Sri Lanka is among developing Indo-Pacific countries contending with crippling debt that can quash decades of poverty reduction efforts, strain social stability and aggravate security threats. Colombo’s debt threatens its economic prosperity and poses challenges for regional security, but domestic adjustments and external partnerships are having positive effects.
Its location makes it a good place for investment with potential to emulate the success of nations such as Malaysia and Thailand, financial experts say. The Indian Ocean island of about 22 million people is off the south coast of an economically dynamic India, and long has aspired to flourish as a trading and manufacturing hub.
Sri Lanka’s economy is based mainly on exports of tea, clothing and workers, and an influx of tourists attracted by sunshine, pristine beaches and heritage sites. It has functioning governmental, judicial and civil service institutions.
However, an acute fiscal crisis caused Sri Lanka to default on foreign debt of more than $50 billion in April 2022. The move triggered a paralyzing economic contraction characterized by steep inflation and widespread financial uncertainty. Sri Lanka’s gross domestic product (GDP) tumbled 7.8% in 2022 and inflation surged to 69.8% that September. Shortages of food, fuel and medicine were accompanied by soaring prices and long lines for essential goods. Poverty increased. Sri Lankans staged mass protests against the nation’s governance, which was dominated by one family, and pervasive economic mismanagement. President Gotabaya Rajapaksa and his brother, Prime Minister Mahinda Rajapaksa, resigned.
Ranil Wickremesinghe became president in July 2022. His administration stepped up discussions with India and the International Monetary Fund (IMF) about an economic bailout and implemented stabilization measures such as removing fuel price subsidies and hiking interest rates to control inflation. The Sri Lankan economy is showing signs of stabilizing, with inflation falling to 5.9% in February 2024 and usable foreign reserves reaching about $3 billion. Lines for essential goods disappeared. Unemployment persisted, however, and the percentage of people living beneath the poverty line doubled to 25%. Child malnutrition increased as families were forced to switch to cheaper, less healthy diets.
Economists’ theories on the reasons for Sri Lanka’s economic crisis include factors such as external shocks, Chinese “debt trap” diplomacy and financial mismanagement.
The COVID-19 pandemic severely hindered exports and tourism in 2020, impoverishing more than half a million Sri Lankans. An economic uptick began in 2021, but Russia’s invasion of Ukraine in early 2022 brought higher bills for fuel and food imports, spurring double-digit inflation and a 30% depreciation of the rupee against the United States dollar. These external shocks hammered an economy already reeling from the costs of the nation’s now-ended decadeslong conflict with insurgents, and persistent fiscal deficits.
Many of those external factors also plagued other developing nations in the region. The United Nations Development Programme in July 2023 identified a dozen Indo-Pacific countries beset with debt problems exacerbated by a global economic slowdown and COVID-19.
Sri Lanka borrowed heavily from Chinese state-run banks — about $13.2 billion between 2006 and 2022 — to invest in highways, ports, airports and other infrastructure. Some projects, such as the Colombo International Container Terminal at Colombo Port, enhanced Sri Lanka’s trade with India. Others, such as Hambantota International Port, Mattala Rajapaksa International Airport and the Lotus Tower, a communications structure and tourist attraction, saddled Sri Lanka with high-interest loans and long implementation delays that translated into unsustainable debt. To help compensate for the Hambantota debt, a company controlled by the People’s Republic of China (PRC) negotiated a 99-year lease to operate the port.
Although the PRC is Sri Lanka’s largest bilateral creditor and has increased the country’s debt burden, private creditors account for most of the smaller nation’s external debt. Sri Lanka’s default demonstrates the risk of imprudent foreign borrowing, whether relying on sovereign bonds with high interest rates to finance development projects or high-interest, low-return Chinese loans.
