On Sri Lanka's Economic Crisis

How Democracy Fails

Sri Lanka

In 2018, Sri Lanka was the most economically developed South Asian country and had the highest GDP per capita at $4,058.80. However, now Sri Lanka is in the worst economic crisis in its history and is the first Asian country to default this century. 

Massive protests and chaos have erupted on the streets of Colombo over soaring fuel and food prices. The year on year change (Feb 2021 to Feb 2022) on prices for potatoes is 74.8% and rice is 64%. Energy shortages have forced government officials to turn off street lamps and implement daily 10 hour power cuts. Schools have canceled final exams due to the lack of paper.

In April 2022, inflation reached record highs at nearly 30%. 

In addition, Sri Lanka has been in a foreign reserve crisis for over a year, lacking the currency for crucial imported goods such as fuel, food, and machinery. Cargo ships are refusing to drop off goods due to lack of foreign currency(they won't take the rapidly depreciating Sri Lankan rupee). 

A Chronic Problem 

Throughout its history, Sri Lanka has had large budget deficits caused by military spending, a large welfare state(free healthcare and college), populist public spending programs, and inefficient state-owned enterprises. Because of these programs, Sri Lanka has scored high on measures of social progress such as life expectancy, education, and sanitation relative to other middle income countries. However, this also caused the Sri Lankans to become accustomed to budget deficits and expensive social programs. Instead of raising taxes or reducing spending, Sri Lanka got away with deficit spending due to generous inflows of concessional loans and grants. Over about 50 years of independence Sri Lanka has been bailed out by the IMF 16 times. 

A brief history of Sri Lanka 

“Sri Lanka was Britain's model Commonwealth country. It had been carefully prepared for independence. After the war, it was a good middle-size country with fewer than 10 million people. It had a relatively good standard of education, with 2 universities of high quality, a civil service largely of locals, and experience in representative government starting with city council elections in the 1930s. When Sri Lanka gained independence in 1948, it was the classic model of gradual evolution to independence.” - Lee Kuan Yew

In addition, Sri Lanka has great geography and natural resources. It is located on important shipping routes from India to China and from the Middle East to China: it could potentially become a major shipping center like Hong Kong or Singapore. It also has some extremely fertile land producing large amounts of tea, rice, and cinnamon. Last, it is a very beautiful country, sustaining a large tourism industry.

Despite all of these advantages, compared to other countries in Asia, growth has been limited. At the time of independence and well into the 1950s, Sri Lanka’s GDP per capita income was much higher than those of Thailand and the Republic of Korea, and it was just below Malaysia’s. However, from the early 1960s, Sri Lanka continued to slip below these countries for the next quarter century. 

The biggest problem in Sri Lanka was the ethnic conflict between Tamils and Sinhalese resulting in a 35 year civil war from 1983 to 2009. This conflict scared away foreign investment and tourists, while slowing education, development, and industrialization. 

Since independence, the Sinhala Buddhist majority has repeatedly elected ethno nationalist presidents, who were not very nice to the Tamils. 

In July 1983, tensions between the Sinhala Buddhists and Tamils erupted into Civil War between the Tamil Tigers militant group and the Sri Lanka Armed Forces. The northern provinces of Sri Lanka, which are overwhelmingly Tamil, declared independence and established a new state called Tamil Eelam. 

Both sides were very nasty. The Tamil Tigers invented suicide bombing, used child soldiers, and gorilla warfare. The Sri Lankan Army has been accused or widespread rape and massacring civilians. 

The civil war ended in 2009 when Mahinda Rajapaksa and the Sri Lankan Army started offensives in Northern and Eastern Provinces crushing the Tigers. At the end of 35 years of war, more than 100,000 civilians and over 50,000 soldiers died. . 

The Beginning of a Crisis 

Mahinda Rajapaksa ended the civil war, then attempted to fix the economy. After the end of the civil war the economy of Sri Lanka was booming. In 2009-2010, gdp grew by 8%. In 2010-2011, gdp grew by 8.5%. In 2011-2012, GDP grew by 9%. However, These numbers are deceptive! 

