Nathan Were Phiri, access to finance Specialist at the World Bank Group
NAIROBI – The island nation of Sri Lanka is not poor. Its per capita GDP – when adjusted for purchasing power – is higher than South Africa, Peru, Egypt, and Indonesia. However, the country now faces its worst economic and social crisis since its independence in 1948. The financial system has collapsed, and fuel, food, electricity, and medicine shortage cripple the island nation of 22 million people. Its people have taken to the streets to protest and demand the resignation of President Gotabaya Rajapaksa, who took over the country in 2019 with a 52 percent election win. Thousands of Lankans are queuing at immigration centers to process passports and flee the country and living conditions have become unbearable.
But how did Sri Lanka get here?
Populist tax reforms
The Sri Lankan Economic crisis was man-made for the most part. External shocks – Covid19 and now the Russian invasion of Ukraine – notwithstanding, the Sri Lankan administration made grave fiscal mistakes that would later plunge the country into a huge fiscal deficit. While campaigning for elections in 2019, President Rajapaksa promised several tax cuts – his argument to free up spending and boost Sri Lanka’s ailing finances. Rajapaksa reduced VAT from 15% to 8% and eliminated seven more taxes to keep up with his election promises. The country was cutting taxes when its public Debt to GDP was hovering around 86%. Cutting taxes meant a drop in tax revenue, and quickly creditors became worried about whether Sri Lanka would honor its domestic and external debt obligations that now stood at $50b. Drop-in tax revenue was not the only effect tax cuts brought. The country’s credit rating was downgraded to negative by fitch – a global outlook rating agency – citing risks associated with debt sustainability. This meant that Sri Lanka had quickly become a risky country to lend to as chances of default had become high as it would not have money to re-pay.
Poor debt management
Countries all over the world borrow; however, keeping debt within sustainable margins is very important. Similarly, when debt becomes unstainable and the ability to service the loans collapses, countries typically turn to lenders to restructure debt repayments and seek debt relief or suspension of interest and principal payments until they’re able to resume payment. Other than turning to lenders to restructure its growing debt, Sri Lanka instead took on more debt to plug its budget deficit. Considering that the country had been negatively rated, it only meant that it could access loans at costly rates – as loan pricing is based on the level of risk. The higher the risk, the higher the interest rate.
Family rule and lavish government spending
It was not just the tax reforms that plunged the country into a deep hole; family rule could have also contributed to its crisis. Shortly after take-over, President Rajapaksa named his elder brother Mihinda, as prime minister. An election in 2020 gave Rajapaksa’s party a two-thirds majority in parliament, allowing his party to re-write the constitution to provide himself with extraordinary new powers. The constitutional amendment gave Rajapaksa powers to hold ministries, sack ministers, and have authority over formerly independent commissions that oversee elections, police, human rights, and anti-corruption efforts. The amendment also allowed the president to dissolve parliament halfway through a five-year term. Following these amendments, Rajapaksa started appointing his family members to top government positions to consolidate his grip on power further. Four of the 26 cabinet members were from his family in strategic ministries such as finance, irrigation, defense, urban development, e.t.c. Calls to cut government spending and increase taxes to stabilize the economy were dismissed as the government went on a lavish spending spree amidst a reduced fiscal space.
Ban on imported chemical fertilizers
In the middle of the pandemic, the government made a very wrong move – to ban the importation of chemical fertilizers. While this decision was later reversed, it significantly impacted productivity. On April 22, 2021, Sri Lankan president Gotabaya Rajapaksa announced a complete ban on the use and importation of chemical fertilizers to make the country the “world’s first 100 percent organic food producer. The government claimed that using fertilizers and agrochemicals, however productive, led to contamination of lakes, canals and rivers and the spread of non-communicable diseases like kidney disease. The move on fertilizer ban significantly affected productivity for paddy and other crops by over 40%. With lower results, food prices went up, and farmers took to the streets to protest. While the move to organic farming was brilliant, the government made the decision hurriedly and without proper consultation with the farmers and mechanisms to cushion the country against the impact of reduced yield. To address the food shortage stemming from reduced productivity, Sri Lanka turned to food importation, further weakening the local currency as demand for the dollar rose.
The crisis in Sri Lanka has been slowly evolving; it is only possible that the pandemic and the Russia and Ukraine crisis brought the country’s problems to the fore. As the first country to fall post the pandemic and Russia – the Ukraine crisis, the journey to its current state should be an eye opened to developing countries, especially around tax reforms, government spending and debt management.
The writer, Nathan Were is a Financial Inclusion Specialist based in Nairobi, Kenya.