Lanka liability – Sri Lanka's tussle with bad debt and a broken system

According to Michael Ondaatje; “In Sri Lanka, a well told lie is worth a thousand facts.” One of the best ones told in recent times was the lie that the Rajapaksa family would deliver national resurrection in the wake of devastating civil war. It was widely believed and matched by impressive – but functionally dubious – megaprojects. Instead, the brothers, variously Gotabaya as President, Mahindra as PM, Basil in Finance delivered national bankruptcy. To this extent the manner and depth of Sri Lanka’s economic fall is unique. What is now more interesting is the manner and extent of Sri Lanka’s recovery because it may provide pointers for other distressed economies in the region as they come under severe balance of payments pressure. 

Sri Lanka’s government is implementing reforms to stabilise the economy after a preliminary agreement with the IMF. We look at some of the key political and economic challenges that are likely to punctuate the country’s journey towards recovery and stability.

  • Without a parliamentary majority, President Ranil Wickremesinghe’s administration hinges upon the support of Rajapaksas to pursue economic reforms, making it deeply unpopular among the masses.
  • While efforts to form an all-party national government have failed, both the opposition and the ruling party are likely to let Wickremesinghe pursue economic reforms until the time is ripe for elections.
  • To fulfil IMF conditions, the government is likely to take deeply unpopular measures – such as increasing taxes and privatising state-owned companies – that will keep civil unrest risks elevated.
  • Such unwelcome reforms, along with the government’s harsh crackdown on organisers of anti-government protests, is likely to trigger further protests in the coming months.

Politics in flux

Sri Lanka’s current president Wickremesinghe faces an uphill task of steering the country out of the current economic crisis even as he remains unpopular among the masses for his proximity to the fallen Rajapaksa family. With the help of Rajapaksa’s party, the Sri Lanka Podujana Peramuna (SLPP), Wickremesinghe, despite being the only parliamentarian from his party, secured the majority in parliament to become president. 

Despite having been the country’s prime minister five times, Wickremesinghe was an unlikely candidate to head the government; his party, the United National Party, was routed in the 2020 general election after failing to win a single parliamentary seat. Wickremesinghe only secured a seat through a proportional representation system – where parties get to nominate a parliamentarian in proportion to their national vote share – becoming the party’s sole representative in the parliament. Even his nomination to parliament had been widely criticised and opposed by rival parties.

Angered by rising commodity prices and shortages of food and fuel, Sri Lankans staged massive demonstrations between March and July against the powerful Rajapaksa family, demanding the resignations of then-president Gotabaya Rajapaksa (2019-22) and government officials from his family. As the economic crisis deepened, protests on the streets swelled, ultimately forcing Rajapaksa to flee the country and resign on 14 July. In what seems like a well-crafted survival strategy, Gotabaya handed over the reins to Wickremesinghe.

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Sit and watch

Political instability remains inherent to the current situation as the Rajapaksas remain powerful by virtue of the SLPP’s parliamentary majority. On 8 September, Wickremesinghe expanded his cabinet to include several familiar faces from the former Rajapaksa administration, including a nephew of Gotabaya as well as many others facing corruption allegations that had been made before the start of the current crisis.

As soon as the economy shows signs of improvement, the Rajapaksas are likely to make efforts to re-occupy prominent positions in the government, with the prime minister’s post being the priority. Before that, they are likely to push Wickremesinghe to pursue constitutional reforms devolving some of the president’s executive powers to the prime minister. For now, the Rajapaksa brothers – Gotabaya and Mahinda, who was prime minister at the start of the protests in March and a former president of the country (2005-15) – would prefer sitting on the sidelines while Wickremesinghe clears the economic mess created by their erratic populist policies.

To do this, Wickremesinghe needs the support of the SLPP parliamentarians to pass the federal budget in the parliament, and make some tough decisions (such as raising taxes and utility tariffs) that are likely to be unpopular among the masses. Support from the SLPP will come with conditions. They will expect Wickremesinghe to ensure security for Rajapaksa family members and shield them from prosecution in alleged corruption cases.

The opposition parties also remain reluctant to extend support to the new administration as they fear public backlash. This has thwarted Wickremesinghe’s repeated efforts to form an all-party government. The opposition lacks the numbers in parliament to topple the government despite their misgivings about its legitimacy. The opposition parties are likely to let Wickremesinghe address the financial crisis until the time is ripe for an election. The opposition, particularly the Samagi Jana Balawegaya (SJB) party, is hoping that unpopular austerity reforms will further dent the credibility of the SLPP, gaining themselves support for the general elections to be held in September 2024.

Austerity bites hard

The Wickremesinghe administration reached a provisional agreement with the IMF on 1 September to secure a USD 2.9bn bailout programme. The agreement includes conditions the Sri Lankan government must abide by, including the implementing of fiscal reforms to shore up revenues and persuade external creditors to restructure their debt. Hours after reaching the agreement, the federal parliament passed an interim budget, increasing value added tax to 15% from 12%, with announcements to cut defence spending and subsidies.

Without giving clear timelines, Wickremesinghe announced that his government plans to reduce public debt from 110% of GDP in 2021 to 100% over the medium term. He also highlighted broad plans to increase Sri Lanka’s tax-to-GDP ratio from the current 8.2% to 15% by 2025.

The budget also made tax registration mandatory for all citizens above 18, irrespective of income. Subsidies on fuel and electricity were slashed while electricity tariffs were increased up to 250% to cut losses by the state-owned power corporation. Such measures are likely to increase hardships for Sri Lankans, which could lead to localised demonstrations by trade unions and other pressure groups.

The government will unveil a new budget for FY22-23 in November, which is likely to expand the tax base by bringing individuals with per annum incomes as low as SLR 125,000 (USD 341) under the ambit of income tax. It has also shown an inclination towards implementing a wealth tax on the financial and real estate assets of higher income groups.

Risks galore

Support from the people is critical to seamlessly pursuing these harsh economic reforms, but so far, Wickremesinghe’s administration is faltering. Alongside economic measures, he is running a harsh crackdown on trade unions and student activists who organised the protests that overthrew the Rajapaksas. Hundreds of activists have been arrested under the Prevention of Terrorism Act in the last few months.

To curb protests, the Sri Lankan government on 23 September designated government buildings and public roads as “high-security zones”. The following day, hundreds of activists marched against the government order in Colombo. The government responded using water cannons and tear gas, arresting 84 activists. In the last few weeks, localised protests have occurred across Sri Lanka, triggered by electricity cuts and other hardships.

The Wickremesinghe administration’s unpopular decisions are likely to trigger further demonstrations, keeping the civil unrest risks elevated in the coming months. Businesses are likely to face operational risks arising from protests against the government’s tax raise and increase in tariff of public utilities. Likewise, political risks will remain heightened as Wickremesinghe grapples with challenges within and outside the government.  

More broadly, Sri Lanka’s crisis has many lessons and warnings for policymakers in developing countries such as Pakistan and Bangladesh. While both Pakistan and Bangladesh have pre-empted a balance of payment crisis by approaching IMF for loans, maintaining a healthy macroeconomic and regulatory environment will be key to avert further challenges. Global headwinds coupled with increased commodity prices are likely to impact debt servicing of other distressed economies. Governments will tighten the taxation norms, cut imports, reduce spending on public infrastructure and welfare schemes to increase revenue collection. Businesses operating in emerging markets must devise crisis management plans while keeping a close watch on political and regulatory developments to predict and tackle possible challenges on the horizon.