Most of this growth was funded by massive deficit spending through high interest commercial loans. This was extremely irresponsible. 

This led to a big increase in Sri Lanka's stock of external debt. In addition 30% of government revenue was being spent on interest compared to 8% in most other countries. 

A couple of further factors exacerbated this problem. First, the loans were not used for productivity-boosting manufacturing industries, but instead for grandiose construction projects undertaken for populist political reasons, which didn’t earn a great return on investment. One example is the Mattala Rajapaksa International Airport also known as the world's emptiest airport. Hundreds of millions of dollars was spent on the airport that serves 50 to 75 people a day.

Second, Sri Lanka lost access to concessionary loans made to low income countries(see chart below). Before, 2008 almost all of the foreign debt of Sri Lanka consisted of low interest concessional loans. 

Instead, The government began creating SLDBs (Sri Lanka Development Bonds). They have higher interest rates, shorter maturity periods, and greater risk. Contrary to public beliefs, Chinese-owned debt represented only a small part of debt. But the real problem lies in the effective interest rates of the SLDBs, which are more than double those of Chinese loans. 

Third, the populist president Mahinda Rajapaksa reduced taxes despite large deficits exacerbating the debt problem. At the beginning of his presidency, tax revenue was about 15% of gdp, but was reduced to 10% of gdp near the end. 

Power Grab 

Mahinda Rajapaksa was extremely popular: He ended the decades-long civil war, and citizens were very happy with the short-sighted populist policies. New buildings! Low taxes! GDP Growth! He used this popularity to attempt to make himself a dictator. 

1 . President Rajapaksa rallied more than the two-thirds majority in Parliament necessary to pass an amendment to the constitution removing presidential term limits. 

2.  Rajapaksa and his family controlled 80 percent of the national budget where Rajapaksa simultaneously served as finance minister and four other cabinet posts on top of the presidency, while his three brothers served as the defense secretary and ministers of economy and ports and the Speaker of the Parliament (Source)

2. Supreme Court, Rajapaksa removed chief justice Shirani Bandaranayake to appoint ally Mohan Peiris. The supreme court would no longer prevent Rajapaska from passing unconstitutional laws. 

3. The Mahinda Vision Manifesto is published. The manifesto pledged to introduce a new constitution within one year of being elected where the "weakness" in the parliamentary system would be eliminated. 

Rajapaksas Stopped 

Within Mahinda Rajapaksa's party, the Sri Lanka Freedom Party, opposition arose to his authoritarian tendencies. The most prominent dissident was the Minister of Health, Maithripala Sirisena. 

Sirisena pledged to abolish the executive presidency within 100 days of being elected, repeal the controversial eighteenth amendment, which removed presidential term limits, and appoint UNP(center-right) leader Ranil Wickremasinghe as Prime Minister. His central pledge was the replacement of the executive presidency with a Westminster-style cabinet. 

However, Sirisena had similar populist policies as Mahinda as they were in the same party. He promised to write-off 50% of farmers' loans, reduce fuel prices, and a salary increase for public servants. In addition, he promised public spending on health would increase from 1.8% of GDP to 3% of GDP, while education spending would increase from 1.7% of GDP to 6% of GDP

In 2015, Sirisena was declared the winner after receiving 51.28% of all votes cast compared to Rajapaksa's 47.58%.  The result was generally seen as an upset. When Rajapaksa called the election in November 2014 he had looked certain to win.

An uneasy coalition 

In an emergency session of parliament held a few weeks after Sirisena’s victory, the 19th Amendment to the Constitution of Sri Lanka was passed. The amendment diluted many powers of the Presidency and increased the power of the parliament. 

 Some of the most important changes are the following: 

1. Reintroduce the two term limit on the president. Reduce president term length from 6 years to 5 years. 

2. President cannot remove the prime minister at discretion. 

3. The President is required to act on the binding advice of the Prime Minister when appointing or removing from office any Cabinet Minister, Non-Cabinet Minister or Deputy Minister.

The Sirisena-Wickremesignhe government also passed legislation to pay back the debts incurred from the Rajapaska presidency. In Prime Minister Ranil Wickremsingnhe’s 2015 address to parliament he declared reducing debt and deficit spending was the top priority. 

In the following year, parliament increased income tax and value added tax, cut public employee compensation, and reduced large fuel subsidies. In addition, many of Rajapaska’s white elephant projects were sold. The Mattala Rajapaksa International Airport was sold to India. Magampura Mahinda Rajapaksa Port was handed over to China in a 99-year lease. As a result of these changes the budget deficit shrunk from 5.3% of GDP to 3.1% of GDP, and the credit rating of Sri Lanka was upgraded. Although the policies were crucial to fix Sri Lanka’s tenuous financial situation, people hated the policies since they slowed the economy:  Sri Lanka recorded just a 3.1% economic growth rate, the lowest in 16 years in 2017. The Sri Lankan people preferred Rajapaksa's policies of large foreign borrowing, tax cuts, subsidies, and high public employee compensation. 

In a 2017 opinion poll, 56 percent of respondents were unhappy with the coalition government. 63 percent of Sinhalese Bhuddists were unhappy with the coalition. In 2018, Mahinda Rajapaksa's proxy Sri Lanka Podujana Peramuna won a landslide victory in the local authority elections. Disputes among the members of the National Government began to surface and a major rift between the President Sirisena and Prime Minister Ranil Wickremsingnhe appeared. President Sirisena, desperate to retain power, wanted to align himself with the victorious Rajapaskas and away from unpopular Ranil Wickremesinghe. 

This tension culminated in the 2018 constitutional crisis. 

1. Sudden Dismissal of Prime Minister Ranil Wickremesinghe by President

2. Ranil Wickremesinghe refuses to step down and a brawl erupts in parliament. 

1. Appointment of Mahinda Rajapaksa as Prime Minister by President

2. Supreme Court finds President's act of dissolving of Parliament to be unconstitutional and illegal and that the President's order of dissolving parliament was overturned

3. Mahinda Rajapaksa backs down from claiming Prime Ministership

4. Ranil Wickremesinghe is reinstated as Prime Minister

The Rajapaksas Return 

In 2019, the three churches in Sri Lanka and three luxury hotels were targeted in a series of coordinated Islamist terrorist suicide bombings on Easter Sunday. Like the United States after 9/11, there was a sharp increase in support for a strong central government, and a rise of nationalism. This furthered the advantage Rajapaskas had in the elections, especially among the Sinhalese Buddhists, since he was credited for ending the 30 year civil war as commander in chief. 

Due to unpopular policies, infighting of the Sirisena- Wickremesignhe government, and the Easter Bombing, Gotabaya Rajapaska(Mahinda Rajapaska’s brother) wins big by 10% margin. Rajapaksa won big among the Sinhalese Buddhists who make up around 70 percent of the Sri Lankan population. In the map on the right below, you can see that Rajapaska won the Sinahalese(Purple) districts, but lost the Tamil(Red) districts. With the Rajapaska having control over the parliament and the presidency the government became a de facto dictatorship once again. The Three Rajapaskas brothers were serving as President, Prime minister and finance minister and their sons as other ministers.

Headed by President Rajapaksa of the Sri Lanka Podujana Peramuna party, the government began implementing populist legislation without regard to fiscal responsibility. Income tax and VAT were cut in late 2019. The automatic fuel pricing mechanism was discontinued, raising fiscal risks from state-owned enterprise losses. The previous government’s plan for central bank independence and fiscal rules were suspended. These policy changes, aimed to satiate their political supporters, increased Sri Lanka’s vulnerability to shocks. 

Economic Collapse

Sri Lanka's fragile economy collapsed during the Covid 19 Pandemic. The economy was dependent on tourism, agriculture, and shipping industries. These industries were wrecked during the pandemic.

