At the time of Sri Lanka’s independence, her macro economy was very healthy. Balance of payment, foreign reserves and balancing the national budget were not significant issues. However, after 1957, Sri Lanka’s trade balance was always negative
by Sirisena Amarasekara
Over the last several months, intellectuals, politicians, and international development agencies have discussed the Sri Lankan economy and fiscal policy more than ever for its mismanagement. The words “foreign Reserves” and ‘’foreign Exchange” have become a common topic even among ordinary people who have never used those words. They talk more about the dollar than the rupee earnings and think the dollar is the panacea for all the economy’s ills. At the time of independence, the world community thought Sri Lanka would be a model economy for most developing countries. Sri Lanka was the second most prosperous country next to Japan in the Asian region. The country had fulfilled most preconditions to take off on the growth tract. However, it struggled to reach the status of a lower middle-income country for 50 years till 1997, while many other developing countries surpassed Sri Lanka. Eventually, in terms of World Bank classifications, Sri Lanka was elevated to a lower middle-income country in 1997. Since then, it has struggled in the lower middle-income trap and reached the status of an upper middle-income country in 2019, after 21 years. But, within a brief period, in 2020, under the World Bank classification, Sri Lanka was downgraded again to a lower middle-income country due to the sharpening economic crisis.
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| An Uber driver waits at a Ceylon Petroleum Corporation fuel station to buy fuel after his bike ran out of petrol on the road, in Colombo, Sri Lanka March 22, 2022. Photo © REUTERS/Dinuka Liyanawatte |
Since the transfer of ruling power from colonial masters to local elites, the fiscal policy adopted by Sri Lanka is short-sighted, irrational, arbitrary and not growth-oriented or sustainable. Those are aimed at winning the heart of constituents to win the next election and remain in power forever. The budgetary policy is nurtured as a bribe to the constituents to grab or stay in power. Throughout history, with changes in government or leadership, policies have oscillated between growth and welfare orientation without policy consistency. Therefore, frequent ups and downs are observed in the path of economic growth. This policy inconsistency has caused catastrophic long-term and short-term economic ramifications. In the 1970s, in the journey to industrialisation, the country faced a scarcity of all imported consumer and intermediate goods due to strict import controls. Rations, coupons, and permits became part and parcel of daily life. Two prices, the control price and the black-market price, became the normal market situation for goods. People had to spend their time in queues to purchase goods for a controlled price. The policy priority was the protection and encouragement of the producer. This was done at the cost of consumer rights and preference.
In 1978, the policy was reversed and removed all import restrictions. The market was flooded with inferior, superior, cheap, expensive, wanted, and unwanted imported goods, prioritising the consumer and consumption. The producer has been deserted without policy support. Following the open economic policy for 24 years till 2017, the year of the highest per capita GDP, the growth rate was maintained above 4%, except in 2001, when a 1.55 % negative growth was reported. In 2002, followed by a negative growth rate, the country faced near bankruptcy, with the government’s debt reaching 105.5% of the GDP. In 2002, the government made several changes in the overall economic policy, including the fiscal policy. The approach was more focused on growth than welfare. Though many opposed pruning welfare programs and privatising public enterprises, the government exerted considerable fiscal control. It trended the debt ratio downward to 90.6 % by 2005, controlled inflation and commenced the gradual economic recovery. From 2005 to 2012, the country maintained a GDP growth rate above 5%, and from 2010 to 2012, it was above 7% for three consecutive years, and the per capita GDP rose above US$ 4077 in 2017. The main contributor to this rapid GDP growth was the construction boom in the public sector infrastructure, funded under local and foreign commercial borrowings. However, there were no adequate investments in goods and service production to sustain the growth momentum generated by the construction boom. As such, the economy could not substantially reap the potential of new infrastructure. In other words, the volume of investment made in the infrastructure within a brief period was beyond the economy’s absorption capacity. The government was forced to service loans before bearing the fruits of costly investments.
