worker remittances – were severely plummeted by the pandemic, some commentators argue that the pandemic only accelerated an older crisis, and didn't create one.
Last year in an address to the nation's military President Gotabaya Rajapaksa admitted that his government was not delivering and that people may have a sense of displeasure towards him and the government accepting that he viewed this as a fundamental challenge.
But accepting the challenge and implementing good policies are two different things.
This was illustrated after the implementation of an ill-planned policy on the ban of chemical fertilisers in May. Agriculture Minister Mahindananda Aluthgamage in November said the private sector would be allowed to import agrochemicals, but the part-reversal was too late, in farmers’ view.
The current Rajapaksa administration has expressed confidence about being able to meet its debt obligations this year, despite its Balance of Payments problem. Finance Minister Basil Rajapaksa on January 4 announced a $1.2 billion package for “economic relief” that includes a special allowance for government employees.
A dominant narrative that assumed a centre stage during this period of turbulence in Sri Lanka suggests that China should be blamed for the present crisis. If we look closely at the engagement between the two countries, we find that this is not entirely the case. Hence, it is important to understand the present situation of Sri Lanka in light of its strengthening economic ties with China over the last decade.
China’s Strategic Investment
The Rajapaksha administration’s soft corner for China paved the way for the latter emerging as an influential lender and investor, driving several high profile infrastructure projects in Sri Lanka. ‘The Diplomat’ accurately outlined that the relations between the two countries are economic and largely taking place across three avenues - debt, investment and trade.
China approved a $ 1.5 billion currency swap agreement with Sri Lanka last year. The country is already indebted to repay about $ 3.5 Billion to China. This money was lent by China to initiate various infrastructure projects including highways, ports, an airport and a coal power plant.
China has invested heavily in various projects in Sri Lanka under its Belt and Road initiative. However, a major controversy erupted in 2017 over the 99-year lease of Hambantota Port by the China Merchants Port Holdings Company Limited (CM Port). Under this arrangement, 70 per cent of the port was leased to CM Port for $ 1.12 billion. However, the ownership remained with the Sri Lankan government. While CM Port would appropriate the profits from the port throughout the lease period, the Sri Lankan Government received the dollar inflow it needed to replenish its foreign reserves and it was able to sustain the Balance of Payment Crisis.
This Private-Public Partnership faced strong backlash, both on domestic and international fronts because China is breaching the ‘sovereignty’ of the island nation by luring it into a debt trap. The premise of this argument was that China had captured the port as Sri Lanka was unable to pay off the debt obtained for the construction of the port. While such allegations became the foundation to criticise China’s BRI initiative, the Sri Lankan government defended the Hambantota project by clarifying that the deal didn’t involve debt-to-equity swap, but was instead a joint venture with China which allowed the government to raise the much-needed funds for further development of the port and the adjacent Special Economic Zone. However, it should be noted that the Rajapaksha government has been infamous for getting involved in various unnecessary ‘white elephant projects across Sri Lanka.
The recent Colombo Port City project is another controversial agreement between both nations. While the political leadership is promising a massive influx of foreign currency, creation of about 2,00,000 jobs and guarantee of foreign direct investment, the critics oppose this deal as a violation of the constitution and a threat to Sri Lanka’s sovereignty. They fear the establishment of a Chinese enclave in their country.
Should China be Blamed?
China’s increasing influence in Sri Lanka should be a major concern for the latter because irrespective of the amount of hope the political leadership puts with these developments, it is difficult to imagine that China’s intent is ‘welfare oriented’ in this case. By giving impetus to its investments in the region, China hopes to resolve its ‘Malacca Dilemma’ and wants to pose a counter to India. Taking huge loans from China to maintain its economic health may impose a huge cost on Sri Lanka in future.
However, it will be wrong to assume that the current Sri Lankan crisis is induced entirely by China. This is because the loans from China comprise only 10 per cent of Sri Lanka’s external debt profile. International Sovereign Bonds (ISB) account for the major chunk of debt (36.4%). While Sri Lanka managed to settle the payment of a $ 500 million sovereign bond, another bond worth $ 1 billion awaits repayment in July.
The Indian Perspective
India has been following the ‘Neighbourhood First’ policy towards Sri Lanka. In response, Sri Lanka has also announced ‘India First’ as a major plank of its foreign and security policy in 2020. Being the third-largest export destination for India after the US and the UK, Sri Lanka has benefited from the liberal policies of India including investments in infrastructural projects, support in countering terrorism and financial aid. The robust historical and cultural bond between the two countries motivates this friendly cooperation.
However, with Sri Lanka reneging the 2019 agreement with India and Japan to jointly develop the Eastern Container Terminal at Colombo Port (ECT) in February 2021, the otherwise cordial relations between the two nations turned sour. While the island nation tried to strike a compromise by offering the Western Coast Terminal for the joint venture project, it didn’t help as it sealed the ECT deal with a Chinese firm later.
India is watchful of China’s advancing economic intervention in Sri Lanka and wants to counter its influence. The recent grant of about a $ 1 billion relief package by India is an evident move to consolidate the Indo-Lanka relationship again.
Relief from India
The diplomatic talks for obtaining financial assistance from India were long underway. In February 2020, the Sri Lankan Prime Minister requested India for a debt moratorium waiver to help Sri Lanka tide over the problems aggravated by the pandemic. In May 2020, the Sri Lankan President Gotabaya Rajapaksha directly requested Prime Minister Narendra Modi for a $ 1 billion swap over a telephone conversation. However, India was sceptical of Sri Lanka’s degenerating economic conditions.
With the start of the new year, the Reserve Bank of India finally agreed to a $ 400 million currency swap with Sri Lanka according to the SAARC Currency Swap Agreement. At the same time, India has allowed Sri Lanka to defer the $ 515 million settlement of the Asian Clearing Union. This $ 900 million aid will provide short term relief to the country.
Following this, India and Sri Lanka have successfully inked the long-pending deal of developing ‘Trincomalee Oil Tank Farm’. The proposal of this joint deal was envisaged 35 years ago, in the Indo-Lanka Accord 1987. This project is significant for India owing to its strategic location, accessibility and high economic value for both countries.
A robust recovery process can only be ensured if Sri Lanka has structural reforms and plans for long term financing. The geopolitical importance of Sri Lanka can be used as a bargaining tool for short term and immediate financing from its neighbours: India and China.
Sri Lanka has repeatedly sought financial assistance from India since the pandemic started – by way of a debt freeze, a currency swap and recently, emergency Lines of Credit for importing essentials, during Finance Minister Basil Rajapaksa’s visit to New Delhi in early December.
The political opposition, think tanks and economists are advocating that Sri Lanka should negotiate a programme with the International Monetary Fund (IMF), restructure its external debt, and mobilise bridging finance for the interim.
Central Bank Governor Nivard Cabraal recently ruled out depreciation of the rupee as well as the Government opting for an IMF program, insisting “home-grown” solutions are delivering desired results. Cabraal reiterated that Sri Lanka settling the $ 500 million worth of maturing International Sovereign Bonds (ISBs) this month proved opposition, critics and sceptics including rating agencies wrong.
The Government maintains it can tide the crisis without resorting to an IMF loan and is counting on other unspecified options. IMF agreements usually come with specific conditions for the borrower, including greater transparency on how the money is spent and accountability on the government's part. “Transparency has never been a strong point of a Rajapaksa regime,” Colombo-based, the Daily Financial Times (FT), said in a recent editorial titled ‘Time for the IMF’.
The government has argued that IMF agreements of the past in fact “worsened Sri Lanka’s economic situation due to their strict conditions”. But in the current situation, it is hard to imagine that the conditions imposed by the IMF could be any worse than the quandary faced by the Sri Lankan public.
“As unpalatable as it may seem in following quarters, the IMF might just be the best way to achieve those goals,” the Daily FT said. Those who oppose the IMF route, argue that such a deal invariably entails austerity measures that will target social services and welfare programmes, which will further aggravate poverty that is growing since the pandemic.
Sri Lanka has overcome such revenue deficits in the past in 2009 and 2012. In the current crisis, avoiding bankruptcy is a critical issue. The only way to keep enough dollars in reserves and to stop its depletion is to suspend the payment of debt since the country is locked out of international financial markets. Economists suggest that Sri Lanka should renegotiate and restructure debt payments. There are two consequences of this move: the immediate effect of this announcement is that ratings further go down since it is considered a restrictive default (RD) but since the country is already on the blacklist it does not change much. But the long term advantage/consequence is the preservation of forex reserves and further assistance from international funds and IMF.
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