Once deemed a basic human needs success story, Sri Lanka is now in its worst economic crisis since independence in 1948. Nonetheless, Sri Lanka’s “moment of truth” now offers lessons for other developing countries.
Sri Lanka has just defaulted on its foreign debt for the very first time. Attributing its current predicament to a Chinese “debt trap” is a new Cold War propaganda distraction — which we will undoubtedly hear much more of.
In this fable, Sri Lanka is a country caught in a debt trap due to white elephant projects mooted and financed by borrowings from China. Blaming Sri Lanka’s debt crisis on Chinese loans is not only factually wrong but also prevents understanding the origins and nature of its current crisis.
Outstanding Sri Lanka government foreign debt in April 2021 was US$35.1 billion. Policy errors have reduced foreign direct investment (FDI), exports and government revenue, changing the composition of its foreign debt for the worse.
Debt to the Asian Development Bank (ADB), World Bank, China, Japan and other bilateral lenders, including India, came to about a tenth each. Borrowing from capital markets — 47%, or almost half — is mainly responsible for its debt unsustainability.
After all, borrowing from multilateral development banks — mainly the World Bank and ADB — and bilateral lenders are mostly on concessional terms, while debt from commercial sources incurs higher interest rates.
Commercial loans tend to be more short term and subject to stricter conditions. As sovereign bonds or commercial loans become due, their full value must be repaid. External debt servicing costs surge accordingly.
As at April 2021, about 60% of Sri Lanka’s debt was for durations of less than 10 years. The US dollar-denominated debt share rose sharply — from 36% in 2012 to 65% in 2019, as Chinese renminbi-denominated loans remained around 2%.
After adding government-guaranteed debt to state-owned enterprises, total borrowings from China were 17.2% of Sri Lanka’s total public foreign debt liabilities in 2019. Meanwhile, commercial borrowings grew rapidly from merely 2.5% of foreign debt in 2004 to 56.8% in 2019.
The effective interest rate on commercial loans in January 2022 was 6.6% — more than double that for Chinese debt. Unsurprisingly, Sri Lanka’s interest payments alone came to 95.4% of its declining government revenue in 2021.
Following its 2001 recession, Sri Lanka recovered, before growth declined again after 2012 and the pandemic contraction in 2020. Sri Lanka also experienced premature de-industrialisation, with manufacturing’s gross domestic product share falling from 22% in 1977 to 15% in 2017.
Government tax revenue declined from 18.4% of GDP (1990 to 1992 average) to 12.7% (2017 to 2019), and an 8.4% pandemic nadir in 2020. Non-tax revenue — mainly dividends and profits from public investments — fell from 2.3% of GDP in 2000 to 0.9% in 2015.
Sri Lanka’s exports-to-GDP ratio almost halved from 39% in 2000 to 20% in 2010. This took a big hit during the pandemic, dropping to 17% in 2020. From 2000, FDI inflows into Sri Lanka were between 1.1% and 1.8% of GDP, before falling to 0.5% in 2020.
During the 2012-to-2019 period, the share of International Monetary Fund (IMF) Special Drawing Rights (SDRs) in Sri Lanka’s debt stock fell from 28% to 14%, as borrowings ballooned. Sri Lanka’s debt crisis is clearly due to the policy choices of successive governments since the 1990s.
In February 2022, Sri Lanka had only US$2.31 billion in foreign exchange reserves — too little to cover its import bill and debt repayment obligations of US$4 billion.
Its 22 million people face 12-hour power cuts and extreme scarcities of food, fuel and other essential items such as medicines. Inflation reached an all-time high of 17.5% in February, with food prices rising 24% in January to February. But economic crisis is not new to Sri Lanka.
As a commodity producer — mainly exporting tea, coffee, rubber and spices — export earnings have long been volatile, being vulnerable to external shocks. Foreign exchange earnings have also come from ready-made garments, tourism and remittances, but their shares have grown little over decades.
Since 1965, Sri Lanka has obtained 16 IMF loans, typically with onerous conditionalities. The last was in 2016, providing US$1.5 billion from 2016 to 2019. Required austerity measures have squeezed public investment, hurting growth and welfare.
Two recent shocks made things worse. First, bomb blasts in Colombo churches and luxury hotels in April 2019 drastically cut tourist arrivals by 80%, squeezing foreign exchange earnings.
Second, the pandemic has damaged not only economic activity but also foreign exchange reserves, as the government often paid monopoly prices to get Covid-19 tests, treatments, equipment, vaccines and other needs.
Tax cuts galore
The ethno-populist policies of the Gotabaya Rajapaksa government, which came to power in 2019, have added fuel to fire. Successfully mobilising majority Buddhist Singhala sentiment — against Tamils, Muslims and Christians — he sought political support by cutting taxes on the “middle class”.
His government cut taxes across the board, collecting only 12.7% of GDP in revenue from 2017 to 2019 — one of the lowest shares among middle-income countries. Losing about 2% of GDP in revenue, its tax to GDP ratio fell to 8.4% in 2020.
Sri Lanka’s value-added tax rate was cut from 15% to 8%, while the VAT registration threshold was raised from LKR1 million to LKR25 million (RM323,796) monthly. Other indirect taxes and the “pay-as-you-earn” system were abolished.
The minimum income tax threshold was raised from LKR500,000 annually to LKR3 million, with few earning that much. Personal income tax rates were not only reduced, but also became even less progressive.
The corporate income tax rate was cut from 28% to 24%.With a 33.5% drop in registered taxpayers (corporate and individual) between 2019 and 2020, Sri Lanka’s tax base shrank.
Thus, even more of the population became exempt from direct taxes, increasing government popularity, especially among the middle class. But tax cuts failed to spur investment and growth — despite old claims by Ronald Reagan, Donald Trump and their “guru”, Arthur Laffer.
Successive Sri Lankan governments thus failed to increase tax collection, squeezing government revenue. To finance budget deficits, they increasingly borrowed from international capital markets — at higher commercial rates, with shorter maturities.
As the government cut tax rates and exempted most from paying income tax, government revenue fell. Owing to its falling revenue and deteriorating credit rating, the government had to borrow more, at higher interest rates.
Facing fiscal and foreign exchange constraints, the government declared Sri Lanka a 100% organic farming nation in April 2021. Banning all fertiliser imports — ostensibly to promote “agro-ecological” farming as part of a larger “green” transformation — compounded the looming “perfect storm”.
Although it was dropped in November 2021, the policy drastically cut agricultural output, with more food imports becoming necessary. Falling tea and rubber output also reduced export earnings, exacerbating foreign exchange shortfalls.
Evidently, the Sri Lankan government addressed the economic challenges it faced with “populist” policy choices. Instead of addressing long-standing problems faced, this effectively “kicked the can” down the road, worsening the inevitable meltdown.
Anis Chowdhury, a former professor of economics at the University of Western Sydney, held senior United Nations positions from 2008 to 2015 in New York and Bangkok. Jomo Kwame Sundaram, a former economics professor, was United Nations assistant secretary-general for economic development. He is the recipient of the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought.