My Say: Sri Lanka’s economic crisis is inflicted by a selfish elite
Once considered a success story in basic human needs, Sri Lanka is currently going through its worst economic crisis since its independence in 1948. Nevertheless, Sri Lanka’s ‘moment of truth’ now offers lessons for other developing countries.
Sri Lanka has just defaulted on its foreign debt for the very first time. Attributing its current situation to a Chinese “debt trap” is yet another distraction from Cold War propaganda – one that we will no doubt hear a lot more about.
In this fable, Sri Lanka is a country trapped in debt due to white elephant projects hinted at and financed by borrowing from China. Blaming Sri Lanka’s debt crisis on Chinese lending is not only factually wrong, but also obscures the origins and nature of its current crisis.
The Sri Lankan government’s outstanding external debt as of April 2021 was $35.1 billion. Policy mistakes reduced foreign direct investment (FDI), exports and government revenue, altering the composition of its external debt.
Debt to the Asian Development Bank (ADB), World Bank, China, Japan and other bilateral lenders, including India, amounted to about one-tenth each. Borrowing from capital markets – 47%, or almost half – is mainly responsible for the unsustainability of its debt.
After all, borrowing from multilateral development banks – mainly the World Bank and AfDB – and bilateral lenders is mostly on concessional terms, while debt from commercial sources incurs higher interest rates.
Commercial loans tend to be shorter in term and subject to stricter conditions. As sovereign bonds or commercial loans mature, their full value must be repaid. The cost of servicing the external debt increases accordingly.
As of April 2021, around 60% of Sri Lanka’s debt was for terms of less than 10 years. The share of debt denominated in US dollars increased sharply, from 36% in 2012 to 65% in 2019, with loans denominated in Chinese renminbi remaining around 2%.
After adding government-guaranteed debt to state-owned enterprises, total borrowing from China accounted for 17.2% of Sri Lanka’s total public external liabilities in 2019. At the same time, commercial borrowing grew rapidly from only 2.5% of external debt in 2004 to 56.8% in 2019. .
The effective interest rate on commercial loans in January 2022 was 6.6%, more than double that of Chinese debt. Unsurprisingly, Sri Lanka’s interest payments alone accounted for 95.4% of its government revenue decline in 2021.
Deep rooted issues
After its recession in 2001, Sri Lanka recovered, before growth declined again after 2012 and the contraction of the pandemic in 2020. Sri Lanka also experienced premature deindustrialization, the share of gross domestic product of manufacturing sector dropping from 22% in 1977 to 15% in 2017.
Government tax revenue fell from 18.4% of GDP (1990-1992 average) to 12.7% (2017-2019), and a pandemic nadir of 8.4% in 2020. Non-tax revenue – mainly dividends and profits from public investments – fell from 2.3% of GDP in 2000 to 0.9% in 2015.
Sri Lanka’s export-to-GDP ratio nearly halved from 39% in 2000 to 20% in 2010. It was hit hard during the pandemic, falling to 17% in 2020. As of 2000, inflows FDI in Sri Lanka ranged between 1.1% and 1.8% of GDP, before falling to 0.5% in 2020.
Over the period from 2012 to 2019, the share of International Monetary Fund (IMF) Special Drawing Rights (SDRs) in Sri Lanka’s debt stock fell from 28% to 14%, with borrowing having exploded. Sri Lanka’s debt crisis is clearly due to the policy choices of successive governments since the 1990s.
prone to seizures
As of February 2022, Sri Lanka had just $2.31 billion in foreign exchange reserves – too little to cover its import bill and $4 billion debt repayment obligations.
Its 22 million people face 12-hour blackouts and extreme shortages of food, fuel and other essentials such as medicine. Inflation hit a record high of 17.5% in February as food prices rose 24% from January to February. But the economic crisis is not new to Sri Lanka.
As a commodity producer – exporting mainly tea, coffee, rubber and spices – export earnings have long been volatile, being vulnerable to external shocks. Foreign exchange earnings also come from clothing, tourism and remittances, but their share has increased little over the decades.
Since 1965, Sri Lanka has obtained 16 IMF loans, usually with onerous conditionalities. The latest, in 2016, provided $1.5 billion from 2016 to 2019. Required austerity measures reduced public investment, hurting growth and welfare.
Two recent shocks have made matters worse. First, the bombings of churches and luxury hotels in Colombo in April 2019 drastically reduced tourist arrivals by 80%, thus reducing foreign exchange earnings.
Second, the pandemic has hurt not only economic activity but also foreign exchange reserves, as the government has often paid monopoly prices to obtain tests, treatments, equipment, vaccines and other Covid-19 needs. 19.
Tax cuts galore
The ethno-populist policies of the Gotabaya Rajapaksa government, which came to power in 2019, have added fuel to the fire. Successfully mobilizing majority Sinhalese Buddhist sentiment – against Tamils, Muslims and Christians – he sought political support by cutting taxes for the “middle class”.
His government cut taxes across the board, collecting just 12.7% of GDP in revenue from 2017 to 2019 – one of the lowest shares among middle-income countries. Losing about 2% of GDP in revenue, its tax-to-GDP ratio fell to 8.4% in 2020.
Sri Lanka’s Value Added Tax rate has been reduced from 15% to 8%, while the VAT registration threshold has been raised from LKR 1 million to LKR 25 million (RM 323,796) per month. Other indirect taxes and the pay-as-you-ear system have been abolished.
The minimum income tax threshold was raised from LKR 500,000 per year to LKR 3 million, with few earning that much. Personal income tax rates have not only been reduced, but have also become even less progressive.
The corporate tax rate has been reduced from 28% to 24%. With a 33.5% drop in registered taxpayers (corporations and individuals) between 2019 and 2020, Sri Lanka’s tax base has shrunk.
Thus, even more of the population became exempt from direct taxes, increasing the government’s popularity, especially among the middle class. But the tax cuts have failed to spur investment and growth – despite the old claims of Ronald Reagan, Donald Trump and their “guru”, Arthur Laffer.
Successive Sri Lankan governments have therefore failed to increase tax collection, thereby reducing government revenue. To finance budget deficits, they increasingly borrowed from international capital markets—at higher commercial rates, with shorter maturities.
As the government reduced tax rates and exempted most income tax, government revenues plummeted. Due to declining revenues and deteriorating credit ratings, the government had to borrow more, at higher interest rates.
Facing fiscal and foreign exchange constraints, the government declared Sri Lanka a 100% organic farming nation in April 2021. The ban on all fertilizer imports – ostensibly to promote “agro-ecological” farming in the part of a broader “green” transformation – has aggravated the “perfect storm” threat.
Although abandoned in November 2021, the policy has significantly reduced agricultural production, necessitating more food imports. Falling tea and rubber production have also reduced export earnings, exacerbating foreign exchange shortages.
Clearly, the Sri Lankan government responded to the economic challenges it faced with “populist” policy choices. Instead of solving long-standing issues, it effectively “kicked the box” down the road, worsening the inevitable meltdown.
Anis Chowdhury, a former professor of economics at the University of Western Sydney, held senior United Nations positions from 2008 to 2015 in New York and Bangkok. Jomo Kwame Sundaram, a former professor of economics, was United Nations Under-Secretary-General for Economic Development. He is the recipient of the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought.