Sri Lanka's storm in a teacup may compel India to bring out its checkbook

Having just seen its $3 billion investment in Afghanistan go up in smoke, India's appetite for economic diplomacy may even be lower than usual.

The Maldives and Sri Lanka, both highly tourism-dependent tropical islands, have seen the pandemic devastate their economies and finances. Government debt this year is expected to linger above 100% of gross domestic product in the two small Indian Ocean nations. Unsurprisingly, both have similar--and similarly poor--credit standings. A default by CCC-rated borrowers is a “real possibility” on Fitch Ratings’ scale.

And yet, the Maldives seems to be turning the corner on visitor arrivals, with numbers last month exceeding the figure for August 2019. Sri Lanka, where a deadly Easter Sunday suicide bomb attack two years ago hit tourism even before the pandemic, is falling behind. 

With a population of just half a million, the Maldives was hit hard by the delta variant. In May, the virus infected almost three out of a 1,000 people in just one day. Sri Lanka, which is home to 21 million, has seen a more manageable spike by comparison, with the surge peaking at a 7-day average of just under 6,000 new cases late August. That’s 0.28 new infections for a thousand people.

A tale of two islands

Since then, Covid-19 is in retreat, and the country is on track to cover 60% of its population with the required two vaccine doses by the end of the month. Among other popular beach destinations, Mauritius, which reached that milestone late last month, is optimistic about a revival in its leisure industry. With some luck, and restoration of international flight links, the winter might bring more holidaymakers to Sri Lanka’s sandy beaches, too. Will it be enough, though, to make up for a 99.6% drop in tourism earnings from the pre-pandemic level? Clearly not.

But that’s not the only problem. It it doesn’t help that the 9% decline in the Sri Lankan rupee since the start of the pandemic--a depreciation that could make tourist towns like Galle and Kandy cheaper for vaccinated travelers from India--has also stoked a food crisis. Amid an acute shortage of imported rice, sugar, milk, pulses and cereals, President Gotabaya Rajapaksa announced a state of economic emergency from Aug. 31, and named an army officer as the commissioner general of essential services, a telltale sign that the food queues are turning serious.

At least they’re serious enough for Finance Minister Basil Rajapaksa, one of the president’s several brothers in the cabinet, to replace the central bank chief. Ajith Nivard Cabraal, who was the governor between 2006 and early 2015, is returning to his old job to find money. After meeting a $1 billion debt repayment out of foreign-exchange reserves in July, the $3.55 billion kitty can barely cover two months of imports. Additionally, $3.65 billion in repayments are coming due next year on hard-currency borrowings. If Cabraal has a magic wand, he has to wave it now--or Sri Lanka will have to seek a rescue from the International Monetary Fund. 

A wall of maturities

Tea, the country’s most famous export, could have helped soften the blow. But the commodity that pulled in $1.2 billion last year is facing its own crisis because of the government’s sudden decision to do away with chemical fertilizers. The industry can’t possibly find enough new buyers of niche, organic tea to offset a threefold jump in the cost of production. Experts warn that crop diseases could lead to unmitigated disasters like in 1869, when the island’s then significant coffee plantations were wiped out by a fungal infection. 

Colombo couldn’t have found a worse time to go back to the 19th century. The country’s share among top global sellers of the beverage has been declining for some time. Rivals who manage to lure more customers away from Ceylon tea won’t let go of them in a hurry. That isn’t all. With even vegetable crops sputtering, the ban on fertilizer imports is untenable. Still, a decision to reverse it was dropped.

Weak tea

The Rajapaksa administration doesn’t want to appear weak politically by changing its mind. Or maybe it knows that Sri Lanka won’t need to go to the IMF. Since the onset of the pandemic, a cozy relationship with China has helped the president secure a $1 billion loan, in addition to a $1.5 billion dollar swap facility with the Chinese central bank and a gift of 600,000 vaccine shots. Colombo could approach Beijing again for help, automatically putting some pressure on its next-door neighbor.

At a public debt-to-GDP ratio of about 90%, India’s own finances aren’t a whole lot better than that of the Maldives and Sri Lanka, though a large, diversified economy gives it a much bigger sway with investors — and a (barely) investment-grade credit rating.

While aware of the economic trouble brewing at its southeastern tip, India has long delayed a decision on Colombo’s request for a loan-repayment moratorium. Having just seen its $3 billion investment in Afghanistan go up in smoke, New Delhi’s appetite for economic diplomacy may even be lower than usual. Still, caught in a debt trap, a previous Sri Lankan government sold the port of Hambantota to China Merchants Port Holdings Co. To stall further Beijing-backed enclaves at its doorstep, New Delhi may be compelled to bring out its checkbook.

A deepening economic crisis is narrowing Rajapaksa’s options, but the president hasn’t run out of cards yet.