As a combined effect of many inappropriate economic and fiscal management decisions and political crises, the growth rate became negligible or has fallen negative since 2018. The GDP per capita income fell from US$4077 in 2017 to US$ 3815 in 2021. An 8.4% negative growth rate has been recorded for the first half of 2022. The government’s debt ratio exceeded 100% again in 2020 and 107% in 2021. The credit rating of Sri Lanka has been downgraded to very low by rating agencies, disabling any further borrowings. Foreign reserves depleted to near zero, compelling for rigorous import control. The government was forced to print money relentlessly to meet its essential domestic expenditure leading to hyperinflation. It eventually defaulted on the repayment of foreign loans and relegated the country to bankruptcy. Days and miles-long queues for essentials became familiar scenes everywhere in the country. Now, the destiny of the proud and conservative Island nation is in the hands of its friends and enemies.
Is it a Premediated Bankruptcy?
At the time of Sri Lanka’s independence, her macro economy was very healthy. Balance of payment, foreign reserves and balancing the national budget were not significant issues. However, after 1957, Sri Lanka’s trade balance was always negative. As a ratio to the GDP, the trade balance was above minus 6% from 1990 to 2021. Consequent to a continuous and extensive negative trade balance, balance of payment and budget deficit, the government has been highly dependent on foreign borrowing for more than six decades. During the 1970s and 1980s government’s revenue ratio to the GDP was above 20%. But since 1991, it has declined rapidly, reaching 8.6 % of the GDP in 2021
During the 1970s, the government debt ratio to GDP was around 60 % and reached 84% in 1980. From 1990 to 2000, the debt ratio increased above 96% and went to 105.5% in 2002. After that, a declining trend was visible, dropping to 77.7% in 1915 and remaining below 79% for three years till 2017. Again, the increasing trend was accelerated, jumping the ratio from 84.2% in 2018 to 107.1% in 2021. In the early stages, the borrowing was from multi-lateral and bilateral agencies on concessionary terms. Sri Lanka denied concessionary credits for many sectors after it became a lower-middle-income country. Then the government opted for borrowing from bilateral agencies at relatively higher interest rates and medium-term repayment periods. Since 2007, Sri Lanka has issued several international sovereign bonds with maturity periods of 5 to 10 years. By the end of 2021, the total outstanding external debt of the government reached US$ 50.7 billion, of which 47% is market borrowings, which are short-term and high costs. These market borrowings were mainly used to repay previous loans. Later, the government was compelled to do market borrowing to settle previous market borrowings, entangling the country into a debt trap.
From the 1970s to the 1990s, government expenditure was around 30% of the GDP. During this period, the government revenue ratio to the GDP was also high, about 20% or above. Till 2015, the overall budget deficit was high, above 7%. Due to the policy changes in 2015, the budget deficit decreased to 5.5% in 2017 and 5.3% in 2018. However, with the policy reversal in the latter part of 2019, it increased again, reaching 12.2% in 2021. In addition to the policy changes, the corvid-19 pandemic also contributed to the budget deficit and demanded more government expenditure than expected. Since 2020, these deficits have been chiefly financed from local borrowings and money printings, an inflationary tool.
While struggling to find additional revenue to meet increasing public sector expenditure, the new government made a highly irrational ad-hoc decision to reduce taxes in December 2019. The maximum personal income tax rate was reduced from 24.5% to 18%, and the thresh hold of taxable income was increased from Rs.500,000 to Rs. 3,000,000. Consequently, the total number of income taxpayers decreased from 1,705,233 in 2019 to 133,445 in 2020, reflecting a 92% reduction. The VAT rate was reduced from 15% to 08 %, and the thresh hold for VAT registration was increased from Rs.12,000 to 3,000,000, resulting in a reduction of VAT registries from 28,914 in 2019 to 8,152 in 2020, reflecting an 83 % decline. Also, the standard corporate income tax rate was reduced from 28% to 24%.
The Economic Service Charge, Nation Building Tax, withholding tax and Debt Repayment Levy was also abolished. After replacing the PAYE system with the APIT scheme, the total number of contributors dropped to 664 828 in 2020 and lost the mechanism for regular inflow of income, which used to receive without much cost and effort. All these changes were made effective from the beginning of 2020, pending formal parliamentary approval. According to the Central Banks Annual Report 2020, the government tax revenue in 2020 has declined by Rs 518.4 billion compared to the previous year. Considering the high price level of 2022, which is affected by hyperinflation, the revenue loss may exceed Rs. 1,100 billion. The income tax reduction increased the purchasing power of the upper middle class and the rich, which created an additional demand to import non-essential or luxury goods, exerting pressure on already sicked foreign reserves.
