Sri Lanka is often held up as poster child for the dangers of Chinese ‘debt trap diplomacy’, even though Chinese debt is just one element in a complexity of structural problems. If we take a decades-long view, Sri Lanka’s current economic trajectory was obvious, and its impending sovereign default a foregone conclusion. As high external debt repayments, a forex crisis, and the pandemic push the country to the brink of an unprecedented default in 2022, decades of strong performance on social indicators are now at serious risk.
Domestic authorities, including the Central Bank Governor, have resisted increasing national and international calls for an International Monetary Fund (IMF) agreement and debt restructuring, insisting that Sri Lanka will service its debt and keep the interests of foreign creditors ‘at heart’. The President, however, recently signalled the government’s intention to restructure its debt with the assistance of its allies and the IMF. Meanwhile, the Sri Lankan public bears the brunt of the crisis, with daily power cuts, fuel shortages, and skyrocketing prices for essential goods becoming the ‘new normal’.
From the 1950s through to the 1980s, high revenue collection supported generous expenditure on food subsidies, health and education. Sri Lanka consistently outperformed peers on social indicators. Since the early 1990s, the tax-to-GDP ratio has declined from an average of 18.4% (1990-92) to one of 12.7% (2017-19), reaching a low of 8.4% in 2020. Interestingly, the revenue decline started after Sri Lanka’s civil war ended in 2009. Governments began spending substantially less on social goods than they did in the past, with average health and education spending in 2010-19 amounting to 1.8% and 1.4% of GDP, respectively.
Since the 1990s, successive Sri Lankan governments committed three cardinal sins, which may be forgivable on their own, but together form an unholy trinity of economic disaster: heavy reliance on commercial borrowings to finance the budget deficit since the mid-2000s; failure to widen the tax net and thereby shrinking government revenue; and missing opportunities to diversify and grow the export market, which in turn led to reliance on a few sources for most forex earnings. The current forex crisis was triggered by the decline in exports and tourism in 2020 and foreign remittances in 2021. The first two sins highlight the weak foundation of an economy that is now collapsing in on itself.
The country’s current crisis has roots in the surge of aid inflows after the economy opened in 1977. This allowed successive governments to run large fiscal deficits while neglecting revenue collection. Aid and avenues for concessionary borrowing dried up as Sri Lanka upgraded to lower middle income status. This led to a heavy reliance on commercial borrowings to finance the national budget.
These loans, unlike concessionary loans from multilateral institutions, had no strings attached. Most of this debt took the form of International Sovereign Bonds (ISBs). But this ‘quick and dirty’ solution came at a price – high interest rates, shorter maturity periods, and higher risks. By 2019, commercial borrowings, which were a mere 2.5% of foreign debt in 2004, had ballooned to 56%.
In comparison, Chinese-owned debt (including public debt and publicly guaranteed debt) represented only 17.2% of foreign debt in 2019. But the real devil lies in the effective interest rates of the ISBs, which are more than double those of Chinese loans. Sri Lanka’s interest payments alone took up 95.4% of government revenue in 2021. For comparison, its credit rating peers Ethiopia and Laos have rates of 11.8% and 6.6%, respectively.
While Sri Lanka’s higher development status should have resulted in greater direct taxation and growth of the tax-to-GDP ratio, its tax system is highly inequitable, with indirect taxation accounting for an estimated 80-82% of revenue. The falling tax ratio is due in part to failing to expand the tax net, reliance on indirect taxation, tax policy instability, and a plethora of tax concessions and reliefs.
Import duties are Sri Lanka’s preferred form of revenue collection, with more than half of government revenue being raised this way. Rich and poor are taxed equally on consumption of essential food imports, cooking fuel, and even sanitary pads. Heavy taxes on consumer goods have created a regressive taxation system which struggles to collect sufficient revenue to finance public spending. In contrast, progressive taxation failed to grow since the 1990s, with the number of individual taxpayers not keeping up with economic expansion.
These unsound policy decisions can be attributed in part to the expansion of the Executive Presidency’s influence over the Treasury and the absence of powerful finance ministers. This was demonstrated in November 2019, when President Gotabaya Rajapaksa fulfilled a campaign promise to slash taxes that ultimately compounded the revenue loss due to the pandemic.
The pandemic can be seen as the ‘straw that broke the camel’s back’ rather than the cause of Sri Lanka’s woes. The situation spiralled out of control when tourism earnings and other sources of foreign exchange took a hit. While worker remittances actually increased in 2020, they reached a ten-year low in 2021 as the fixed exchange rate led to the increased use of informal channels to repatriate earnings.
