Crisis in Sri Lanka: lesson for India

Since the era of the great Emperor Ashoka, India and Sri Lanka have had cultural, social, intellectual, religious and economic ties. Whenever the Indian Ocean tear was in distress, India acted like a Big Brother. Whether it’s the Sri Lankan civil war in the 1970s or the current economic crisis, India has proven to be Sri Lanka’s constant friend.

At present, Sri Lanka is going through the worst economic crisis and India is the only country providing aid to the country by supplying basic commodities and providing line of credit to purchase fuel and fertilizer. Moreover, the crisis has also raised some economic concerns in India.

Recently, External Affairs Minister S Jaishankar in a multi-party meeting said, “The lessons of Sri Lanka are very, very strong. They are about budgetary prudence, responsible governance and that there should not be a culture of gratuity”,

What led to the economic crisis in Sri Lanka?

Sri Lanka is an island nation driven by the tourism industry which contributed 13% to its overall GDP growth according to 2019 data. When the world was in lockdown due to the COVID-19 pandemic, this subsequently impacted the flow of foreign currencies into the country. Due to travel restrictions, the number of international tourists has dropped significantly, which has led to the depletion of foreign exchange (forex) reserves. The country is also heavily dependent on the export of tea, and this industry has also been affected by the pandemic and the ongoing Russian-Ukrainian conflict, as these two countries are the largest importers of Sri Lankan tea and also represent a large number of tourists. .

Another reason for the fall in foreign exchange reserves was to take out loans to import food products. In 2021, the Sri Lankan government switched to organic farming without guaranteeing food safety. This reduced agricultural production to 30%, as a result, agriculture became inefficient to meet the country’s demand, thus pushing the government to import food products. The port of Hambantota was another white elephant project of the Sri Lankan government intended to alleviate its economic difficulties. Instead, it only compounded the debt problem Sri Lanka was facing by leasing the port to China for 99 years for $1 billion to pay off previous sanctioned loans. In addition, the depreciation of the Sri Lankan rupee against the dollar and borrowing from the IMF have affected the economy of Sri Lanka.

The final nail in the coffin was the Sri Lankan government’s populist economic policy. To win public votes, political parties have announced social policies without paying attention to the country’s current budget deficit. The elected government lowered the goods and services tax from 15% to 8% and removed the tax slab for high earners from 500,000 to 3,000,000 Sri Lankan rupees. Drastically, the percentage of people paying taxes fell to 33%. The country took out expensive short-term loans and issued international sovereign bonds, but instead of investing the money in development projects, it channeled the money into social and populist programs. Thus, the country failed to generate a new source of revenue and increased the debt-to-GDP ratio by 60%.

What’s in it for India?

Top bureaucrats and pundits pointed to populist schemes and giveaways from states like the governments of Punjab, UP, West Bengal, Andhra Pradesh and Telangana. The government of these states announced populist schemes and giveaways to win the elections. Experts have expressed concern over the greater spending autonomy granted to the state government under the 14th Finance Commission. Instead of focusing on development projects, revenues are transferred to populist projects. As a result, their income growth has remained slow over the years and the debt-to-GDP ratio has increased significantly. In 2017, the central government proposed the Fiscal Responsibility and Fiscal Management Act which stipulated that the debt to GDP ratio should remain below 60%, and the ideal percentage is 40. For states, the recommendation is below 40% and ideal at 20%.

Many states like Punjab, whose revenue generation is declining over the years, announced free electricity and Rs 1,000 pension for women which led to increase in debt to GDP ratio to 53%, which is the highest of all Indian states. Also, the government of Uttar Pradesh announced programs such as free LPG cylinders and free cycles for schoolgirls which increased the interest debt at the rate of 6%.

According to RBI, 18 states’ debt-to-GSDP ratio crossed 53%, while state market borrowing reached 63% of GSDP.

Even though the state receives revenue from the GST offset from the central government, the independent source of revenue is very less for the states. They depend on revenues from alcohol and gasoline excise duties, property taxes and motor vehicle registration. Over the years, investments in health and social welfare have increased due to the COVID-19 pandemic, and states have had to borrow money for welfare.

Go forward

Experts underlined the need for the fiscal council to apply the FRBM mechanism and also assess state spending. Federal cooperation between central and state governments is needed to develop sustainable social protection programs. The efficiency of public spending should be at the center of policies. In addition, documentation of the results should be done to verify the scope of the policy. State-specific policies can be developed to reduce the states’ debt-to-GDP ratio, as each state is unique and has different requirements. States should consider the fiscal condition before announcing a social protection scheme because this scheme has a direct impact on lower investment in development projects, thus creating fewer jobs.

Eventually, Sri Lanka discovered that excessive consumption cannot be sustained without a corresponding increase in income and independent production of basic necessities. Therefore, it is crucial to be careful before converting to organic farming, undertaking large projects which may not be profitable and increasing the debt to GDP ratio. The country should focus on developing industries to be self-sufficient.

India is moving in the right direction by launching initiatives like Atmanirbhar Bharat, which promotes localized production and implements Production Linked Incentive Schemes (PLIs) for several economic sectors. Even India’s export basket is much more diverse, unlike Sri Lanka. Lessons from Sri Lanka may even enable India to showcase a sustainable consumerism and self-sufficient manufacturing economic model that is unfettered by the influence of multinational corporations and banks.

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