Sri Lanka’s economic problems have drawn attention to India’s macroeconomic policies and management. While the two countries are vastly different in terms of size (Sri Lanka’s GDP is $80 billion vs India’s $2.6 trillion), this is an opportunity to reflect on where Sri Lanka went wrong and whether there is some lesson for India.
According to Sri Lankan media, an interim president will be sworn in on Wednesday and an all-party government will be formed. President Mahinda Abeywardena, the party leaders have decided to elect a new president on July 20, through a vote in Parliament. Opposition leader Sajith Premadasa is the main candidate for this post. A petition has been filed in the High Court to prevent the former president, former prime minister and other former senior ministers from leaving Sri Lanka.
The whole world is watching the events in Sri Lanka. As of now, there is practically no functioning of the government, the Prime Minister’s house was set on fire by the protesters, and the Presidential Palace has become a picnic spot for the protesters, who bathe in the pool and cook on campus. The protesters have said they would leave the Presidential Palace once the new government takes office.
Some of the policy changes made by Sri Lanka in recent years are similar to those in India, but India is not affected by the common global shocks faced by both nations.
Sri Lanka’s policy mistakes form a long list. He slashed indirect taxes in November 2019 and abolished some other taxes. In September of the same year, India cut corporate tax rates to boost private investment. Both countries posted larger fiscal deficits in subsequent years as tax cuts failed to deliver immediate revenue gains while COVID-19 hit in the following months.
Sri Lanka increased revenue spending during the COVID-19 crisis by providing cash transfers and loan moratoria. India followed suit but enjoyed a rebound in GDP growth and healthy tax collection, while the Sri Lankan economy has struggled to recover from the pandemic.
The crisis has been mainly due to the shortage of foreign exchange reserves. They have plummeted 70% in two years to just $2 billion at the end of February, which can barely cover two months of imports. Meanwhile, the country has foreign debt obligations of about $7 billion this year. The currency crisis is the result of several factors.
Tourism, which is the country’s third-largest earner of foreign exchange, came to a virtual standstill after the 2019 Easter Sunday suicide bombings that killed more than 250 people. Tourist arrivals fell by up to 70%.
And then the pandemic came, dealing a huge blow to the tourism industry. And remittances from foreign workers, which is the country’s largest source of dollars, plummeted 22.7% to $5.5 billion in 2021.
Colombo’s response was to clamp down on imports and continue to borrow abroad to meet its external obligations. But the loss of foreign exchange earnings from tourism (since the 2019 terror attacks and later compounded by COVID-19-related travel restrictions) led to a sharp drop in central bank foreign exchange reserves of $10 billion in 2019 to $2 billion today.
During the same period, India’s foreign exchange reserves increased from $200 billion to $600 billion. Several factors helped. Multiple structural reforms by the government and the steady hand of the Reserve Bank of India allowed foreign investment to flow even during the pandemic. The central bank provided liquidity support to the economy during the pandemic and allowed the rupee to depreciate based on market forces.
A weaker rupee helped export competitiveness and also allowed remittances to keep flowing. Although India’s foreign exchange reserves have dwindled in recent months after the Ukraine crisis, they are still large enough to provide an 11-month import hedge. By comparison, Sri Lanka’s import coverage is just a few weeks.
Sri Lanka also missed out on reforming its economy when it should have. It has a whopping 527 Public Sector Enterprises (PSEs) compared to the 277 central PSEs in India. India has been trying to reduce the role of the inefficient public sector in the economy and encourage private investment. Sri Lanka’s approach has been to persist with a deficit public sector. His government has been plagued by corruption, and Transparency International ranks him 17th behind India in perceived corruption.
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