While external commitments and Chinese debt played a role, government mismanagement looms large, exacerbated by inward-looking, home-grown economic remedies in response to the pandemic. Multiple policy missteps included ruling out IMF assistance for fear its austerity measures would be unpopular; a highly expansionary monetary policy leading to high inflation; continuing a fixed exchange rate policy without supporting foreign reserves; using bilateral swaps with regional central banks for external debt management; comprehensive tax cuts which reduced government revenues; and a ban on chemical fertilizer imports without farmers’ consent, prompting a surge in food prices.
Answering Sri Lanka’s urgent request for external financing pending IMF relief, India mobilized the largest bilateral aid package in its history. India’s rationale was underpinned by its Neighbourhood First Policy, the unfolding humanitarian crisis in Sri Lanka and worries about refugees. India mobilized about $4 billion of aid for Sri Lanka in 2022, including credit lines, loans and grants. The amount exceeds total bilateral aid to Sri Lanka by other development partners and has enhanced India’s reputation as a key donor. India’s previous aid to Sri Lanka focused on housing reconstruction in conflict-torn areas, scholarships at Indian higher educational institutions and security assistance.
With Sri Lanka’s economy improving, the time seems ripe for bilateral ties to shift from aid to deepening trade and foreign direct investment. The Adani Group, an Indian conglomerate, announced it is investing $1.14 billion for wind power plants in the Mannar basin off Sri Lanka’s northwest coast and at the West Container Terminal at Colombo Port, a joint project with the John Keells Group, a Sri Lankan conglomerate. Adani’s projects account for nearly 67% of Indian investments in Sri Lanka between 2005 and 2019. India’s largest power utility, NTPC Ltd., and Sri Lanka’s state-owned Ceylon Electricity Board have agreed to pay more than $138 million for a solar power project and a transmission line running beneath the Indian Ocean to promote bilateral power trade.
The Indian infrastructure projects are intended to transform Sri Lanka with skills and technology as well as capital, while stimulating additional Indian light-manufacturing and service investments. India and Sri Lanka should encourage such investments through marketing, liberalizing entry regulations and digitizing proposal processes. Completion of a comprehensive India-Sri Lanka trade agreement also would help by easing Sri Lanka into regional supply chains, shifting from the PRC to India.
Sri Lanka rebuffed a $480 million grant from the U.S.-based Millennium Challenge Corp. (MCC) to promote growth by reducing Colombo’s traffic congestion, improving bus transport and rural roads, and providing secure land titles. Critics peddled unfounded fears of ulterior geopolitical motives and threats to Sri Lanka’s sovereignty. The benefits of grant aid, which does not have to be repaid, were ignored despite Sri Lanka’s growing economic distress. The MCC Board withdrew the offer in December 2020. The U.S. has continued sending aid to Sri Lanka, however. The U.S. Agency for International Development donated more than 3.4 million doses of COVID-19 vaccines and other aid to Sri Lanka during the pandemic, including 200 portable ventilators. This evolved into support for private sector development and trade. In November 2023, the U.S. International Development Finance Corp. announced it would invest $553 million in the Colombo Port West Terminal Project.
The IMF’s investment of $2.9 billion over 48 months seeks to stabilize Sri Lanka’s economy by restoring fiscal and debt sustainability. It calls for higher taxes, better public expenditure management and anti-corruption measures, improved poverty reduction programs, an independent central bank and financially stable banks.
An IMF bailout after the default had geopolitical consequences. India and the U.S. quietly supported IMF involvement. Meanwhile, debt-restructuring talks with the PRC lagged. The PRC eventually gave creditor assurances to the IMF after discussions between Sri Lanka’s president and senior Chinese officials.
Sri Lanka is showing signs of economic stabilization, bolstered by government policies, foreign investment, aid from development partners such as India and the U.S., and the IMF’s recovery program. Continuing the IMF program and implementing economic reforms will give Sri Lanka a chance of recovery, while attracting foreign investors and accepting financial assistance remain crucial for the nation’s economic success.
Ganeshan Wignaraja is the Professorial Fellow for Economics and Trade at Gateway House and a Visiting Senior Fellow at the Overseas Development Institute.
This article was first published by the Indo-Pacific Defense Forum.