India should step in to help Sri Lanka—it’s in our own interest

Inflation is in double digits, as is the fiscal deficit as a proportion of GDP. Foreign debt as a percentage of GDP is in the three digits. Even as Sri Lanka has given priority to meeting its debt servicing obligations to foreigners, Fitch downgraded Sri Lanka’s credit rating to CC earlier this year. The downgrade was from CCC, speculative grade, very high risk. CC stands for speculative grade, very near to default. The current account deficit was 3.8% of GDP in 2021.

Why has the Emerald Island lost its sheen? Various people parade their pet theories: the switch to organic farming, a tradition of privileging welfare and social sector spending over hard infrastructure, being hooked to Chinese debt, the pandemic, corruption, economic mismanagement. The real explanation is probably a mixture of all these factors, with decades-long violence stemming from majoritarian chauvinism as the overarching shadow that keeps the sun of economic prosperity shining over the land.

Sri Lanka imports a whole lot of what it consumes but has generally managed to pay for its imports with earnings from plantation exports, healthy tourism earnings and a steady infusion of foreign currency borrowings. Tourism accounts for some 10-12% of GDP. In April 2019, on Easter Sunday, Sri Lanka witnessed a series of bomb blasts at churches where Christian devotees had assembled, and at three luxury hotels in the Capital. The death toll was 277, including eight suicide bombers. Besides, 500 odd were injured. While the attack was perpetrated by Islamist radicals, and the victims were mostly Christians, the violence resurrected the Sinhala majority’s Buddhist chauvinism, which had been starved of fuel ever since the decimation of the Liberation Tigers of Tamil Eelam in 2009. On the strength of this revival, the government changed and Sri Lanka got back the strongman rule of the Rajapaksa brothers.

Tourism dried up in the wake of the terror strikes. Before the economy could recover from this disaster, reductions in the value-added tax contributing to a fall in revenues rather than to a boost in economic activity, the pandemic struck the next year. The economy shrank, the government responded with effective vaccination, welfare handouts, a fiscal deficit in excess of 10% of GDP and an easy money policy. The economy recovered somewhat in 2021, but tourism stayed depressed, the current account widened, and inflation climbed.

When foreign exchange grew scarce, the government discovered the virtues of organic farming: avoiding fertilizer imports was, of course, only an ancillary benefit. Organic farming is like a garnish, not a substitute for the main dish. Cultivation with reduced use of pesticides and without the use of fertilizers led to a decline in agricultural production, not to speak of productivity. That increased the reliance on imports for basic consumption, accelerating the external payments crisis.

China’s desire to deploy its ever-accumulating current account surpluses in real assets, rather than just in financial assets abroad, was a major driver of its Belt and Road Initiative, through which it hoped to construct a new Silk Route, along which to push its never-ending stream of exports (in 2021, Chinese exports totalled $3.36 trillion). In 2010, with a former Rajapaksa government, the Chinese struck a deal to invest to develop a port at Hambantota, on Sri Lanka’s southern coast. The port was built by 2017, but the total cargo volumes were not enough to service the capital invested, and the Chinese ended up taking over the majority (70%) ownership of the port.

Rajapaksa’s fascination for China’s silken promises has not ebbed. In its current proposal to build a new special economic zone, in part by reclaiming a few hundred hectares from the Indian Ocean, adjacent to the Colombo Port, the government has ceded a sizeable chunk of the 266 hectares of Colombo Port City to the Chinese in a 99-year lease. Concerned Sri Lankans are trying to figure out whether this would lead to a One-Country, Two Systems, structure in Sri Lanka, with extra-territorial powers for Beijing over its leased territory, a reclaimed chunk of the Indian Ocean adjacent to Colombo.

It does not make sense for India to let the Chinese take over expanding chunks of Sri Lankan territory. India must offer Sri Lanka financial help, policy advice and investment from Indian entrepreneurs. Indian businesses must build supply chains that intertwine the Indian and Sri Lankan economies in goods and services ranging from the export of tea to information technology services.

Sri Lanka’s crisis offers some lessons: for a brute majority to oppress a small minority (Sri Lankan Tamils are 15% of the population) is to lose out on opportunities for economic growth, via loss of internal cohesion, civil unrest and eventual avoidance by global capital; over-reliance on a single external benefactor is to end up in a debt trap, in which you surrender sovereignty in dibs and dabs; it is best to raise domestic tax revenue and shrink government expenditure to limit borrowing, particularly sovereign borrowing from external sources.

Sri Lanka has some advantages, whose potential positive economic benefits have so far been thwarted by divisive politics and economic mismanagement: high human development and upgradable skills. India, rather than any other nation, should help steer Sri Lanka towards realizing its potential, to reap the rewards of a stable, friendly neighbourhood.