After sweeping tax cuts in 2019 led to a credit rating downgrade in 2020, Sri Lanka lost access to international financial markets and, subsequently, its ability to roll over the ISBs. While some of the repayments were supplemented with increased multilateral and bilateral borrowing, Sri Lanka started dipping into its foreign reserves to meet its debt obligations. This resulted in foreign reserves plummeting from a healthy level of USD8,864 million in June 2019 to USD2,361 million in January 2022 (of this, usable reserves are in fact only USD792 million). Unable to bring its foreign earnings back to pre-pandemic levels, Sri Lanka now faces a dire forex crisis. Again, the pandemic merely exposed the country’s vulnerabilities rather than precipitating its crisis.
Sri Lanka has a globally unique problem of consistently outperforming its peers on development indicators while contending with dangerously low levels of government revenue. Its economic decline presents a cautionary tale of weak public finance management and short-sighted policies. Rather than being a victim of pervasive lending practices, Sri Lanka is a victim of its own crumbling and politicised institutional foundations. Its trifecta of sins has brought it to the brink of a default and could undo decades of progress and post-conflict stability. The government insists that “Sri Lanka always pays its debts”, and while this seems like an admirable stance, how long will the Sri Lankan people bear the cost of that stance?
This post is part of a collaborative series with The Asia Foundation.
I think that it’s very important to the South Asia and Pacific Region the stability of Sri Lanka ’cause the strategic position of the country. India, United Kingdom (former colonial power), Australia and so on (other ones) have interest in Sri Lanka and the geopolitical equilibrium may need a neutral Sri Lanka in political subjects for Asia. These countries above (I should include Japan and South Korea and Taiwan too) may help Sri Lanka for helping to maintain its political stability .
Well written. However, the criminal negligence of rulers to save their country from such down sliding speedily must be highlighted. Generally corruption and corrupt practices of rulers ruin the country.
Pakistan is also in trouble due to its bad economy. A comparison between both countries may be made for opening eyes.
An incredibly well written article which sums up almost everything that took place.
This is a good exposition of a difficult story. Essentially bad governance and lack of accountability is the source of the problem. These problems did not start in this century. They predates at least to 1970’s when the democratic system started its reform process that transferred power to an Executive presidency and took away instruments of public accountability and scrutiny. This followed a significant brain drain and severe lack of absorptive capacity at present, that has led to excessive mismanagement to the extent that managers themselves do not consider that there is a problem.
I fully agree with the comment “The pandemic can be seen as the ‘straw that broke the camel’s back’ rather than the cause of Sri Lanka’s woes”. The Pandemic just exposed underlying structural weaknesses that remained unaddressed over several decades. I cannot think of any quick fixes unless effective democracy can be restored and accountability brought to bear. That is a long bow. Hopefully, the current sad state may pave way to some welcome changes. It is unconceivable that it can get much worse.
Knowledgeable, analytical, logical and based on good theory. Well presented as well.
This is a good analysis over the situation and the regarding the tax cuts gave this crisis the boost it needed
The writer ignores one critical element in this disaster. Most of the money that was borrowed for development projects have been stolen and syphoned off by politicians and high government officials acting together. So, very little of the money actually went into the projects themselves. The costs of most projects appears to have been inflated two or three times the actual cost for the express purpose of syphoning money off. The Global International Integrity Project in Washington has estimated that between 2005 to 2014, 19 billion dollars have been taken out of the country illegally. That is far more than what the country needs to service the debt and for all imports in a given year.
Utterly myopic kakistocratic government whose sole aim appears to be a wealth generating exercise for the benefit of one family.
The need of the hour is to defenestrate the incumbents and appoint a national Government to bring calm and stability to a volatile desperate situation, engage with the IMF and restructure the debt, restore integrity to the financial system by appointing qualified people to crucial positions, ensure the Judiciary is independent, and appoint credible politicians to the various ministries.
Illegal money transfer is a major problem mainly in developing countries. UN estimates the amount of money transferred from African countries is 86 billion USD per year. The corruption index is almost same for all developing countries. The writer’s analysis is well balanced view of what happened since 1977 when the economy was opened and successive governments wanted to balance the budget using foreign loans and aids without improving the export market and local industries.
Absolutely right. The place was ransacked by Rajapakse’s and the money was corruptly siphoned out of the country until it broke its back. These idiots thought the money supply was unlimited
We all witness the luxurious lifestyle of many politicians and it’s our guess that they robbed public funds… But it’s not proven so it cannot be quoted in a professional writeup…
Overall a comprehensive analysis of what happened to Sri Lanka….