With thousands of years of a flourishing civilization in past, over 2,500 years of that history recorded in writing, once being a creditor to the United Kingdom Treasury for years, and 74 years after independence from a colonial power, Sri Lanka declared bankrupt in April 2022. The shock was sudden, but not the process. Structural weaknesses and testing of different economic models augmented by political mismanagement resulted widening the effects of external vulnerabilities, which ultimately affected in extending its ‘developing line’ downwards.
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Since independence in 1948, Sri Lanka, as most of other postcolonial economies, was burden with adhering to the post-war global finance system structured by the Bretton Woods Agreement, implemented through the World Bank (WB) and International Monetary Fund (IMF), which prescribed its “comparative advantage” economic concept, ‘encouraging’ developing economies in exporting low-value-materials such as coffee, tea, rubber, coconut, and minerals etc, while industrialized countries were allowed controlling the manufacturing, high-value trades, technology and exporting expensive finished goods. Not surprisingly, that ‘unequal exchange’ (according to Dependency Theorists) buttressed the structural inequality further and widened the gap between developed and developing countries. To thwart these unfavourable conditions, Sri Lanka strived to achieve self-sufficiency by adopting the policy of Import Substitution Industrialization (ISI) 60’s onwards, gradually. When Sri Lanka sought external support to manage it debt crisis, the response of the WB and IMF was the introduction of the Structural Adjustment Programme (SAP), as common to all developing countries, which shrunk down the policy space of the government in developing industrial sector, imposed opening of their markets, and required them to seek guidance for even macroeconomic policies. By 1970, IMF had loaned Sri Lanka thrice, starting from 1965, but the expected results were not even in sight. The government in 1970 resorted to the ISI policy rigorously by imposing exchange controls, import restrictions, and state monopolies on trade etc, but the country experienced shortages of goods, quota systems, and even slow growth.
Inspired by South Korea and Singapore success stories, the new government in 1977 adopted the open economy system; the first country in South Asia. Sri Lanka was hailed as a model of liberalization due to the success it achieved during the initial years with its around 7% GDP growth, increased Foreign Direct Investments (FDI), large-scale infrastructure developments, and thriving tourism industry etc.
However, several structural and political constraints have resulted faltering sustainment of this economic model in the long run. Civil wars and political instability Sri Lanka experienced for over 30 years with extreme insurgent movements, from both north and south, damaged the tourism sector and discouraged FDIs. Another factor was the weak industrial base, due to the absence of upgraded technology and strong industrial policy, ill-coordinated value chains and local linkages, and continued dependency on low-value-added manufacturing.
External vulnerabilities i.e. rise of global oil prices and interest rates, coupled with susceptibility to global shocks as liberalization increased the dependence on foreign capital and imports, which widened the trade deficit as imports grew faster than exports, also factored in slowing down the effectiveness of the open economy model. Uneven development was also another factor not conducive in achieving expected objectives. Economic activities concentrated mainly in the urban and Western region resulted in neglect of traditional sectors. While manufacturing and service sectors were given priority, only little benefits were offered to the agricultural sector on which rural areas depend. The factor that affected even all the above reasons also appeared to be the policy inconsistency and poor governance. The practice of revoking, partially reversing, applying previous governments’ reforms haphazardly, corruption, and political patronage not only stalls but also erodes the progress. The ultimate result was the rise of public debt due to borrowing, not for productive investment but for corruption to a greater extent under the pretext of defense and consumption.
Thus, the Island’s economy by the 2000s was more service-biased, rather than manufacturing. Exports enjoyed a limited diversification, mainly of traditional agricultural products and garments (over 40%). This structural weakness; having been distracted from the core objectives of its open economy model i.e. industrial transformation and broad-based export diversification, and falling into an import-dependent and consumption-driven system due to weak governance, enslavement to foreign capital, and political instability, appeared to have led to what Sri Lanka ended up in the 2022 debt crisis and bankruptcy. The following, inter alia, furthered the acceleration of the process.
a. One of the main reasons that Sri Lanka fell into bankruptcy in 2022 was the unsustainable accumulation of external debt for projects that were not generating much economic returns and less-utilized, but financed through high-interest commercial loans in contrast to concessional loans from formal institutions. Sri Lanka shouldered US$51 billion of external debt by 2020, and approximately 70% of government revenue was diverted to debt servicing by 2022.
b. The nearest and pinnacle moment of continued erroneous fiscal management driven by populism i.e. maintaining an excessive public sector and unsustainable subsidy programs, was the expansive reduction of VAT and corporate taxes in 2019. It resulted in a fall of around 25% of the government’s revenue, thus causing difficulties in domestic borrowing and increased dependence on external credits. And by 2021, the inflationary pressure caused by artificially maintained interest rates and the printing of large amounts of money by the Central Bank of Sri Lanka resulted in the erosion of investor confidence and further dwindling of foreign reserves.
c. The external shocks since 2020, mainly of COVID -19 and its impact felt by the global economy, affected both the tourism sector and remittances from Sri Lankans working abroad, which led to further depletion of foreign reserves, from over US$7.5 billion to less than US$50 million usable reserves from 2019 to 2022. It compelled the government to impose restrictions on imports, resulting not only in the dearth of essential goods, including food, fuel, and medicine etc, but rising anti-government sentiment as well.
d. The ban on chemical fertilizers in 2021, aimed to emerge as the first fully organic farming country while the whole globe is probing how best to manage its limited resources against the effects of COVID-19 pandemic, was another major policy blunder, though the government reversed within months having realized the chaos it caused within both agricultural and export sectors. But the damage was done; it further accelerated both already high inflation and social uproar.
e. Nepotism, de facto family regimes and their unconcealed personal and populist economic agenda, discourtesy to the rule of law, and alleged corruption practices etc, especially over the immediate years, not only undermined effective governance and reduced the confidence of investors, but resulted in international rating agencies downgrading Sri Lanka of its credit status. Defaulting on foreign debt in April 2022 symbolized Sri Lanka’s bankruptcy, officially. The rise of inflation over 60% resulted in a skyrocketing of goods prices and island-wide public protests, forcing the incumbent president to resign. Then only the new government sought IMF assistance, and received US$3 billion bailout in 2023. The usual structural reforms followed i.e. tax increases and reduction of subsidies.
Sri Lanka achieved remarkable economic and political stability by 2025, however. But the path ahead, while the whole globe is entangled with a series of geopolitical turbulences, would not present a smooth journey in the future.
By – Dr. Prathap Tillekerathne
Major General (Retired)
Sri Lanka Army