Even before the said tax alienation, the government had faced a heavy budget deficit, a negative balance of payment and depleting foreign reserves for many years. The government was pressured to do more local and foreign borrowings to service previous loans and continue with the welfare and development-oriented budget. This is a significant fiscal challenge faced by all governments after depleting the avenues for foreign grants and concessionary credits. The IMF and World Bank kept advising Sri Lanka to take appropriate action to improve government revenue, rationalise expenditure, and minimise corruption instead of costly commercial borrowings.
While all these ailments are in the backdrop, the government has decided to reduce taxes significantly for unknown reasons without any cost-benefit analysis. One obvious thing is that the decision is not based on economic, social, or broader political interests. According to the Central Bank Annual Report -2020, “the government implemented measures to lower the tax burden of business and individuals, thereby supporting the rebuilding of economic activities and enhancing incomes of the people”. The isolated ad-hoc policy instrument did not work, while all other harmful factors for investment remained unchanged. Instead, it negatively affected the overall economy and government budget, creating multiplier effects.
Is it a result of Ignorance or a Political Gimmick?
As explained above, a persistent budget deficit due to declining government revenue, increasing expenditure, and unfavourable trade balance became a chronic issue. After opening the economy, the fiscal policy was more weighted toward a consumption-oriented economy than a production-oriented economy. The constituents also got accustomed to using voting power to bargain for more and more government handouts. Political parties are also accustomed to pledging more and more subsidies and free goodies in their election campaigns(bribes) instead of telling the truth to the people and facing reality.
Since 1965, Sri Lanka has sought the assistance of the International Monetary Fund on 16 occasions for bailout packages to heal economic wounds, especially the negative balance of payment. The IMF assistance is always conditional that Sri Lanka will undertake structural adjustments for the long-term sustainability of the economy. Among them, fiscal and economic reforms such as the devaluation of the rupee, controlling the government expenditure, strengthening the government revenue, reducing the budget deficit, correcting the price distortion in the market, privatising the loss-making state-own enterprises, minimising/alleviating corruption, targeting the subsidies only to the poor, supporting an export-oriented economy are the prominent recommendations/conditions. On every occasion, the same conditions have been enforced with some modifications. However, a new requirement has been proposed for the 17th occasion in 2022, requiring negotiating with lenders for credit restructuring. On every occasion, the government has agreed to IMF conditions. But, once the bailout package is disbursed, agreed requirements are disregarded and back to loosen fiscal policy for political advantage. No political party have learned a lesson from past mistakes and keeps repeating the same. They expect camouflaging fundamental issues to mislead the donors, and the people can continue forever. Suppose we had fully complied with the agreed requirements and continued with a growth-oriented fiscal policy and economic restructuring for several years. In that case, we could have cured the wound permanently without recurring it. But the government’s behaviour is like enabling the patient to move from the sick bed; the patient escapes from the hospital without facing the surgery.
On all previous occasions, the government approached the IMF before bankrupting the economy and benefited from bail-out packages. Since the beginning of 2020, the symptoms of the economic crisis have been visible. However, the government was reluctant to seek IMF assistance due to the possible challenging fiscal discipline that may enforce on the eve of the general election. Even after the general election, the government wanted to maintain a loose budgetary policy to accommodate popular election pledges. Towards the middle of 2021, it was clear that the economy would collapse without severe remedial actions and policy reversal. Even at this stage, the authorities did not realise the gravity of the situation and thought the same loosened policy could be continued with temporary homegrown solutions. An attempt was made to relieve the foreign exchange crisis by controlling the imports while keeping the value of the rupee artificially high. Also, the authorities believed the government could service all external borrowings without defaulting through the savings generated from import restrictions and printing money to finance the domestic expenditure, guided by the “new monetary theory”. Available foreign reserves were used to service the external borrowings and maintain the rupee’s value artificially high. But they did not understand that this solution would deprive the people’s basic needs and collapse the domestic economy, which depends heavily on imported inputs.
