Budget crunch: Sri Lankan government weighs economy, unrest

SRI LANKA’S FINANCIAL COLLAPSE

Sri Lanka faced financial collapse in May. In order for the country to benefit from a major bailout package worth $2.9 billion, International Monetary Fund (IMR) approval is necessary. Such approval is contingent on receiving assurance from the country’s debtors on closing financial gaps as well as government measures such as tax reforms, restoring flexible exchange rates and raising social spending.

Wickremesinghe’s budget spoke of boosting tax revenues by increasing tax and interest rates in a bid to secure IMF funding. Its proposals were in line with the IMF’s suggestions — hiking income tax rates to double the tax to GDP ratio from the current 12.7% was an especially notable measure. Gaining the approval of the IMF is necessary to Sri Lankan solvency. However, analysts and citizens are not impressed. Further spending to keep the economy running or to boost demand will mean further borrowing, which is likely to exacerbate the situation.

While the crisis became acute in 2022, there have been a number of long-term factors fueling financial breakdown. There are three main reasons for the economic crisis: the 2019 Easter bombings, the COVID-19 pandemic and government initiatives such as the ban on imports of synthetic fertilizers.

Sri Lanka, pre-COVID, was highly dependent on tourism as a major contributor to its GDP. Tourism was the third largest contributor of foreign exchange, which dropped significantly after the Easter bombings in 2019. 

The suicide bombings, carried out by a local militant Islamist group, targeted and killed both Sri Lankan and foreign nationals. Tourist footfall reduced 70% year-on-year and the industry suffered losses of an estimated USD $1.5 billion. Running on the promise of improving the safety and security of the nation, referencing his role in planning and executing the attacks that ultimately put an end to the civil war in Sri Lanka in 2008, Gotabaya Rajapaksa won the 2019 presidential elections. 

Even with Rajapaksa at the helm and a seeming uptick in tourist activity by the end of 2019, the country then dealt with two successive blows to its economy — the COVID-19 pandemic in 2020 and a complete ban on importing synthetic fertilizers in April 2021. 

Because of COVID-19, the tourism sector imploded, leaving Sri Lanka unable to repay the Exim Bank of China and other Chinese lenders who had invested in major infrastructural development in the country. Forex reserves at the end of 2019 were $7.6 billion, lower than the expected $8.2 billion. 

Government expenditure on imported fertilizers had reached close to USD $500 million that year and was crucial for the growing of crops including rice and tea. In order to reduce the import bill by promoting organic farming, Rajapaksa introduced a policy measure that banned synthetic fertilizer imports in April 2021. As many farmers were dependent on cheap fertilizers, the lack of it led to a steep decline in agricultural output across the country. This threatened domestic food security and led to a dependency on food imports, costing the government USD $6.9 million.

Government borrowing continued increasing to compensate for a lack of foreign exchange revenue from tourism and to pay for organic fertilizer and food imports to reduce the threat of the drop seen in agricultural yields. 

THE FALLOUT

With little to no revival in tourism, looming debt payment deadlines in April and July 2022 and no avenues to fill foreign exchange coffers, cracks began to appear early in 2022 when ships were unable to unload imports of fuel, food and medicines. The government had not paid import dues. India extended a $1 billion dollar credit line to the Sri Lankan government and sent supplies of rice, but these were temporary measures that could not gloss over Sri Lanka’s $50 billion debt. From being one of the world’s leading exporters in rice and tea, the country had to now begin importing these goods to ensure domestic demand was met.

Sri Lanka’s dependency on importing food, fuel and medicines and its inability to pay the import bills for the same led to an acute shortage of these commodities across the country. Reports of long lines to buy fuel emerged, with people waiting for days without any luck purchasing fuel. The lack of fuel also led to day-long power outages across the nation. The healthcare industry had to reduce its operations to only treating patients needing emergency assistance because of shortages in basic items like bandages and cotton.

Tens of thousands of protestors took over Colombo as people waited in line for days to be turned away from buying fuel, day-long power cuts occurred and families across Sri Lanka began skipping meals amid shortages of supplies and high rates of food inflation. A flurry of high-ranking government official resignations did not satisfy protestors who demanded the resignation of President Rajapaksa. Instability reigned domestically as then Finance Minister Ali Sabry tried to negotiate an emergency deal with the IMF in April at the World Bank spring meetings in Washington.

As many other leaders of the Rajapaksa clan were banned from leaving the country, Gotabaya held onto his presidential seat until July. The president attempted to form a united party in parliament to ride out the financial crisis several times. All of Rajapaksa’s elected party members from the Sri Lanka People’s Front (SLPP) resigned from the party on April 3 and represented themselves as independents in parliament. Gotabaya ultimately fled the country when protestors stormed his residence, the presidential palace, and occupied it on July 9. Only after Gotabaya reached Singapore did he officially resign from power, a week after the protestors stormed the palace.

After emergency sittings of parliament and an election, Ranil Wickremesinghe was declared President with Dinesh Gunawardena becoming his prime minister. Many analysts hailed the outcome as a step in the right direction for political and economic stability. An IMF delegation visited Colombo and began negotiations with the government that focused on a debt-restructuring program and windfall taxes to increase revenues. 

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THE ROAD AHEAD

By ensuring its budget measures echo the IMF’s conditions, Sri Lanka is guaranteed that its bailout will be sanctioned, along with loans from donor countries like India and China. These measures included raising tax revenues by up to 70% and opening up loss-making government-owned enterprises to private investments. 

The ability to convert the country’s GDP to a positive figure in the next two years, as stated in the budget, hinges on Wickremesinghe and his cabinet of ministers using the loan amounts effectively. Wickremesinghe’s budget, despite laying out the roadmap for the country’s economic recovery, lacks concrete timelines for execution. The lack of concrete timelines means the government cannot be held accountable for not putting into action some of its proposals.

Even without these timelines, the measures could plunge the country into further financial problems as they are likely to affect the middle and lower economic classes. Taxation increases are likely to further anger a public already dealing with record inflation rates and cuts in welfare programme spending. Additional spending at this stage is not likely to help the country reduce its year-on-year inflation of 66%.

Fuel rationing continues. The import of medicines continues to be a problem with shortages still being faced and hospitals scrambling for basic necessities. The fertilizer ban was removed in November 2021 and various loans are being given out to compensate the farmers to recover their agricultural losses, as well as help them to slowly reach the agricultural output level they were at before the ban was instated, which will positively impact domestic food security in the medium-term. 

This impact on the lack of easy access to these essential items will likely have a negative effect on the public. Despite the protests becoming fragmented with several groups withdrawing support, they are likely to continue because of the persisting shortages of essential commodities. 

Another way in which the Wickremesinghe government is looking to save on spending is by downsizing the government. Tourism is also seeing a healthy recovery and could continue to impact economic recovery in a positive way. While pre-2019 levels will take a few more years, short-term improvement will continue to grow and bring in much needed foreign exchange.

With all of these efforts to recover itself via the IMF restructuring, boosting agriculture and domestic food security, gradually improving tourism and government downsizing, Sri Lanka’s economic recovery remains contingent and precarious.