Is Sri Lankan economy nearing a tipping point?

The Sri Lankan economy, which has undergone many crises since Independence, has always relied on the IMF to bail it out: sixteen times, to be precise

The term tipping point has either a positive or a negative connotation depending on the context. It signifies the threshold, the boiling point, or the point of no return. 

The Merriam-Webster dictionary defines it as follows: “The critical point is a situation, process, or system beyond which a significant and unstoppable effect or change takes place.” In an economic sense, a tipping point is a red flag, a grim signal or warning to indicate that the country is at a serious threshold. Once it crosses the threshold, the economy is almost certain to crash. 

An economic collapse in the Sri Lankan context will occur if and when the government runs out of foreign currency reserves; supply chains and essential services break down totally; the power grid and the filling stations shut down; and the country plunges into darkness. 

An economic collapse does not occur in isolation; it is often accompanied by mass hysteria and mob violence. The end result is anarchy. “God help us,” would be the plaintive cry of all Sri Lankans if this were to happen. 

Repercussions of Sri Lanka’s economic crisis

Here is how an ABC reporter in Colombo (standing beside a long line of disgruntled consumers with empty gas cylinders) described the situation on April 8th: “These people have been waiting for nearly twelve hours just to fill their cylinders with cooking gas. They say they’re struggling to do basic things like cooking food and they’re not sure. They’re leaving it to a point where they’ll be able to fill up these cylinders tonight. Now this is just one of the repercussions of Sri Lanka’s economic crisis, the worst in recent history. But now there are two pressing issues that have recently come to light. 

The first is fuel. New forecasts are showing that Sri Lanka will run out of diesel by the end of April as the country has spent a loan from India very quickly. The second issue we’re hearing about is medicine. Now the Medical Association here has recorded the first death in Sri Lanka due to medicine shortages. It has been an issue that has been building up for weeks. 

Now this economic crisis is due to huge debt been racked up over several years to foreign countries including China, and the country relies heavily on imported goods and basic services like power, like gas, like fuel, and like food. So now the question is what happens next. 

Every night there are protests here in Colombo calling for the leaders of this country to stand aside. They’re refusing to do that. Experts say though the solution is urgent foreign bailouts. They’re saying that this country urgently needs money from overseas to bring back these basic services. So the government is working on negotiations that are upcoming with the International Monetary Fund and that’s their only hope of getting out of this disaster.” 

The Sri Lankan economy, which has undergone many crises since Independence, has always relied on the IMF to bail it out: sixteen times, to be precise. 

Soon this number will go up to seventeen as the government, which is utterly bankrupt and completely demoralized, prepares to negotiate with the IMF for assistance in restructuring the external debt on a case by case basis, accessing bridge loans for financing imports, and implementing a macroeconomic stabilization program involving the adoption of fiscal restraint measures over a 4-5 year period. 

Then we will share with Pakistan the dubious distinction of being the two Asian nations with the highest number of IMF bailouts.  Unsurprisingly, both countries are reeling from widespread anti-government protests triggered by one economic crisis dovetailing into another. 

Imran Khan is no longer the Prime Minister of Pakistan. He was ousted by a no-confidence vote in parliament on April 9th. Does the same fate await the Sri Lankan PM, who is hanging on like grim death? 
The future of the Sri Lankan President is also uncertain as the anti-government protests are aimed at ousting the entire Rajapakse clan. 

For the first time in Sri Lanka, the masses are exercising people power on a national scale. This is a spontaneous movement with no leader at the helm. Though it is impossible to predict when the end game will be reached and how it will pan out, it is eminently clear that Sri Lankan politics is currently undergoing a sea change, triggered by a large crowd attempting to storm the President’s house on March 31st night. 

Gone is the creed of subservience by the people to national leaders, however powerful they may be.
The point to be noted is that even if there is a regime change, the economic crisis remains. It won’t simply evaporate. Unless the new regime possesses the skills and the capability to prevent the crisis from deepening, the economy is likely to implode.

Similarities with Lebanese economic crisis
Another country that is undergoing its worst economic crisis in recent history is Lebanon. Here is an excerpt from an assessment of the current economic and political situation in Lebanon by a WION reporter: “A financial meltdown, collapse of the Lebanese pound, sky-high prices for basic goods, and anger on the streets. Lebanon is being hammered by one crisis after another. 

