Correcting the course of the Sri Lankan economy

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Recently, Sri Lanka has become accustomed to refinancing its debt using loans at commercial rates on the international financial markets rather than bilateral or multilateral concessional loans.

by Rehana Thowfeek

As 2022 dawns, Sri Lanka appears to be heading for a real sovereign debt crisis. Recently, major credit rating agencies downgraded the country’s credit ratings, including Fitch, Moody’s and S&P, indicating that default appears imminent to many observers. Sri Lanka’s debt problems stem from the culmination of long-running “twin deficits”: the country has simultaneously run a fiscal deficit and a current account deficit and relies heavily on debt to finance it. Debt interest payments can be very expensive, and when maturities are short, they can put pressure on a country’s finances.

The crisis is partly linked to events that have shaken investor confidence. A failed constitutional coup in 2018, followed by the 2019 Easter Sunday bombings a few months later, and the 2020 COVID-19 pandemic have worsened Sri Lanka’s economic prospects. The election victory of populist President Gotabaya Rajapaksa also led to the implementation of several unorthodox economic policies, reversing previous attempts at fiscal consolidation and further exacerbating Sri Lanka’s unstable economic situation.

To deal with the immediate debt crisis, the Sri Lankan government needs to embark on a debt restructuring program, but it is not in a position to take this step on its own. Therefore, policymakers are considering support from the International Monetary Fund (IMF), albeit reluctantly. President Rajapaksa has also asked bilateral lenders like China, India and Japan to cooperate with Sri Lanka to restructure their bilateral debts. The Sri Lankan government cannot simply commit to solving its immediate debt problems; it must also address the deep structural problems that have plagued the country for decades to ensure that Sri Lanka does not return to such a situation in the future.

Recently, Sri Lanka has become accustomed to refinancing its debt using loans at commercial rates on the international financial markets rather than bilateral or multilateral concessional loans. Commercial borrowings have higher interest rates and shorter maturities than concessional borrowings and are therefore more expensive forms of debt. Without access to international financial markets since its decommissioning and the depletion of its foreign exchange reserves, Sri Lanka faces the inevitable choice of restructuring its debt. Yet the policies of the Sri Lankan government do not reflect this urgency. For example, its 2022 budget promises a series of populist “economic relief” programs, more government jobs and high defense spending, racking up a deficit of LKR 1.6 trillion (around $7.9 billion) – which means that the state must borrow again. Sri Lanka must repay $4 billion to $5 billion in debt each year until 2026.

Sri Lanka also faces the burden of a large current account deficit. In response, the government has implemented sweeping import bans on the economy, but only 25% of its imports are consumer goods, while the remaining 75% are intermediate and capital goods. – such as fuel and machinery – which are not easily replaceable. The Central Bank’s decision to impose an artificially low official exchange rate diverted workers’ remittances and exports away from formal channels, worsening the availability of foreign currency. Import bans, arbitrary exchange rates and low foreign exchange reserves have created difficulties for Sri Lankan businesses to operate at their standard capacity.

How should Sri Lanka reform its economy?

The end of Sri Lanka’s civil war in 2009 raised hopes for rapid economic growth, but these hopes did not materialize as Sri Lanka failed to liberalize its economy. The country’s post-war economic growth was mainly driven by government spending and large debt-financed infrastructure projects, which led to a significant increase in Sri Lanka’s fiscal deficit over time, while the economy was faltering. Since institutionalizing fiscal discipline is key to controlling a budget deficit, Sri Lanka should review and rebuild the legal, constitutional and institutional structures to enforce effective budget control, parliamentary oversight, transparency and accountability.

State intervention in Sri Lanka’s economic activity is high. There are over 500 public enterprises (EPs) operating in almost all key sectors. State-imposed prices have also hindered the development of free markets in the country. Many of Sri Lanka’s state-owned enterprises suffer massive losses due to mismanagement, compounding the government’s deficit and debt problems. Reforming state enterprises through divestments, downsizing and closures will immediately improve investor confidence and signal that the country is serious about reform.

The role of the state as an employer has also grown in importance over time. The state employs about 16% of the country’s workforce, while another 600,000 former state employees are retirees. In 2021, the government spent 73% of its revenue to pay the salaries and pensions of all these employees. The Sri Lankan public sector is overstaffed and inefficient, placing a heavy recurring burden on taxes. Therefore, reducing public sector employment is essential to public sector reform.

Sri Lanka’s per capita GDP fell from $463 to $3,680 between 1990 and 2020, but its tax revenue as a percentage of overall revenue fell from 19% to 11.5% over the same period. Sri Lanka’s tax structure is highly regressive, relying excessively on indirect taxes, including border taxes, to finance public expenditures. Regressive tax structures increase income inequality by falling disproportionately on the poor, but income taxes, which are more progressive, constitute only 25% of its tax revenue. In 2019, Sri Lankan President Gotabaya Rajapaksa implemented tax cuts that led to a 30% reduction in government tax revenue. At the time, this led to the worst budget deficit the country had ever seen and eroded its already weak tax base by 33.5%. This type of tax system is woefully inadequate to meet the needs of a nation on its development trajectory, requiring reforms for a progressive tax structure.

Sri Lanka is a highly protectionist economy that relies heavily on import duties to protect national industries and interests. The composition of Sri Lanka’s exports has also not changed much since the 1990s. Although it has entered into several bilateral free trade agreements and benefits from generalized preference programs of the United States and the EU, Sri Lanka has failed to diversify its export basket beyond clothing and tea. Sri Lanka’s trade openness, which measures merchandise trade as a percentage of its GDP, has declined significantly since the late 1990s. Trade policy is highly bureaucratic, making it difficult to start and run businesses focused on import/export. Transparent and simplified tariff structures on customs, removal of tariffs on raw materials used in production and improved trade facilitation will improve trade competitiveness and market access in Sri Lanka and allow over time, the country to achieve a sustainable current account balance.

The path to follow

Sri Lanka’s debt situation is crushing, and as the country struggles to come to terms with it, the proposed reforms are key to changing for the better. These reforms are intrinsically linked to the political economy of Sri Lanka. The reforms have so far been ignored by successive governments due to their political ideologies and fears of upsetting the status quo, creating the explosive crisis that currently threatens the well-being of their citizens. Even if Sri Lanka manages to solve its immediate debt problems, the failure to undertake these reforms to control its deficits and orient its economy outwards increases the risks that Sri Lanka will return to an equally unpleasant state in the future. .

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