At the beginning of 2022, it had proved that all homegrown solutions have miserably failed, and the country is running into a catastrophe. Towards the end of the first quarter of the year2022, the economy virtually collapsed, without foreign exchange to import petroleum, coal, gas, medicine, essential food items and many more. Eventually, the rupee was floated and allowed to depreciate. The immediate impact was the devaluation of the rupee by more than a hundred per cent pushing the cost-of-living sky high and days-long queues for all essentials, including fuel, food, and medicine. Meanwhile, the government was compelled to default on repayment of foreign loans to save the meagre foreign exchange for importing bear minimums. Due to the speculation of further devaluation of the rupee, foreign exchange earners stopped sending their earnings to the country through official channels. The country came to a standstill without inputs and mobility for industries, agriculture, and day-to-day operations for living. This resulted in multiplier effects such as constraints on industries resulting in low export income, high demand for imports, unemployment, low tax income to the government etc., creating a vicious cycle. It came to total anarchy, creating a political nightmare. Social unrest escalated to an unmanageable level, and eventually, the democratically elected president and prime minister were forced to resign.
Eventually, after failing all home-grown solutions, the government sought IMF assistance to bail out the crisis in April 2022. Then it was too late, and people and the economy suffered severely. Consequently, the recovery period will be much longer than the average IMF support program. Perhaps, it may take another five to six years to reach the per capita GDP to the 2017 level. If this decision had been taken at least in mid-2021, the recovery period could have been shorter, with less damage to the people and the economy. Relevant authorities could have bungled the episode from December 2019 to June 2002. But it isn’t easy to believe, as the president and finance minister were backed by many senior economists and experienced development administrators. Perhaps it may be the ego and deformed ideologies of the relevant authorities who are unwilling to listen to others’ views and productive criticisms. Another possibility is that some forces could have conspired by assigning bunglers to critical positions to mismanage the economy and thereby oust the non-political carrier president and capture power. This inference seems more pertinent, having observed entire political episodes from December 2019. Whatever the cause behind it, it has created long-lasting adverse socio-economic effects. Some of them are irreparable, such as child malnutrition and health hazards. Perhaps those who have abandoned farming may not be into agriculture again.
Conclusions
The limping economic legacy of over half a century has been further aggravated due to the nonsensical tax reduction in December 2019 and several other senseless decisions taken by the new government. Accelerated unproductive government expenditure, such as recruiting 50,000 unemployed graduates and 100,000 unskilled less educated youths to the public sector, Weda Lakshayak (hundred thousand projects) and the 100,000 Km Road program, put more burden on the already unwieldy budget. Banning chemical fertilisers paralysed agricultural production. Alienating a considerable volume of government revenue, overnight switching to organic agriculture, and blindly trusting homegrown solutions for structural economic issues are the most preposterous decisions ever taken by a government. All these could have resulted from ill advice by bunglers guided by personnel agendas and deformed ideologies.
Since its independence, the power-greedy politicians competitively made Sri Lanka a nation lacking self-confidence and depending on subsidies and lives beyond its means. As a nation, Sri Lanka consumes more than it produces. To overcome this situation, we must learn to live within our means. There is no free lunch. Everything has a price. People must be ready to enter an era of new economic and political order. People must be prepared to produce more than they consume. Politicians in power should allow newcomers to take the reins and change the whole system to match the modern world instead of reinforcing the century-old corroded systems. The bureaucrats should be ready to switch on par with the contemporary world, proactive and able to drive the political masters on the right track instead of carrying forward the residua of feudal administration practices of their predecessors. All stakeholders in the governance system should be thoroughly determined to avoid financial and power corruption. We need a charismatic patriotic leader who can transform the whole society into a forward-looking, dynamic one.
Sirisena Amarasekara is a Sri Lankan public servant and diplomat. He is the former Sri Lankan High Commissioner to South Africa, Mozambique, Namibia, Zambia, Zimbabwe, Lesotho, Angola, Botswana, and Eswatin. He had functioned as the secretary to the Prime Minister on two occasions, and as the secretary to the Cabinet of Sri Lanka. Having completed more than 50 years of public service, Amarasekara is one of the most senior Sri Lankan public servants.
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