Tourism earned Sri Lanka $4.4 billion and contributed 5.6% to GDP in 2018, but this dropped to just 0.8% in 2020.

 The agricultural sector was setback by Rajapaska’s all organic farming policy that banned the import of synthetic fertilizers and pesticides on the country’s 2 million farmers. The Rajapaska wanted to save valuable foreign currency by switching away from heavily subsidized imported fertilizer. The result was terrible. 

“Against claims that organic methods can produce comparable yields to conventional farming, domestic rice production fell 20 percent in just the first six months. Sri Lanka, long self-sufficient in rice production, has been forced to import $450 million worth of rice even as domestic prices for this staple of the national diet surged by around 50 percent. The ban also devastated the nation's tea crop, its primary export and source of foreign exchange.” - https://foreignpolicy.com/2022/03/05/sri-lanka-organic-farming-crisis/

With a combination of severe recession, huge amounts of high interest foriegn loans, and low government revenue due to tax cuts, Sri Lanka was near default. In the beginning of 2020, Sri Lanka was using 70% of government revenue to pay interest. 

Unfortunately, the Sri Lanka government didn't want to turn to the IMF as the Rajapaskas didn't want to make the structural reforms the IMF would no doubt require (such as drastically cutting the number of state employees and raising taxes). Instead, the government tried to print money and establish price controls on essential goods like food and fuel.  

“Central Bank Governor Prof. W.D. Lakshman is reported to have stated at a recent economic forum that domestic currency debt in a country with sovereign powers of money printing is not a huge problem, as the modern monetary theorists would argue. Since rupee-denominated bonds are within the ‘sovereign powers’, money could be printed to repay them as indicated by MMT, he argues.” - Source

As standard economic theory would indicate, printing money to pay debt did not go too well. Hyperinflation and currency devaluation quickly followed. Food price inflation reached 36.76% in December 2021 (according to Advocata’s Bath Curry Indicator), which risks plunging many middle-class Sri Lankans into poverty. Long lines and shortages of goods are the natural consequence of the price controls. 

In addition, there is a severe shortage of foreign reserves due the attempt to keep the Sri Lankan Rupee’s Value steady. The Sri Lankan government soft pegged the rupee to the dollar at a rate of around 203 rupees to dollars. If they had allowed the rupee to float it would have rapidly depreciated, making it much more expensive for people to buy foreign goods. However, the black market rate quickly increased and became around 265 rupees for a dolar as demand for the currency fell due to political instability, low productivity, and inflation. 

To combat excess supply of its own currency in foreign exchange markets, the central bank used its reserves of foreign currency, like U.S. dollars, to demand its own currency and thus cause an appreciation of its exchange rate. But the central bank has effectively run out of US dollars. Now the government is unable to pay foreign debt or import crucial goods.

In March of 2022, Sri Lanka was forced to float its currency, resulting in a large devaluation of the rupee as seen below and a currency crisis. 

IMF Reform

Due to widespread protests, Mahinda Rajapaska has resigned as Prime Minister, Basil Rajapaska has resigned as Finance Minister, while President Gotabaya Rajapaska has promised not to run for reelection. The government has also agreed to work with the IMF, who will provide needed loans to Sri Lanka, but will demand sweeping changes in exchange. Without the financial crisis, these unpopular changes would be impossible to make due to Sri Lanka's long history as a democratic-socialist country and decades of deficit spending. 

I will go over some policies the IMF has recommended. You can read the entire report here.

1. Tax Code Changes

Sri Lanka gets the majority of its tax revenue from para-tariffs. High para-tariffs hinder competitiveness and growth and are regressive. 

Sri Lanka’s tax-to-GDP ratio is among the lowest in the world, reflecting low tax rates following the 2019 tax cuts and low collection efficiency. The IMF recommends increasing efficiency of the value added tax and the income tax. 

