Sri Lanka's Economic Crisis: Why and How? 

Despite being ahead in many ways compared to other countries in South Asia, Sri Lanka has recently plunged into a severe economic crisis. Various data show that the inconsequential policies of the last few years, increased commercial debt dependence, unconceived mega projects without judgment, the spread of widespread corruption led by one family, and adverse international conditions have pushed Sri Lanka's economy into such a crisis. In this paper, some specific causes have been identified by looking into the source of the crisis. 

High-interest commercial loans from international capital markets:

One of the notable reasons for Sri Lanka's economic crisis is the acceptance of sovereign borrowings in foreign currency (dollars) at high-interest rates from international capital markets.[1]  The difference between these sovereign commercial loans or Sowerin bonds with bilateral or multilateral loans taken from different countries, starting from the World Bank, IMF, and ADB, is that the term of these commercial loans is only 5-10 years, the interest rate is more than 6 percent, the interest has to be paid twice a year, and the actual repayment has to be made once, at the end of the term which puts a lot of pressure on the foreign exchange. Loans taken from different countries or multilateral agencies have different conditions. However, their interest rates are low (0.25 to 3%), long-term (20 to 40 years), grace periods, and interest can be paid in year-to-year installments. As a result, there is not as much pressure on foreign exchange as it does on the repayment of commercial debts collected through sovereign bonds.[2]  The most pressing is when the International Sovereign Bond (ISB) is matured. Because then, the entire amount of the loan has to be repaid in foreign currency at one time, which puts much pressure on the balance of payment. Suppose 5 or 10 years of foreign currency loans are spent on such activities, with no foreign exchange income to repay the original with high interest. In that case, that loan is bound to become a non-renewable burden. That is precisely what happened to Sri Lanka. While Sri Lanka's external debt was growing, export earnings in proportion to GDP steadily declined. In 2000, foreign exchange earnings for the export of goods and services such as garments, textiles, tea, rubber, et cetera, were 39 percent of GDP, which fell to 20 percent in 2015.[3]  At the same time, as the pressure to repay the debt increases, a large part of the foreign exchange income has to be spent on repaying loans taken in foreign currency, which increased to 33.5 percent of the export earnings in 2020. In this situation, Sri Lanka began to make more and more sovereign debts to pay off foreign debts.[4]  Sri Lanka started raising $500 million from international capital markets by issuing the first international sovereign bond (ISB) in 2007. The tenure of this loan was five years, and the interest rate was 8.25 percent. Since then, year after year, the amount of this debt has only increased, with a large part of the debt collected from sovereign bonds being spent on paying interest on previous bonds. From 2011 to 2019, Sri Lanka raised $500 million, $600 million, or $100 million each through sovereign bonds 13 times, with a validity of five years, six years, ten years, or eleven years.[5] Thus in 2007, while Sri Lanka's commercial debt accounted for only 4.3 percent of its external debt, by the end of 2019, the international commercial debt stood at 47 percent of the country's external debt, most of which ISB. According to the Department of External Resources of the Government of Sri Lanka, other countries and organizations with which Sri Lanka has external debts apart from international commercial loans are ADB (13 percent), China (10 percent), Japan (10 percent), World Bank (9 percent) and India (2 percent).[6]  All in all, Sri Lanka is now in such a situation that even if the required foreign exchange is not sufficient enough to import essential commodities such as food or fuel, it has to exhaust its foreign exchange reserves to pay off sovereign debts. For example, in January 2022, Sri Lanka had to repay a 10-year sovereign debt of $500 million, taken in 2012, even in the midst of this severe economic crisis.[7]  Sri Lanka has a foreign exchange reserve of $2 billion. However, this year, Sri Lanka will have to pay off $7 billion in foreign debt, of which $1 billion will have to be repaid by July.[8] In such a situation, Sri Lanka temporarily suspended the payment of all foreign debts. According to previous estimates of this decision, Sri Lanka had a liability of paying off $5 billion in 2023, $4.8 billion in 2024, $5 billion in 2025, and $3.8 billion in 2026, including development bonds and external debt borrowed from countries including China, Japan, India.[9] 

Sri Lanka's tax crisis and government income reduction:

