Photo courtesy of Ceylon Independent

At Independence in 1948, Sri Lanka was second to Japan on most socio-economic indicators and ahead of South Korea on per capita income in 1960; it has since slipped behind most Asian neighbours. In April 2022, Sri Lanka defaulted on its foreign debtfor the first time, triggering the worst economic crisis in its history: the economy contracted by 7.8 per cent in 2022, and income poverty (at $3.65 a day) is estimated to have doubled between 2020 and 2022 to around 25 per cent of the population. With foreign debt distress risks rising in the developing world amidst an uncertain and increasingly risky global economy, this post suggests six policy lessons from Sri Lanka’s experience.

Policy consensus

The Sri Lankan economic crisis may largely be attributed to a lack of political consensus on a clear, consistent and predictable development strategy. Since the 1960s, there has been a series of repeating cycles characterised by constant policy reversals which have bred economic instability and uncertainty. Sri Lanka pursued inward looking import substitution policies with haphazard state interventions in the 1960s and 1970s; the upshot was an economy characterised by very low investment, low growth and extremely high unemployment.

By 1977 the country was ripe for economic reform. The reform package introduced at the time resulted in significant economic gains but only partially made the economy more oriented to international trade and markets. This is perhaps attributable to a lack of political consensus on reforms triggered by vested interests; for many years there was a tension between those who emerged after the “1956 Revolution” which gave prominence to inward looking nationalist thinking policies. The more outward looking policies associated with the “English speaking” class were constantly being rolled back, leading to an economy that became overly focused on non-tradeables and the domestic economy. This policy framework severely constrained growth, foreign investment and the creation of higher value jobs. It meant, in turn, that Sri Lanka was not able to replicate the economic success of neighbours in East and Southeast Asia.

A consensus on a 10 year vision for national economic development should be reached among political parties, business organisations, trade unions, and civil society. Conferences and seminars co-hosted by think tanks and the media can facilitate candid conversations on the merits of inward versus outward looking policies in an uncertain global economy. Areas of agreement should be codified into a readable national economic development vision document for the next decade outlining:

  • Economic development achievements and failures;
  • Realistic targets for economic development;
  • An outward-oriented, market-friendly policy agenda;
  • Risks to implementation.

To raise public awareness of the national vision for economic development, nation-wide outreach activities should be conducted. Often cited success stories of South Korea, Malaysia, Singapore, and the United Arab Emirates offer practical lessons in crafting and implementing such national visions for economic development.

Fix macroeconomic imbalances

Macroeconomic stress arising from the government’s weak fiscal performance has been the main cause of Sri Lanka’s poor economic performance since her Independence. The structural deficits in the government budget can be attributed to four key factors:

  • A sharp decline in revenue from taxing the three tree crop plantation economy caused by a fall in global commodity prices, a botched land reform programme and the costs of some improvement in the extremely exploitative living standards of the plantation workers;
  • Emerging sectors like tourism, apparel and IT services were granted generous tax exemptions which worsened the negative revenue from the plantation sector. While this may have been required to get emerging sectors over initial hurdles, continuing them has eroded the revenue base. The graduation from a low to middle income country status, the loss of concessionary financing and exposure to international capital markets and rating agencies required better macroeconomic management. An International Monetary Fund (IMF) supported stablisation programme was initiated in March 2023 and early signs seem positive.
  • Revenue reduction was not compensated by rationalisation of expenditure. Thus, a primary surplus in the government budget was only achieved in three years since 1954. The outcome has been a build up of unsustainable fiscal defects and public debt over decades. This was compounded by fiscal forbearance in monetary policy through deficit financing and financial repression;
  • Addressing macroeconomic stress through IMF programmes were not sustained because of the electoral cycles. Thus, the problem kept building up until it reached the default in 2022 where the structural weakness in the budget was compounded by imprudent tax cuts in 2019.

Fiscal policy should be made more effective by having legislation that imposes transparent fiscal rules. This will ensure that the primary balance will remain in surplus over time. Making this happen would require effective public expenditure management and efficient revenue mobilisation through widening the tax base and strengthening revenue administration. Further, an independent public debt management office and a coherent debt management strategy needs to be put in place.

Emphasise forex reserves

With worsening macroeconomic imbalances, the policy framework for earning foreign exchange (through exports, attracting FDIs, tourism, and remittances) was ineffective. For instance, the partial opening up of the economy to trade and an overvalued exchange rate – linked to the behaviour of strong inward-oriented business lobbies –  has meant that Sri Lanka’s trade regime continues to exhibit an anti-export bias. Long term exemptions of tax and import duty have had little effect on FDI inflows. Despite expensive tourism promotion campaigns, the highest number of tourists per year has only hit the 2 million+ mark in 2018, which is a fraction of the number in countries of Southeast Asia. Finally, an overvalued exchange rate has meant that remittances are sent through informal channels and has created a parallel market. These issues stem from politicisation and limitations of capacity; the outcome has been little build-up of foreign exchange reserves to the IMF rule of thumb of a minimum of three months of import cover. Also, reserves have been built up artificially through foreign borrowing often at commercial interest rates rather than by running current account surpluses as was done in East Asia.