2. Privatization of SOE 

Sri Lanka has grossly inefficient State Owned Enterprises that should be privatized. SOEs that cannot be privatized need to be held accountable. 

Unlike most other nations, Sri Lanka’s SOEs have very little transparency. It is recommended that Sri Lanka mandate internal audits of their SOEs and publish an annual overview with a balance sheet. Currently, financial information is available for just 10.4% of SOEs. 

The lack of accountability leads to corruption, nepotism, and inefficiency. For example, the Sri Lanka Coal Company engaged in fraudulent deals to purchase coal causing a loss of over Rs. 4 billion. In addition, political supporters are commonly given jobs at SOEs instead of qualified workers. 

Conclusions 

Mainstream news is inaccurate 

The New York Times released this article on the crisis: “Lavish Projects and Meager Lives: The Two Faces of a Ruined Sri Lanka.” This article is purposely designed to satisfy their left-wing readers' political views. They assert the Rajapaskas were elected due to racism, then used Chinese loans to bankrupt the country. A similar thing happened in the article by ABC news. “China becomes wild card in Sri Lanka's debt crisis. “ This narrative is flawed for multiple reasons.

1. “China says its initiative to build ports and other infrastructure across Asia and Africa, paid for with Chinese loans, will boost trade. But in a cautionary tale for borrowers, Sri Lanka's multibillion-dollar debt to Beijing threatens to hinder efforts to resolve a financial crisis so severe that the Indian Ocean nation cannot import food or gasoline” - Source 

China was not a major lender to Sri Lanka- only about 15% of Sri Lanka’s foreign debt is from China. Additionally, the loans they offered were a great deal with low interest rates and long maturity periods. In reality, commercial loans were the real problems, since they made up the majority of Sri Lanka’s foreign debt, and had higher interest rates, shorter maturity periods, and greater risk. 

2. “Local citizens who might once have supported the Rajapaksas for their ardent Buddhist Sinhalese nationalism” 

After, the 2019 Easter bombings terrorist attacks in Colombo there was a rise of nationalism and anti-muslim sentiment. The ex-military strongman Rajapaska certainly benefited from this. However, after closer inspection, we can see this was not a major factor in the election. Even before the Easter Bombings, the Rajapaskas won landslide victories in local elections.This was because the coalition government led by center-right prime minister Ranil was extremely unpopular. Ranil passed laws to balance the budget of Sri Lanka and help pay back foreign debt. He increased income tax and value added tax, cut public employee benefits, and reduced large fuel subsidies. People preferred the Rajapaksa's populist policies. 

3. A collective problem 

The title, “The Two Faces of a Ruined Sri Lanka” imply that the economic crisis was largely caused by the Rajapaskas. They fail to mention that the Rajapaskas won landslide victories in parliament and in the presidential elections. Further, the populace was fully aware of the Rajapaksa's tyrannical tendencies and irresponsible spending.  

Failure of Democracy 

Sri Lanka is the quintessential example of the Tyranny of The Majority. As soon as Sri Lanka received independence from the United Kingdom, the majority Sinhalese Buddhist used its political power to oppress the minority Tamil Population. These policies caused a 30 year civil war, widespread death, and human right abuses. Democracy ultimately reflects the will of the majority. In this case the majority wanted to oppress the minority. 

In addition, the Sri Lanka people refused to moderate their consumption, and instead demanded for their government to provide ever increasing handouts regardless of the financial health of the nation. Over its approximately 60 years of independence they have been bailed out 17 times. They demanded the government to increase fuel subsidies, reduce taxes, and support government employees with no foresight or consideration for future generations.  As late as January 2022, when Sri Lanka was drowning in debt and interest payments , the authorities introduced a 1.2 percent of GDP spending package, consisting of increases in public sector wages, pensions, and social transfers. Even in the midst of its worst economic crisis in decades, Sri Lanka refused to stop increasing spending on government employees. Ultimately, The current crisis is the fault of the citizens of Sri Lanka voting for populist politicians.