Paradise Squandered: What Really Happened to Sri Lanka’s Economy?

April 13, 2022

By Yolani Fernando

Sri Lanka is often held up as the poster child for the dangers of Chinese “debt trap diplomacy,” even though Chinese debt is just one element in a complex of structural problems. If we take a decades-long view, Sri Lanka’s current economic trajectory was predictable, and its impending sovereign default a foregone conclusion. As high external debt repayments, a foreign exchange crisis, and the pandemic push the country to the brink of an unprecedented default in 2022, decades of strong performance on social indicators are now at serious risk.

Domestic authorities, including the governor of the central bank, have resisted growing national and international calls for an IMF agreement and debt restructuring, insisting that Sri Lanka will service its debt and keep the interests of foreign creditors “at heart.” The president, however, recently signaled the government’s intention to restructure its debt with the assistance of its allies and the IMF. Meanwhile, the Sri Lankan public bears the brunt of the crisis, with daily power cuts, fuel shortages, and skyrocketing prices for essential goods becoming the new normal.

From the 1950s to the 1980s, robust tax revenues supported generous subsidies for food, healthcare, and education. Sri Lanka consistently outperformed its international peers on social indicators. Since the early 1990s, however, the nation’s tax-to-GDP ratio has declined, from an average of 18.4 percent in 1990–92 to 12.7 percent in 2017–19 and a low of 8.4 percent in 2020. Interestingly, the revenue decline started after Sri Lanka’s civil war ended in 2009. Governments began spending substantially less on social goods than they had in the past, with average health and education spending in 2010–19 amounting to 1.8 percent and 1.4 percent of GDP, respectively.

Since the 1990s, successive Sri Lankan governments have committed three cardinal sins, which may be forgivable individually but together form an unholy trinity of economic disaster: heavy reliance on commercial borrowing to finance the budget deficit since the mid-2000s; failure to widen the tax base, thereby shrinking government revenue; and missed opportunities to grow and diversify the export market, which in turn has led to reliance on just a few sources for most foreign exchange earnings. The current foreign exchange crisis was triggered by the decline in exports and tourism in 2020, and in foreign remittances in 2021. The first two sins reveal the weak foundations of an economy that is now collapsing inward on itself.

(Photo: Charles Sasiharan / The Asia Foundation)

The country’s current crisis has roots in the surge of aid inflows after the economy opened up in 1977. This allowed successive governments to run large fiscal deficits while neglecting revenue collection. Aid and avenues for concessionary borrowing dried up as Sri Lanka rose to lower-middle-income status. This led to a heavy reliance on commercial borrowing to finance the national budget.

These loans, unlike concessionary loans from multilateral institutions, had no strings attached. Most of this debt took the form of international sovereign bonds (ISBs). But this quick and dirty solution came at a price: higher interest rates, shorter maturity periods, and greater risk. By 2019, commercial borrowing, which was a mere 2.5 percent of foreign debt in 2004, had ballooned to 56 percent.

In comparison, Chinese-owned debt (including public debt and publicly guaranteed debt) represented only 17.2 percent of foreign debt in 2019. But the real devil lies in the effective interest rates of the ISBs, which are more than double those of Chinese loans. Sri Lanka’s interest payments alone took up 95.4 percent of government revenue in 2021. For comparison, its credit-rating peers Ethiopia and Laos have rates of 11.8 percent and 6.6 percent, respectively.

While Sri Lanka’s higher development status should have resulted in more direct taxation and the growth of the tax-to-GDP ratio, its tax system is highly inequitable, with indirect taxation accounting for an estimated 80–82 percent of revenue. The falling tax-to-GDP ratio is due in part to the failure to expand the tax base, reliance on indirect taxation, tax policy instability, and an excess of tax concessions and relief.

Import duties are Sri Lanka’s preferred form of revenue collection—more than half of government revenue is raised this way. Rich and poor are taxed equally on consumption of essential food imports, cooking fuel, and even sanitary pads. Heavy taxes on consumer goods have created a regressive tax system that struggles to collect sufficient revenue to finance public spending. In contrast, progressive taxation has failed to grow since the 1990s, with the number of individual taxpayers not keeping up with economic expansion.

These unsound policies can be attributed in part to the expansion of the executive presidency’s influence over the treasury and the absence of powerful finance ministers. This was demonstrated in November 2019, when President Gotabaya Rajapaksa fulfilled a campaign promise to slash taxes, which ultimately compounded the revenue losses due to the pandemic.

The pandemic is best seen as the straw that broke the camel’s back, rather than the cause of Sri Lanka’s woes. The situation spiraled out of control when tourism earnings and other sources of foreign exchange took a hit. While remittances from overseas workers actually increased in 2020, they reached a 10-year low in 2021 as the fixed exchange rate led to the increased use of informal channels to repatriate earnings.

After sweeping tax cuts in 2019 led to a downgrade of the nation’s credit rating in 2020, Sri Lanka lost access to international financial markets and with it the ability to roll over its ISBs. While some of the repayments were supplemented by increased multilateral and bilateral borrowing, Sri Lanka started dipping into its foreign reserves to meet its debt obligations. This resulted in foreign reserves plummeting from a healthy level of USD 8,864 million in June 2019 to USD 2,361 million in January 2022. (Of this, usable reserves are in fact only USD 792 million.) Unable to bring its foreign earnings back to pre-pandemic levels, Sri Lanka now faces a dire foreign exchange crisis. Again, the pandemic merely exposed the country’s vulnerabilities rather than precipitating the crisis.

Sri Lanka has the unique problem of consistently outperforming its peers on development indicators while contending with dangerously low government revenues. Its economic decline is a cautionary tale of short-sighted policies and weak management of public finances. Rather than being a victim of predatory lending practices, Sri Lanka is a victim of its own crumbling and politicized institutional foundations. Its trifecta of sins has brought it to the brink of default, and could undo decades of progress and years of post-conflict stability. The government insists that “Sri Lanka always pays its debts.” But while this may be an admirable stance, how long will the Sri Lankan people have to bear the cost?

This post is part of a collaborative project with the DevPolicy Blog of the Australian National University, where it previously appeared.

Yolani Fernando is a senior program officer for The Asia Foundation in Sri Lanka. She can be reached at [email protected]. The views and opinions expressed here are those of the author, not those of The Asia Foundation.

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