Beset by multiple external and internal shocks, Sri Lanka is grappling with a terrible debt and economic crisis. India has played an important first responder role in providing foreign aid to Sri Lanka. This article looks at the relationship between foreign aid and domestic policies in tackling Sri Lanka’s crisis. It discusses the causes of Sri Lanka’s crisis, Indian aid to Sri Lanka, and policy priorities for President Wickremesinghe’s administration.
Sri Lanka’s terrible crisis
This is by far Sri Lanka’s worst economic crisis since independence from British rule in 1948. The default on external debt obligations in mid-April 2022 and a dollar shortage to pay for essential imports (e.g., food, fuel and medicines) has brought unprecedented economic misery to a country that was once on the cusp of upper middle-income status. About three-quarters of a million additional people may become the “new poor”, reversing decades of admirable gains in poverty reduction in Sri Lanka. Inflation has soared to over 60%, raising food and fuel prices which have in part created shortages and food insecurity for the population. Many families are down to one meal a day and there is a risk of malnutrition among children. Reflecting contractions across economic sectors, the Sri Lankan economy may contract by about -8 to -10% in 2022.
In simple terms, Sri Lanka’s present economic crisis can be explained by external shocks (such as the COVID-19 pandemic and the Russia-Ukraine conflict) and poor macroeconomic management by ex-President Gotabaya Rajapaksa’s government. Reference is made to the 2019 tax cuts, fostering an already-bloated public sector, the ban on chemical fertilisers, increasing red tape regulations, and the inexplicable delay in going to the International Monetary Fund (IMF).
To sort out its balance of payments problems, Sri Lanka finally began negotiating an IMF agreement in May 2022. But this process will take some time as Sri Lanka needs to whittle down its external debt of USD 51 billion to sustainable levels and get assurances from its creditors before it can reach an IMF agreement. Meanwhile, Sri Lanka has been seeking bridging finance to provide dollars for essential imports of food, fuel, and medicines from friendly countries. This has proved particularly challenging as 60% of the world’s poorest countries are also experiencing debt distress, while a possible second global recession in three years could dampen advanced economies’ enthusiasm to support Sri Lanka.
India has gradually shifted from aid recipient to aid donor since the early 2000s, following its impressive achievement of becoming one of the world’s fastest growing economies. India was the first responder to Sri Lanka’s desperate request for bridging finance and foreign aid, motivated by the unfolding humanitarian crisis affecting the Sri Lankan people and political pressure from South Indian states to provide aid. In the first six months of 2022, Indian aid worth USD 3.8 billion has flowed to Sri Lanka through credit lines, deferred loans, and grants, making it India’s largest bilateral aid programme in recent times. Back-of-the-envelope calculations suggest that Sri Lanka would require financing of between USD 20-25 billion over the next three years to provide essential imports and to help stabilise the economy. India alone may not be able to mobilise such a large aid envelope in the short run. Nonetheless, the South Asian giant has a unique opportunity to cement its reputation as an emerging donor by leading an aid consortium for Sri Lanka, working closely with other friendly countries (e.g., Japan, the US, and the EU), the IMF, and the World Bank.
Supporting Sri Lanka could be in India’s best interest. Stabilising Sri Lanka’s economy could be a major win for Prime Minister Modi’s neighbourhood-first policy and to enable India to steal a march over China as an emerging donor. Moreover, once the Sri Lankan economy stabilises, India can deepen its trade and investment linkages with Sri Lanka, transcending the current humanitarian aid relationship. This could spur regional integration and prosperity. It could also help advance India’s long-held ambition of securing a seat on the United Nations Security Council. Meanwhile, an unstable Sri Lankan economy could pose security risks to India and lead to a flood of refugees across the Palk Strait.
International experience offers some lessons on how to make Indian aid more effective in Sri Lanka. First, it would be prudent to have appropriate controls in place to ensure that leakages and deadweight losses are minimised to acceptable levels. Second, aid should be divided into smaller projects directed to the poor and distributed island-wide rather than just to the Western Province. Third, where possible, the private sector and grassroots non-governmental organisations (NGOs) should complement nationwide aid delivery by state institutions.
There has been growing scepticism in India as to why its taxpayers should bail out Sri Lanka, when there is a perception that Sri Lanka’s debt default is the result of economic mismanagement, inefficient state-owned enterprises, and corruption. Sri Lanka’s decision to allow the Chinese dual-use spy ship a port call at the Chinese-built Hambantota Port despite Indian protests has also sparked criticism of the Modi administration’s foreign aid to Sri Lanka. Clearly, a “flip flop” foreign policy does little to reassure development partners like India that Sri Lanka is serious about tackling the root causes of its crisis and in moving forward to build a harmonious and prosperous economy.
International experience suggests that the impact of aid from India and others can be maximised only if Sri Lanka adopts comprehensive economic and political reforms. There are five important items in the in-tray of President Wickremesinghe’s administration which recently assumed office:
- It has to show it is serious about stabilising the economy by concluding talks on an IMF programme which will increase taxes and utility prices to raise revenue and increase interest rates to control inflation while preserving social welfare expenditures to protect the poor. The conclusion of a staff-level IMF agreement in September 2022 was a step in the right direction but the approval of the IMF Board is needed before IMF funds can flow to Sri Lanka. IMF Board approval is subject to conditions such as a proper debt restructuring plan.
- It has to implement comprehensive structural reforms to make the economy more market-oriented (i.e., allow market forces to determine resource allocation rather than the state) and more inclusive of all sections of society and the environment. This means a big agenda aimed at removing barriers to trade and foreign investment, cutting red tape strangling business, increasing the participation of women in economic activities, promoting the use of renewable energy, and supporting regional development throughout Sri Lanka.
- It has to build national consensus across political parties on implementing the IMF programme and reforms by explaining to the public that this is the only solution to the crisis. Previous so-called “home grown solutions” emphasising inward-oriented, state-centred development under the Rajapaksa administration gave false hope to the people and arguably made the economic situation worse.
- It has to restore the rule of law and enforce strong anti-corruption policies (including asset declarations for all parliamentarians and a strong anti-corruption office supported by the United Nations). Later, the executive presidency should be abolished and a return made to a Westminster style of parliamentary system.
- It has to reset foreign policy towards a more neutral direction and away from the pro-China stance of former presidents Mahinda Rajapaksa and Gotabaya Rajapaksa.
The Wickremesinghe administration faces the challenging task of tackling Sri Lanka’s economic crisis in an unfolding scenario of domestic political uncertainty and a looming global recession. By emphasising more aid effectiveness and leading an aid consortium for Sri Lanka, India can cement its growing reputation as a first responder in the developing world. A strategic location in the Indian Ocean gives Sri Lanka a sporting chance of achieving some economic normalcy in the next few years if it can harness the political will to implement good policies. The alternative is the bleak prospect of a lost development decade for Sri Lanka (2022-2032) which could see a development reversal with falling per capita incomes, rising poverty, and more misery for the people of Sri Lanka.
The opinions expressed in this article are those of the author. They do not reflect the opinions or views of Debas.
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Cover Photo: Dr S Jaishankar on Twitter
Dr Ganeshan Wignaraja is Professional Fellow in Economics and Trade at Gateway House: Indian Council on Global Relations in Mumbai and Senior Research Associate at ODI Global in London.