Sobering lessons from Sri Lanka’s economic crisis

The economic crisis in Sri Lanka has been in the making for several years. Hence, all of it cannot be blamed purely on the pandemic or on the war in Ukraine. These two factors were external to the Sri Lankan economy and certainly had an impact.

The pandemic caused tourism revenue to drop to nearly zero, even the inward remittances declined sharply as Sri Lankan non-resident workers from elsewhere lost their jobs and incomes and were unable to maintain the pace of an annual inflow of nearly $8 billion. With a double whammy from tourism and remittances, the economy was badly hit. The spike in oil prices on an economy totally dependent on imported oil has been more than the proverbial last straw. But the devastation and chaos that we see now was in the making for several years.

These external macro shocks were able to derail the economy because of the characteristic decline in the resilience of the economy over many years. If the economy has not developed resilience in terms of a low and manageable fiscal deficit, or comfortable forex reserves, or low inflation and moderate taxation, then the slightest of shocks, external or internal, can lead to an economic crisis.

The decline in economic resilience has been caused mainly by populist economic policies and complacency by one and all of ignoring the worsening macroeconomic parameters. For instance, a wider fiscal deficit during normal growth times is ignored by justifying it as a growth inducing necessity. Such a fiscal deficit can be caused by either an increase in expenditure or by reducing taxes. And this is what the Rajapaksa government did in 2019. The newly-elected government in 2019 announced a series of populist tax cuts, reducing value added tax by half and eliminating capital gains tax.

The governance at the top was very unusual, to say the least. Four brothers became the President, the Prime Minister, and Ministers for Finance and Agriculture, and a fifth — the Minister for Sports — was a nephew. How can one expect sound democratic governance in an atmosphere of nepotism like this? Dissent and disagreement are essential elements of democratic discourse, and when that is suppressed one can be sure of a decline.

Sri Lanka’s fiscal reclessness had begun even earlier. It has had to declare a default on a whopping $51 billion foreign debt, with a base GDP size of about $80 billion. In relative terms, this is a huge default and will surely dent its country rating and debt-raising capacity. The default is being justified as interim while Sri Lanka negotiates emergency funding from the IMF.

Sri Lanka had chosen the risky path of floating a sovereign dollar bond and since 2007 accumulated bond debt of more than $12 billion. Of this, $4.5 billion is due to be paid this year (ie, redeemed) but the country’s forex reserves are down to just $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 (fiscal and current account), inflation of more than 19% percent, and country-wide daily power outage for 13 hours.

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 might turn out to be as bad as Argentina’s forex crisis. It is a cautionary tale for India’s own plans to float a sovereign dollar bond. If you are borrowing in someone else’s currency, you don’t have the freedom to repudiate nor to print yourself out of the debt hole.

While Sri Lanka is in dire straits, with food and forex shortages, country-wide unrest, with the entire cabinet resigning, and now dependence on aid from donors like India, the situation in Pakistan is equally instructive. The ouster of Imran Khan’s government was mainly the culmination of spendthrift policies, economic mismanagement, high inflation of 15% and unsustainable debt accumulation. The charges and countercharges of an international conspiracy is additional smoke and mirrors.

The popular mandate of Khan unfortunately led to populist policies. An Opposition MP, Nafisa Shah, accused Khan of having “destroyed political culture, weakened parliament and institutions”. In a perceptive piece, journalist Marvi Sirmed warns that it would be foolish to conclude that democracy has prevailed in Pakistan and Imran Khan’s ouster is proof of that. She asserts that it is mostly the army’s doing and it will take quite some time for political parties to become truly independent of the army’s influence. The fact remains that, neighboring India or Bangladesh, Pakistan has suffered economic mismanagement and the unlike high inflation is but one manifestation of that. Excessive dependence on debt, whether from the IMF or China, is also a factor.

Populism and fiscal reccklessness have no happy ending. India’s 1991 crisis itself was the culmination of profligate fiscal policies tipped over by the Gulf War of 1990, high oil prices leading to a full-fledged currency crisis. Thankfully, since then, despite many external macro shocks such as the East Asian crisis of 1997, the dot-com bust, 9/11, the Lehman crash, or presently the pandemic and Putin’s war, India’s macroeconomy has been resilient and hence, crises have been avoided.

But that should be no reason for complacence. Some of the debt and default policies pursued by individual state governments are becoming unsustainable, if not outright crisis-prone. Punjab’s debt-to-state GDP (GSDP) ratio is already at 53%, as against the 20% recommended by fiscal responsibility norms.

The Centre’s debt-to-GDP ratio declined steadily from 63.9% in 2006 to 47% in 2019 but has since then risen steeply and is now at 61.7%. Interest payments were 45% of revenue receipts in 2021. Some states want to discard the national pension scheme in favor of fiscally irresponsible “defined benefits” schemes. Populism and large welfare spending is rising. We can’t ignore what happens to economic resilience when fiscal caution is thrown to the winds.

(The writer is a noted economist)

(Syndicate: The Billion Press)

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