Sri Lanka's tax system is grossly unfair. Because 80 to 82 percent of the government's revenue comes from indirect taxes, for example, Value Added Taxes, import duty, et cetera. The Sri Lankan government's most preferred way of earning revenue is the import duty (more than half comes from import duties). As a result, the import of essential food items, cooking fuel, and even sanitary pads is taxed equally by the rich and the poor. On the other hand, not being able to increase the number of individual taxpayers in line with economic growth has resulted in a decrease in direct tax rates, which has led to the financial crisis in public investment. Sri Lanka's tax collection is meager compared to GDP. It is assumed that if a country is developing economically, its tax-GDP ratio increases comparatively. The opposite happened in Sri Lanka. Since the 1990s, the tax-GDP ratio has declined from an average of 18.4 percent (1990-92) to 12.7 percent (2017-19), which further decreased to 8.4 percent in 2020.[10]  In such a situation, when Gotabay, who has been plagued by allegations of corruption and irregularities, was elected in 2019, Sri Lanka's already weak economy was further strained. During this time, the corporate income tax was decreased from 28 to 24 percent, and VAT was decreased from 15 to 8 percent. Other steps taken this time were, the reduction in the tax rate in the infrastructure and manufacturing sector, increasing the vat registration limit from 12 million rupees to 75 million rupees a year, the abolition of the nation development tax (nation-building tax) and as much income as you earn (Pay As You Earn- PAUE) system.  Steps were also taken to increase the personal taxable income limit from half a million rupees to 3 million rupees.[11]  As a result, between 2019 and 2020, the number of individual taxpayers decreased by 33.5 percent, the amount of taxable income equal to about 2 percent of GDP was lost, and the income from VAT was reduced to half.[12] 

Declining income of the tourism sector:

Tourism is Sri Lanka's third-largest foreign exchange earning sector after remittances and garments. On average, 25 percent of Sri Lanka's foreign exchange comes from the remittance sector, 20 percent comes from garments and textiles, and 15 percent comes from tourism.[13]  However, Sri Lanka's foreign exchange earnings from tourism have dropped significantly due to the Easter Sunday bombings of 2019 and the corona epidemic of 2020, putting additional pressure on the balance of payments. In 2018, revenue from the tourism sector was $438 million, which decreased by 17 percent to $3.6 billion in 2019. After that, in 2020, the revenue from tourism was only $680 million, and in 2021 it was $260 million.[14] 

Conclusion:

In a way, the ongoing economic crisis in Sri Lanka is simply a problem of balance of payments or balance of exchange. Sri Lanka's foreign exchange reserves have almost run out due to the high cost of foreign exchange earnings, making it difficult for the country to import essential commodities like food, fuel, medicines, powdered milk, or paper and pay off various types of foreign debt. But the decisions, processes, ideologies, individuals, and groups have played a different role in this economic phenomenon of increased expenditure than foreign exchange income is purely political. Had there been minimum accountability and democratic practices in Sri Lanka's governance, it would not have been possible for an import-dependent country like Sri Lanka to have a series of foreign debt-based infrastructure construction projects, from taking high-interest commercial loans in foreign currency to massive tax concessions or banning the import of chemical fertilizers, even amid a declining export income in proportion to GDP.

Resources:

[1] Infrastructure Financing in Srilanka: Lessons Learnt and Future Collaborations, European Institue for Asian Studies, Dec 2021; Sri Lanka’s race to meet ISB obligations, The Sunday Morning, 5 Dec 2021.

[2] Cost of Bilateral and Multilateral Loans, publicfinance.lk, 19 January 2021; Sri Lanka’s Foreign Debt Crisis Could Get Critical in 2021, 9 February 2021, The Diplomate.

[3] What’s happening with the Sri Lankan economy?, longform.watchdog.team, 1 February 2022.

[4] The Sri Lankan Foreign Debt Problem, longform.watchdog.team, 4 March 2022.

[5] ISB repayment headaches totaling $14 billion stretches until 2030, The Sunday Morning, 11 July 2021.

[6] Foreign Debt Summary, erd.gov.lk

[7] Sri Lanka averts major default; repays USD 500 million international sovereign bonds, The Times of India, 18 January 2022.

[8] Sri Lanka reverses course, seeks financial support from IMF, Al-Jazera, 15 March 2022.

[9] ISB repayment headaches totalling $14 billion stretch until 2030, The Sunday Times, 11 July 2011.

[10] Sri Lanka Airlines Linked to ‘Corruption Running Into Billions of Dollars’, NBC News, 6 April 2015.

[11] Clamor for crackdown on hidden wealth jolts Sri Lanka elite following Pandora Papers revelations, November 1, 2021, ICIJ

[12] Hyatt heist!, Daily Mirror, 1 July 2015.

[13] Annual Statistical Report 2018 & 2019, Sri Lanka Tourism Authority. 

[14] Sri Lanka Tourism Revenue, 1966 – 2021, CEIC DATA.