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Solving Economic Problems in Sri Lanka’s Current Collapse

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In recent years, South Asia’s neighbors have been plagued by crises. Myanmar, for example, is battling a massive humanitarian crisis involving the exodus of the ethnic Rohingya, severe food insecurity, and soaring unemployment following a military coup in 2021. Meanwhile, Pakistan’s new government is seeking an International Monetary Fund (IMF) debt bailout in the country’s economic disaster, which will cost $6.4 billion over the next three years.1 The COVID-19 pandemic has caused supply chain disruptions, exacerbating economic challenges across the region. Ukraine’s conflict with Russia has further exacerbated the situation, as Western sanctions against Russia have had devastating economic consequences.

This paper examines the crisis in Sri Lanka – one of the worst economic disasters in South Asia’s contemporary history. To be sure, the interconnectedness of the global economy does not allow the national economic emergency in Sri Lanka, home to some 22 million people, to be viewed in isolation. Indeed, the pandemic and the supply chain disruptions following the Russo-Ukrainian conflict have exacerbated Sri Lanka’s crisis. In turn, Sri Lanka’s woes are bound to have implications across regions, trade regimes, and global value chains (GVCs).

This paper discusses six major economic challenges that have created the proverbial perfect storm for Sri Lanka: the state of the domestic economy; the balance of payments (BOP) crisis; successive IMF loans; unfounded agrarian reforms that have led to foreign exchange shortages and soaring inflation; the decline of tourism; and the country’s historical worship of sovereign debt.

Domestic economy and tax cuts
Sri Lanka is facing its worst economic crisis since the country’s independence from British colonial rule in 1948, and new dynamics are emerging daily in the island nation. the resignation of Prime Minister Mahinda Rajapaksa in May 2022 paved the way for the appointment of a new Prime Minister, Ranil Wickremesinghe – just the latest of important political and economic developments in Sri Lanka in recent years [2 ].

The 26-year civil war that ended in 2009 had a dramatic impact on the fundamentals of Sri Lanka’s domestic economy. the global financial crisis of 2008 depleted the country’s foreign exchange reserves, and successive governments’ economic mismanagement led to the twin challenges of budget shortfalls and balance-of-payments deficits. The country’s soaring external debt, coupled with increased government spending to implement the COVID-19 bailout, has further structurally weakened the domestic economy. The country’s GDP growth rate has plummeted from 8.01% in 2010 to (-) 3.56% in 2020, when the pandemic hit.

 

Source: World Bank, Central Bank of Sri Lanka’s 2022 forecast[3]
In late 2019 and early 2020 prior to the pandemic, the government implemented significant tax cuts to fulfill election promises. This resulted in the loss of approximately 1 million taxpayers between 2020 and 2022 – [4] a significant challenge for an economy already suffering from widespread tax evasion. Table 1 shows the revised direct and indirect taxes of the Sri Lankan government.

 

Prior to these tax cuts, Sri Lanka already had one of the lowest tax-to-GDP ratios in the region; these cuts have placed a further burden on the treasury. After unplanned tax cuts in 2019 and 2020, the ratio falls to a disastrous 7.7% in 2021 [6]. (See Table 2)

 

Mainstream economic theory suggests that such tax cuts will increase disposable income and money circulation in the economy, which in turn will stimulate economic growth in the medium to long term. However, for Sri Lanka, the consequences are dire. Given the island’s weak economic fundamentals and the sharp rise in spending on various welfare measures triggered by the epidemic, further frictions in resource mobilization have widened the budget deficit and increased the external debt of the Lankan economy. The budget deficit has increased significantly from 9.6% of GDP in 2019 to 11.1% and 12.2% of GDP in 2020 and 2021 respectively. The total government debt to GDP ratio also increases from 86.9% in 2019 to 100.6% in 2020 and 105.6% in 2021. [8]

