Once deemed a basic human needs success story, Sri Lanka (SL) is now in its worst economic crisis since independence in 1948. Nonetheless, SL’s ‘moment of truth’ now offers lessons for other developing countries.

China scapegoat

SL 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, SL is a country caught in a debt trap due to white elephant projects mooted and financed by borrowings from China. Blaming SL’s debt crisis on Chinese loans is not only factually wrong, but also prevents understanding the origins and nature of its current crisis.

Outstanding SL government foreign debt in April 2021 was US$35.1bn. Policy errors have reduced foreign direct investment (FDI), exports and government revenue, changing the composition of its foreign debt for the worst.

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 of April 2021, about 60% of SL’s debt was for durations of less than ten 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%.

Adding government guaranteed debt to state-owned enterprises, total borrowings from China were 17.2% of SL’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, SL’s interest payments alone came to 95.4% of its declining government revenue in 2021!

Deep-rooted problems

Following its 2001 recession, SL recovered, before growth declined again after 2012 and the pandemic contraction in 2020. SL also experienced premature deindustrialisation, with manufacturing’s GDP share falling from 22% in 1977 to 15% in 2017.

Government tax revenue declined from 18.4% of GDP (1990-92 average) to 12.7% (2017-19), and a 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.

SL’s exports-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 SL were between 1.1% and 1.8% of GDP, before falling to 0.5% in 2020.

During 2012-19, the share of International Monetary Fund (IMF) Special Drawing Rights (SDRs) in SL’s debt stock fell from 28% to 14%, as borrowings ballooned! SL’s debt crisis is clearly due to the policy choices of successive governments since the 1990s.

Crisis-prone

In February 2022, SL 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 2022, with food prices rising 24% in January-February 2022. But economic crisis is not new to SL.

As a commodity producer – mainly exporting tea, coffee, rubber and spices – export earnings have long been volatile, 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, SL has obtained 16 IMF loans, typically with onerous conditionalities. The last was in 2016, providing US$1.5 billion over 2016-19. 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 it 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 mobilizing 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 in 2017-19 – one of the lowest shares among middle-income countries. Losing about 2% of GDP in revenue, its tax-GDP ratio fell to 8.4% in 2020.

SL’s value-added tax rate was cut from 15% to 8%, while the VAT registration threshold was raised from one to 25 million SL rupees monthly. Other indirect taxes and the ‘pay-as-you-earn’ system were abolished.

The minimum income tax threshold was raised from 500,000 SL rupees annually to three 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, SL’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 SL 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. Due 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 SL a 100% organic farming nation in April 2021. Banning all fertilizer imports – ostensibly to promote ‘agro-ecological’ farming as part of a larger ‘green’ transformation – compounded the looming ‘perfect storm’.

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 SL government addressed the economic challenges it faced with ‘populist’ policy choices. Instead of addressing longstanding problems faced, this effectively ‘kicked the can’ down the road, worsening the inevitable meltdown.

Related IPS articles:

1. China Debt Traps in the New Cold War
2. Most Financial Inflows Not Developmental
3. IMF, World Bank Must Urgently Help Finance Developing Countries
4. Paltry International Support for Spending Needs Sets South Further Back

This article was originally published on KSJomo.org.

(Anis Chowdhury is Adjunct Professor, Western Sydney University and University of New South Wales, Australia. Jomo Kwame Sundaram was an economics professor and United Nations Assistant Secretary-General for Economic Development.)