A comprehensive and integrated national strategy should be adopted to earn sources of non-debt creating foreign exchange. This should emphasise:

  • Reducing the anti-export bias in the trade regime through more effective export marketing and a more realistic exchange rate alongside gradual reduction of import protection;
  • Better targeted investment promotion, time-bound investment incentives and cutting red tape through digitisation of approval processes;
  • Outsourcing tourism promotion to experienced marketing consultants in key markets;
  • Better incentivising remittance funds into the formal banking system.

Also, a single well resourced promotion institution like a public-private sector venture should be seriously considered.

Independent Central Bank

Repeated cycles of fiscal forbearance in monetary policy have greatly compounded macroeconomic instability. There was little recognition in political circles that the Central Bank was not a national development bank and that price stability is its primary responsibility. The actions of the Central Bank of Sri Lanka which supported fiscal indiscipline on a consistent basis led to an amplifying of the adverse effects of fiscal imbalances. During the crisis, treasury bills were issued to finance the fiscal deficit resulting in inflation, pressure of balance of payments and increased debt. The yield curve was supressed through financial repression which led to unsustainable leveraging for business and households. And attempts to artificially fix the exchange rate led to a rapid depletion of reserves.

Ideally, there should be a framework for Central Bank autonomy to pursue a data-driven, forward-looking monetary policy to achieve price stability. The new Central Bank bill identifies flexible inflation targeting as the best monetary policy framework for Sri Lanka where the use of monetary aggregates has proved inadequate, and using an external anchor is rendered impractical by the persistent current deficits. Also, adopting a flexible exchange rate becomes the first tool to adjust external imbalances. The political oversight of monetary policy occurs through a written agreement on the inflation target between the finance minister, the governor of the Central Bank and parliamentary scrutiny. The governance will be better ensured by a two part board, on monetary policy formulation and management of the Central Bank respectively. These boards will have a majority of independent members and no representation from the Treasury.

Targeted social protection

Sri Lanka’s British-style welfare system provides free universal healthcare through a system of public hospitals and universal education through state schools and universities. Sri Lanka also has the Samurdhi Programme – a poverty reduction initiative launched in 1995 – covering about 1.8 million beneficiaries. It provides cash transfers and various empowerment programmes (e.g., rural infrastructure, livelihood support, social development, housing programmes, and microfinance through Samurdhi Bank). Critics argue that Samurdhi benefits are not well targeted as deserving cases have not been receiving them and the sums offered are small in relation to needs during periods of food price inflation. There are also very heavy leakages due to high administrative costs and rent-seeking. The effectiveness of the programme has also been undermined by politicisation, and safety nets have proved insufficient during the economic crisis to stem growing poverty and social discontent over rising food inflation and shortage of food and fuel.

In an ideal world, targeted donor funded cash transfers should be introduced at the onset of an economic crisis along with a rationing of basic food and fuel where necessary. Eligibility also should be determined through a unique ID system and the benefits should be transferred directly to bank accounts of beneficiaries (as in the UIDAI (Aadhar) System in India) to eliminate rent-seeking and inefficiencies. The World Bank is currently working with Sri Lanka on a new cash transfer system (the Aswesuma social welfare benefit programme), introducing a unique ID system to better target the poor, reduce leakages and expanding bank accounts for the poor.

Increasing agricultural productivity

Sri Lanka’s agricultural sector is characterised by uneconomic small holdings, inefficient plantations, low technology and a lack of capital. It is kept viable only through agricultural subsidies for inputs, fertilisers, price support and irrigation, among others. Additionally, botched land reform of plantations in the 1970s contributed to a significant fall in agricultural efficiency and agricultural exports as well as increased reliance on food imports in US dollars (except paddy). These conditions led to food insecurity and malnutrition during the economic crisis: in 2022, Sri Lanka was faced with a Hobson’s choice of either paying interest on foreign debt or importing food to feed its people.

Looking ahead, it would be prudent to ensure an efficient agricultural sector that both maximises its foreign exchange potential from exports through modern farming and provides food security though sufficient domestic production. A comprehensive review of land use and crop mix would help in achieving these objectives.

A last word

In March 2023 Sri Lanka began its 17th IMF Programme, and the toughest one yet. The good news is that there has been some progress in controlling inflation and building external reserves. Accelerating structural reforms to promote growth, social inclusion and environmental sustainability is necessary for economic recovery. Implementation of reforms is key to Sri Lanka’s future success given the country’s lacklustre record and elevated risks. Risks include domestic uncertainties related to the debt restructuring process and heighted geopolitical risks including the Israel-Palestine conflict. Other debt distressed countries in the developing world may do well to heed policy lessons from Sri Lanka and adapt them to local circumstances.

This article was first published in the South Asia Blog of the London School of Economics.