The country is currently in free fall. Fuel is running out, bread prices are rising, and the army needs funds to feed its soldiers. The country’s Deputy PM says Lebanon is bankrupt. This is Lebanon’s worst crisis in modern history, posing the biggest threat to civility since the civil war. 

The currency has lost 90 percent of its value, foreign currency reserves have dropped dangerously low. The country has now reached a deal with the IMF. It is a 3 billion dollar loan facility, the first in two years. The IMF loan will be disbursed over four years. This will be in return for the implementation of an economic recovery plan, one that will see the country overhaul its banking sector, restructure its debts, and rationalize government spending. 
The crisis (which began in 2015) further unfolded in late 2019, spiraling out of control in this country of over 6 million. A foreign currency shortage crippled the import-dependent nation. This left residents struggling. They could not find fuel, medicines, and basic supplies. 

Daily power outages last for hours, leaving entire neighborhoods in darkness and threatening hospitals and food stores. Across the country, protests have rocked cities. Demonstrators scuffled with security forces. They called for concrete reforms and blamed the country’s political system for the crisis. Crushed under a mountain of debt, decades of corruption and scandal, and a financial meltdown like no other, Lebanon is facing its worst crisis since the civil war. And there seems to be no end in sight.”

The reporter may well have been describing the current economic and political situation in Sri Lanka. The Lebanese crisis seems to mirror the Sri Lankan crisis, does it not? Both countries appear to be rapidly approaching a tipping point – a consequence of poor governance, grave macroeconomic mismanagement, and systemic corruption. 

It seems mighty strange that an IMF deal has been made in Lebanon at a time when the country is preparing for a general election and the government is in limbo. If the election campaigns are disorderly and violent, they may tip the economy over the edge and plunge the nation into anarchy. 
If a general election is called in Sri Lanka while the country is attempting to secure its seventeenth IMF bailout and the economic crisis deepens due to political factors overriding all other considerations, a perilous situation could unfold.    

Good governance necessary for creating macroeconomic stability

When British colonial rule ended in Sri Lanka in 1948, our per capita income was one of the highest in Asia. Now many other nations have surpassed us. Despite the economic liberalization of 1977, we have fallen way behind in the race to attain newly industrialized country (NIC) status. 

The irony is that all the Asian nations which have attained NIC status were poorer than us in the 1950s. Only Japan had a higher per capita income than Serendib, as the island was once known. Perhaps it was from this exotic name that the word serendipity was coined. Sadly, the current situation in the island is anything but serendipitous, given the power outages;the food, fuel and medicine shortages; the skyrocketing prices; the protest marches; and other everyday inconveniences which we and the few tourists who are here have to put up with.

Under the British, the country enjoyed sustained macroeconomic stability – the key factor that enabled countries like Singapore, Malaysia, Thailand, Hong Kong, South Korea, and Taiwan to grow rapidly and attain NIC status. Foreign direct investment (FDI) played a pivotal role in this economic transformation which produced a dramatic increase in per capita incomes that were widely shared; so much so that some of these countries now enjoy a standard of living comparable to that of Japan, New Zealand, and Australia. 

The strong link between macroeconomic stability and FDI inflows suggests that foreign investors generally stay away from countries that fail to demonstrate sound macroeconomic management. Good governance and macroeconomic stability go hand in hand. Fiscal prudence and monetary discipline are the cornerstones of sound macroeconomic management. 

Macroeconomic instability, economic stagnation, and a harsh and volatile business environment are prominent features of countries flagrantly violating the principles underlying good governance and sound macroeconomic management. 

Pakistan and Sri Lanka are two of the biggest culprits in this regard, which is why they are now sharing the top spot for the highest number of IMF bailouts in Asia. Macroeconomic stabilization is the principal objective of IMF-sponsored policy reforms. The creation of a stable and consistent macroeconomic policy frameworkvia monetary, fiscal, regulatory and trade policy reformis what a Fund-backed stabilization effort is all about.Fiscal consolidation (reduction of the ballooning budget deficit to a manageable level over 3-4 years) will surely be a key component of macroeconomic stabilization efforts. 

The contractionary effects of fiscal consolidation may aggravate poverty in the short runas it entails a substantial reduction of government recurrent and capital expenditure and a significant increase in government revenue via higher direct and indirect taxes. 

