Island nation needs an urgent IMF bailout to avoid bankruptcy in the coming months
When Sri Lanka President Gotabaya Rajapaksa campaigned for the presidential election in 2019, he advanced a vision of political stability and economic progress after years of chaos and decline.
Three years later, Sri Lanka’s economy has hit rock bottom, with protests spreading across the country over electricity outages, food and medicine shortages and soaring prices. The shortages are becoming so acute that some believe they could spiral into a humanitarian crisis.
Reports said the Ceylon Petroleum Corp. requested the public not to queue for diesel on Wednesday and Thursday after the state-run refiner failed to unload a shipment of 37,500 metric tonnes of the fuel. Wire agencies interviewed doctors and health workers who spoke of dire shortages of imported vital drugs and diagnostic chemicals.
Sri Lanka’s trade deficit doubled to US$1.1 billion in December. It reportedly had about $2.3 billion of foreign-exchange reserves last month and faces a $1 billion bond repayment in July.
Authorities have devalued the local currency, curbed imports and raised fuel prices and interest rates in a bid to control the situation, so far to no avail. Stock trading was briefly halted for the second straight day Wednesday after a key index plunged 5%.
Part of the crisis has been driven by the Covid-19 pandemic and the ongoing Russia-Ukraine war, which among other things has drastically driven up global oil prices. But the real story of Sri Lanka’s descent into chaos starts with the rise of President Gotabaya and his populist, strong-man rule in 2019.
This rule was facilitated by hard-line Sinhala Buddhist nationalist forces, including those dominated by former military men such as Viyathmaga. These organizations projected themselves as agents of transformation and their model of centralized governance was presented as what was needed after three disastrous years of the coalition government of the United National Party and the Sri Lanka Freedom Party.
To dramatically alter Sri Lanka’s fortunes, a new policy vision prepared in part by Viyathmaga, “Vistas of Prosperity and Splendor”, was issued to guide Sri Lanka’s path to glory.
Apart from other issues – including the existing constitution – plaguing Sri Lanka, this vision identified that “the prevailing tax system has contributed to the collapse of the domestic economy.”
Accordingly, the Gotabaya government introduced, soon after coming into power, massive tax cuts that reduced its revenue by a whopping 28%, Sri Lanka central bank data shows. This was a major turn away from the path of fiscal consolidation undertaken by the previous government.
Moreover, this decision ran counter to the International Monetary Fund’s 2019 review of the Sri Lankan economy, which it said needed “sustained efforts to mobilize revenues will be needed in 2020 … to protect the economy against shocks, allowing for exchange rate flexibility in the event of market pressures.”
As a result, Colombo was left with what the IMF called in early 2020 a “weak revenue performance and expenditures overrun”, pushing the island nation down an unstable fiscal path. This was followed by a formal closure of the IMF’s program in the country.
In early 2020, the revenue shortage was further exacerbated by the Covid-19 pandemic, which stripped Sri Lanka of a critical source of foreign currency: tourism. With the pandemic and subsequent lockdowns being a global phenomenon, worker remittances, traditionally a key source of foreign exchange for Sri Lanka, fell hugely by almost 23%.
In April-May 2020, Sri Lanka’s sovereign ratings were downgraded to B-negative. Among the reasons cited for the downgrade was the Gotabaya regime’s decision to introduce tax cuts that exacerbated already rising public and external debt challenges.
Crucially, this downgrade also locked Sri Lanka out of international financial markets. In December 2021, the rating was further downgraded to “CC”, deepening market perceptions of the nation’s financial straits.
While Sri Lanka’s access to foreign exchange was curtailed, Colombo continued to settle its debt repayments using existing foreign-exchange reserves throughout this period.
Even though in the following months Sri Lanka’s reserves continued to fall – dipping from $7.6 billion in 2019 to $2.3 billion in October 2021) – Colombo did not consider going to the IMF for an emergency bailout that ultranationalists – including the Rajapaksa family itself – think would compromise Sri Lanka’s sovereignty.
Instead, Sri Lanka opted for currency swap deals with China and India, which, apart from temporarily bolstering the reserve position, did nothing to consolidate Colombo’s failing fiscal position.
As a result, in early 2022, Sri Lanka’s actual useable reserves fell below US$1 billion, prompting Colombo to simultaneously approach India and the IMF for urgent help.
New Delhi, seeing in Sri Lanka’s acute economic crisis an opportunity to consolidate its own geopolitical foothold vis-a-vis China, has agreed to open a $1 billion credit line to help Colombo buy essential goods, including oil and medicine. Colombo is also already in fresh talks with India for yet another loan of $1.5 billion. This is apart from the ongoing talks with the IMF for a bailout package.
This has all been necessitated by the fact that there is no way Colombo can avoid going bankrupt without securing a bailout. There is simply no way for Colombo to repay the $6.9 billion owed in 2022 with less than $1 billion currently in reserves and the economy still staggering. The IMF, the bogeyman of Sri Lankan nationals, is now the only source of sufficient funds to avoid bankruptcy.
Gotabaya’s government, meanwhile, is in denial. The president addressed his nation in the third week of March outlining how the crisis was not his doing while confirming his government’s decision to accept the IMF’s bailout conditions to be formally discussed in April.
“Subsequent to my discussions with the International Monetary Fund, I have decided to work with them after examining the advantages and disadvantages,” Rajapaksa told his beleaguered nation in a somber address. As several analysts have pointed out, the speech aimed to ease investors’ growing concerns that Sri Lanka will be bankrupt in a month or so.
Sri Lanka, very much like the heavily indebted Argentina, is also seeking to go to the World Bank after securing an IMF bailout package to provide for what Sri Lankan officials are calling “budgetary support.”
A World Bank statement released to the media said that the Bank is not currently in talks with Colombo, but that they are “engaging with the authorities to identify a comprehensive structural reform program needed to ensure sustainable growth, and around which such support may be possible in the future.”
Most analysts believe that Colombo will be able to secure an IMF bailout, but its road to recovery is going to be long and difficult insomuch as it would depend upon how robust Sri Lanka is in implementing the IMF’s recommended structural reforms.
These will include cutting government expenditures and subsidies, privatizing state-owned enterprises, stopping money printing, floating the exchange rate and laying off public sector workers, among other tough measures.
While these reforms, if implemented, will take time to bear fruit, industries like tourism are unlikely to flourish amidst the worst power cuts and oil and medicine supply shortages in recent memory. Meanwhile, the ruling Sri Lanka Podujana Peramuna (SLPP) will have to ensure it does not internally disintegrate amid the inevitable backlash against the IMF and World Bank’s recommended reforms.
If the SLPP government is able to survive, one thing that it can and must do immediately is to drastically cut its expenses and take the opposition parties on board to minimize the political fallout. Reports indicate that the SLPP is moving in this direction. It has decided after the opposition demanded to table the IMF report in the parliament for debate.
What this means in practical terms is shifting from an exclusionary and ultranationalist set-up to a more inclusive dispensation.
Whereas the recent exit of hardcore nationalist ministers like Udaya Gammanpila indicates a probable restructuring of the government, Gotabaya’s recent – and first-ever – meeting with the Tamil National Alliance also indicates a shift towards a more inclusive approach to stabilize its own regime and discourage the opposition from launching agitation.
While this may be merely symbolic, there is no denying that the way out of the crisis involves both political and economic restructuring.
