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Home / Opinion / Lessons from the implosion of Sri Lanka’s tiny economy

The entire cabinet of Sri Lanka resigned this week, collectively expressing its inability to handle the country’s worsening economic crisis. This was just hours after the lifting of a curfew that was imposed nationwide. The curfew followed the previous week’s imposition of a state of emergency by its president due to a deteriorating food and fuel crisis. This is Sri Lanka’s worst ever economic crisis. The pandemic severely dented tourism revenues, which were about $4 billion annually in a $80 billion economy prior to 2019. Even its inward remittances dropped from roughly $7 billion before the pandemic to less than half that level presently. Tourism and remittances are two of the island economy’s top three foreign-exchange earners. The third is apparel exports, which too have been hit during the pandemic. A crucial forex earner is tea, whose production plummeted thanks to a ban on the use (and import) of chemical fertilizers. The president tried to camouflage that ban (which was actually a desperate measure to save the outgo of precious forex) as being nature-friendly and pro-organic farming. That fertilizer ban also adversely affected rice production, causing the nation to import rice for the first time.

As if the whammy on tourism, remittances, apparel and tea wasn’t enough, the final whack was via crude oil. Almost all the oil Sri Lanka needs for transportation and energy is imported. The price spike caused by the Ukraine war made matters worse. It’s a classic food-and-fuel shortage-induced crisis, first manifested and then made worse by the nation’s twin deficits: fiscal and current account. These deficits spiralled out of control as both domestic and foreign debts kept piling up. Sri Lanka also undertook the risky path of floating a sovereign dollar bond, and since 2007 has accumulated dollar-bond debt alone of nearly $12 billion. Of this, $4.5 billion is due to be paid (i.e. redeemed) this year, but the country’s forex reserves are down to just around $2 billion. Under normal conditions, the country would have been able to raise new debt to pay old debt. But no foreign lender today will touch Sri Lanka willingly, given its twin deficits, inflation of more than 19% and countrywide daily power out-age for long hours. Sri Lanka is on the brink of bankruptcy. The path to raising forex by floating sovereign dollar bonds is seductive but can quickly turn ugly. Sri Lanka is not the first country to experience being left in the lurch by foreign bond investors. It’s a cautionary tale for India’s own plans to float a sovereign dollar bond. If you borrow in someone else’s currency, you do not have the freedom to either repudiate or print yourself out of a debt hole.

Meanwhile, Sri Lanka has imposed several curbs on social media and news flow, its stock market and currency is sharply down. Unrest is brewing, so police action, possibly brutal, looks inevitable.

As for governance, here’s a clue. The newly-elected government in 2019 announced a series of populist tax cuts, reducing value added tax by half and eliminating capital gains tax. Presently, Sri Lanka’s president, prime minister and ministers for finance and agriculture are all brothers. And a nephew holds the sports portfolio. Emergency aid is forthcoming from neighbouring India via food and fuel shipments. China has already loaded a lot of debt onto Sri Lanka as part of its Belt and Road Initiative. So more debt from the Chinese is probably not welcome. Some debt relief might be.

Lessons for India from Sri Lanka’s economic crisis were highlighted by senior bureaucrats in a briefing to Prime Minister Narendra Modi. Their caution was about the state of finances of certain states of India, such as Punjab, Bengal, Delhi, Telangana and Andhra Pradesh, all of which provide people plenty of freebies from their respective budgets. These include free electricity, water or direct cash. Additionally, states like Chhattisgarh and Rajasthan are shifting to pensions based on “defined benefits" rather than “defined contributions" by individual workers in their pre-retirement years. The hard-earned reforms which culminated in the National Pension Scheme of 2005 now seem in danger of being derailed. The returns one gets from pension plans have to be in some way commensurate with how much one ‘puts in’ rather than a guaranteed benefit in the nature of a freebie. While fingers are pointed at states that are throwing fiscal caution to the winds, we mustn’t overlook some sins of the Centre. The One Rank One Pension scheme has caused pension payments to go up from 54,000 crore to 1.2 trillion in just six years, a compound annual growth of 14%. The cabinet decision of extending free rations of foodgrain to September 2022 is an additional burden of 80,000 crore, which was executed as if by the stroke of a pen. India’s tilt towards populist welfarism is visible both at the state level and the Centre. Whether we can afford such populism remains to be seen. That is why this lesson from tiny Sri Lanka is relevant.

Sri Lanka’s crisis was in the making from much earlier than the pandemic or Ukraine war. It was in the populism of tax cuts, in the spendthrift ways of piling up debt (that too denominated in a foreign currency) and a cavalier approach to fiscal discipline.

During times of normal growth and peaceful geopolitics, such fiscal extravagance reminds one of a frog in slowly boiling water. But an adverse shock of the kind we have seen can unravel and topple an economic edifice quite quickly. This might be a year of slowing growth and rising inflation. The dangerous strain of twin deficits cannot be ignored. We can ignore Sri Lanka only at our own peril.

Ajit Ranade is a Pune-based economist.

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