Sri Lanka's economic crisis may encourage it to strengthen ties with India

In exactly a year since April 2021, the Sri Lanka government’s decision to peg its currency to the US dollar has come back to haunt the island nation. International Monetary Fund (IMF) data shows the economy’s net international reserves have been negative since December last year, and in this fiery April, Sri Lanka has less than a month’s reserve of forex to service a debt of $7 billion. The currency peg has dried up all remittances to add to the vacuum from tourist earnings. A quarter of Sri Lanka’s tourists come from Ukraine and Russia.

In the maelstrom, Sri Lanka could now end up signing several agreements for stronger economic ties with India. These have been tossed around for a long time, without closure. But the economic template India will use to deal with Sri Lanka will also have ramifications for use in the neighbourhood, since other countries such as Pakistan and possibly Nepal are also falling into debt traps (see table).

Both Pakistan and Nepal have been given credit by the IMF, while Sri Lanka is negotiating for a package. “Large externally financed infrastructure projects are a debt trap unless the economy is growing rapidly,” said Dhiraj Nayyar, former officer on special duty and head, Economics, Finance & Trade at Niti Aayog. “I am not sure Pakistan and Nepal meet those conditions.” 

For Sri Lanka, Nayyar pointed out that the country has, over the past decade, offered huge tax concessions to attract foreign investment for questionable infrastructure projects such as the Colombo Port City. It also added massively to welfare spending, accounting for 4 per cent of GDP by 2020, up from 2.5 per cent in 2010, including higher pensions for military, free electricity and fertiliser subsidies due to election compulsions.

The immediate risks if the island does not get a foreign bailout are stark. “It remains unclear how the large FX [foreign exchange] debt service obligations this year and beyond can be met,” the IMF said, and the crisis is expected to continue till the year 2026.

A lifeline from an earlier era could have been a monetary union in the subcontinent, proposed when Atal Bihari Vajpayee was the prime minister in early 2004. That is unlikely to make a comeback. There are plenty more lifelines of recent vintage that could be fast-tracked instead with Sri Lanka now far less prickly about closer connect with India.

Since Sri Lanka has been put on CCC ratings by Standard & Poor’s, which shuts off commercial loans from abroad, the IMF assessment notes the only way the island can crawl out of this crisis is hope for forex support from foreign governments. Since January, India has provided assistance of $2.4 billion, including a $500 million line of credit, and $1 billion for food and essential items. The Reserve Bank of India has also extended a currency swap of $400 million and deferred $500 million due for settlement through the Asian Clearance Union.

But this means that Sri Lanka must stick to the borrowing terms. Only with India as the guarantor will Japan or even the United States step in to offer more currency swaps and soft loans for infrastructure projects. “Sri Lanka is facing a liquidity problem and needs to merge its recovery with a reform programme,” said Sabyasachi Kar, RBI chair professor at the Delhi-based Institute of Economic Growth.

The problem is Colombo has had a patchy record on this score. Last year, it cancelled a 2019 deal with India and Japan to develop and operate the East Container Terminal at Colombo Port. Months later, it offered the same terminal to China for development. It was a major loss for India as almost all of its transhipment traffic uses the East Container Terminal. Japan has refused to offer Sri Lanka any support since.

One way the island nation can make amends was visible last week when it signed a deal to set up a hybrid power plant on a northern island, overriding a plan to set up another China-run coal fired project there. India will hope this will lead to more mutually beneficial policies such as cross-border energy trade. Prime Minister Narendra Modi had nudged the current President Gotabaya Rajapaksa and his predecessor Maithripala Sirisena to move on it. Sri Lanka’s installed power generation capacity is close to 4.1 Gw and India, since 2018, had suggested extending its over-supplied southern grid through overhead lines to the island. An earlier plan to use underground cables was given up as too costly. The riots on the streets of Colombo were triggered by the crisis in its domestic power supply arrangement. Sri Lanka might not have reached this point if the power sharing arrangement was already in place.

At present 51 per cent of the total installed electricity capacity of the island comes from thermal (42 per cent is hydro and 7 per cent from renewable energy). Within thermal, nearly 40 per cent is imported oil, according to ADB data. The rest of the thermal power is principally the Chinese-owned sole coal-fired Lakvijaya Power Station. It was to break China’s stranglehold that India had suggested the integrated grid. Financing the grid was to come from Japan, and Sri Lanka will have to think through this link carefully.

A closer look at India-Sri Lanka ties shows that little happens beyond the signing of memorandums of understanding (MoUs) — there are six of them from a common satellite in space to aligning rules for road driving. India also has a pact with Bangladesh, Bhutan and Nepal to harmonise road driving standards. In operation since 2016, it has gradually opened up road cargo traffic across the four countries, but Sri Lanka sat this out. As a result, there is no space for trucks from either country to travel to inland destinations. To make it possible, an MoU for a ferry service was signed in 2011, but given up due to opposition from unions in Lanka.

Those prickly relations are unlikely to change, not least because Sri Lanka does not fully admit to its problems. Sri Lanka, the IMF says, has a problem of “overestimating revenues and underestimating interest payments”. The IMF expects Sri Lanka’s real GDP to dwindle to a growth rate of 2.6 per cent; the government expects real GDP growth to “rebound to 5 per cent in 2022 and accelerate to 7 per cent of GDP over the medium term”.