In 2020 and 2021, the economy makes net repayments to foreign creditors, so the entire budget deficit is financed by domestic sources such as the Central Bank of Sri Lanka. [9] The large amount of monetary financing by the central bank exacerbated inflation and the exchange rate. As the situation deteriorated significantly, fiscal consolidation was required through increased revenues and rationalization of expenditures. Recognizing the unsustainability of tax cuts, the government is considering raising tax rates again to attract revenue. To this end, the government made a number of important announcements on May 31, 2022 – including an immediate increase in VAT from 8% to 12% (expected to raise approximately $180 million in revenue); an increase in corporate income tax from 24% to 30% starting in October 2022 (expected to raise approximately $145 million in revenue ). [10] In addition, withholding taxes on employment income have become mandatory and personal income tax exemptions have been reduced.

However, it is important for the government to complement its revenue-raising policies with appropriate spending rationalization measures needed to promote economic growth and job creation. At the same time, it is critical to extend immediate social protection measures for the poorer segments of society most affected by the epidemic. However, given that the economic impact of the pandemic is skewed toward women and the poor, any macroeconomic restructuring must be guided by the basic principles of inclusive progress. [11] Finally, given the public mistrust that led to civil unrest and the country’s historical pattern of massive tax evasion, [12] the government must make the tax collection system more robust in order to increase revenues in the medium to long term.

Balance of Payments Deficit
Sri Lanka is experiencing the classic case of the “twin deficit” hypothesis: an economy’s current account moves in the same direction as its fiscal account. To establish the link between the two, we have: [13] CA = (𝑆p-𝐼 ) + (𝑇 – 𝐺 ); [A] where CA is the current account balance, Sp is gross private saving , I is private investment spending, T is government tax revenue, and G is government spending (including transfers), so that total government savings Sg = (𝑇 – 𝐺 ) denotes the fiscal account balance. The twin deficits are characterized by a consumption-driven economy associated with high levels of domestic and international debt, as is the case in Sri Lanka. In this case, excess demand in the domestic economy increases imports and pushes up inflation, which in turn weakens the competitiveness of domestic goods in global export markets.

For Sri Lanka, the twin deficits of the current and fiscal accounts have been moving in tandem since 1970 (except when a current account surplus emerged in 1977), and the correlation between the two has weakened since 2000 (see Figure 2). The economy’s national saving has been lower than its national investment, but the gap has narrowed over the years after reaching a peak difference of 19.8% of GDP in 1980, when the country implemented a massive public investment program (see Figure 3). [14]

 

The twin deficit phenomenon increased Sri Lanka’s dependence on external debt, making the economy more vulnerable to exogenous shocks such as the COVID-19 pandemic. During the pandemic, Sri Lanka’s government expenditures (G) increased in tandem with those of economies around the world, while tax cuts on the eve of the pandemic led to a sharp decline in tax revenues (T) – significantly increasing the fiscal deficit and corresponding current account deficit.

In fact, Sri Lanka’s balance of trade (BOT) [b] has been in deficit, with a broadly upward trend over the years (see Figure 4).
On the other hand, Sri Lanka’s capital account is not affected by its current account or exchange rate; however, the reverse may not be true. Econometric analysis shows that interest rates have a positive effect on the capital account. [19] Theoretically, the capital account can negatively affect the current account in two ways: first, an increase in capital surplus increases investment and releases liquidity, which tends to increase consumption demand and thus leads to a current account deficit through increased imports. [20] Second, capital inflows lead to an appreciation of the local currency, making imports cheaper and exports more expensive in relative terms. As a result, a surge in imports and a decline in exports lead to a widening of the current account deficit. [21]

Historically, Sri Lanka’s capital account and current account balances have followed opposite trends: the former has been in surplus, while the latter has been in deficit for a long time. To be sure, there have been some exceptions, such as the sharp decline in Sri Lanka’s capital account balance during the financial crisis of 2008-09 (see Figure 5). Such differences are typical of consumption-driven developing economies, which are hotspots for inward capital investment, raising

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