The onus is on the government to work with the IMF on ensuring that the poor and near-poor, who probably account for about 40 percent of the Sri Lankan population, are adequately protected via an effective safety net program, which requires careful targeting as well as constant monitoring and evaluation.  

Imprudent spending and excessive borrowing 

When Sri Lanka achieved Independence, the economy was on a sound footing. The British colonial government exercised fiscal prudence and monetary discipline at all times. It did not attempt to live beyond its means because it understood that a government which throws caution to the winds and begins to live beyond its means will sooner or later bring the economy to its knees by creating an unsustainable debt. 

This is exactly what is happening now, seventy four years after Independence. The economy is on its knees – the cumulative effect of over seven decades of imprudent borrowing which has caught up with the government. Macroeconomic fundamentals (production, marketing and distribution, GDP growth rate, exchange rate, inflation, employment, trade balance, fiscal balance, debt sustainability, official foreign currency reserves, capital inflows, private investment, interest rates, demand and supply, poverty incidence, etc.) are in such disarray that for the first time in its post-colonial history, the economy is teetering on the brink of collapse – a situation resulting from imprudent spending and excessive borrowing. 

Sri Lanka has one of the lowest income tax takes in all of Asia, and its tax to GDP ratio is more similar to low income African countries than to those of an aspiring Asian NIC. Another problem is that for decades successive Sri Lankan governments have handed out tax holidays and fiscal relief to one sector and/or favored project after another. This has left the government in a position of having fewer and fewer domestic resources with which to discharge ever-growing government responsibilities.

This was always a fiscal path that was inevitably headed for a crash-and-burn, and the COVID-shock simply brought forward what was inevitable after decades of fiscal recklessness. If Sri Lanka had simply kept its revenues in the 15-17 percent of GDP range, none of the chaos that we now see would have materialized.

Critical need for bridge loans to ward off economic collapse

Though we have finally decided to go to the IMF (too little, too late, perhaps), there will be no immediate relief as a bailout package will take 3-4 months to negotiate. 

This period (May-August) is critical as the economy could reach the tipping point before any agreement is signed. There are two key issues in this regard. 

The first is that recently obtained credit lines from China and India are nearing exhaustion. The country needs around US$ 2 billion a month to finance imports but foreign currency reserves amount to only US$ 1.9 billion. 
If no new bridge loans are forthcoming, this means an economic collapse may occur 6-8 weeks from now. In which event, the country will fall apart long before an IMF deal is reached.

The second is the US$ 1 billion international sovereign bond (ISB) repayment due in July. Since the government is bankrupt, it will be forced to default on this specific debt-service obligation unless it can negotiate a restructuring of the debt (orderly default) with the creditors, for which purpose a team of experts would need to be assembled.  What should be noted is that first, the government has little or no experience with restructuring State debts and that second, it is a complicated and sensitive process. In the case of the ISB, if the government chooses the easy way out by going for a disorderly default (telling the creditors bluntly, “Sorry, folks, no money today”), it may have serious implications for Sri Lanka’s future borrowings in respect of both official and commercial loans.

If the creditors sue the government for damages, there will be various ripple effects directly impacting the economy, such as loss of credibility. Friendly nations may decide to give the government a wide berth, which means no more credit lines, no more bridge loans. And foreign suppliers may not accept letters of credit from local commercial banks. 

The worst case scenario is that by burning all its bridges, the government will push the economy closer to the tipping point. Let us hope therefore that sanity will prevail and that the government will settle for an orderly default, in which event its reputation will remain intact. 

The bottom line is this: Will India, China, Japan or some other friendly nation rescue Sri Lanka by providing a $ 8-10 billion bridge loan (with equity guarantees) while the IMF negotiations are in progress? This may be wishful thinking, but it’s our last hope. And can the government restructure the state debts and break this habit of borrowing good money to throw after bad?  

For decades Sri Lanka has blatantly ignored the costs of its foreign borrowing, and successive governments have figured that repayment will be some other government’s problem. That recklessness has finally come home to roost and the country is now choking on a debt that it cannot sustain.  Borrowing less, then less and less as time goes on, is the only way the country can kick its bad-borrowing habit.
(The author is a retired economist/international consultant to ADB/Manila. He can be contacted at snabeyratne
@gmail.com)