The crisis of governance that Sri Lanka is currently facing is unprecedented in post-war Sri Lankan politics. Two individuals claiming to be prime minister and one major party boycotting parliament illustrate the point. There is no need to recount in detail the events of the past five weeks that are publicly known. The purpose of this article is to note some of the serious implications of this crisis for the economy of the country and to stress the importance of resolving the crisis in a manner that would reverse these adverse trends.
Politics and Economics are closely inter-twined in the real world. Thus the term “political economy’ is used here to describe the conceptual framework that best suits to understand the ramifications of the crisis for the nation’s economic health and the economic welfare of its people.
First, political uncertainty causes policy uncertainty. That in turn makes investors hold back investment and wait to see which way the pendulum would swing. In short political uncertainty is bad for jobs and economic growth. Sooner the crisis is resolved the better.
Second, there are credible reports of short-term adverse economic consequences attributable to the current crisis. Recall that in May of this year Tourism Minister John Amaratunga officially announced that the number of tourist arrivals in 2018 first projected to be 3.0 million had been cut back to 2.5 million on account of the Anti-Muslim riots in March and the outbreak of Dengue fever. That announcement notwithstanding, the respected travel guide Lonely Plant last October named Sri Lanka as the “best in travel for 2019”. With such a boost, it is unfortunate that tourism, that generate about 5% of Sri Lanka’s GDP worth about $88 billion, faces a serious setback owing to events completely beyond the control of the industry.
Third, there are credible reports, albeit informal, that many government officials are reluctant to sign off on legitimate economic transactions – contracts, release of funds payable, release of imported material from ports, and a myriad of other routine things – that must happen for a complex economy to function smoothly. One example that the present writer is aware of involves literally dozens of small contractors who are involved in construction in almost every district of the country. The funds for the project concerned come from a major western donor and the flow of funds came to a virtual halt for about one month because of bureaucratic uncertainty arising from the crisis.
Fourth, some donors have announced that they will hold back funds that they were in the process of releasing. One of the most notable examples is the grant assistance amounting to $450m. that the US Millennium Challenge Corporation (MCC) has approved for Sri Lanka. MCC funds are principally aimed at assisting the private sector. In December 2016 MCC announced that Sri Lanka was eligible for its assistance. In September 2017 the Government of Sri Lanka completed a study that identified the three “most binding constraints that prevent private-sector led growth in Sri Lanka.” The MCC grant is to be used to reduce or resolve these constraints. The first is “policy uncertainty” in areas such as tax policy. Second, is the bottlenecks in transportation, especially in the Western Province that accounts for 42% of Sri Lanka’s GDP. Third, to help establish a policy that will make it easier for the private sector to access state land for development projects. In December 2017 the MCC Board “reselected” Sri Lanka for assistance. In August of this year MCC notified the US Congress that it would negotiate a new compact for assistance. Now US has suspended that process. “Democratic Rights” and “Control of Corruption” are essential preconditions to be eligible for MCC assistance. The events of the past few weeks if not reversed are likely to be seen as violations of both these conditions making Sri Lanka ineligible for the MCC grant.
Fifth, between 2006 and 2016 annual exports to EU were relatively stable between Euro 2,087m. and Euro 2,225m. In 2010 EU withdrew GSP+ trade concessions that allowed duty free access to the EU market for some exports from Sri Lanka. The reason given for the withdrawal was that the country had failed to adhere to three UN human rights conventions. In May 2017 the GSP+ privilege was given back after EU became satisfied that the UNF government was meeting its threshold for protecting human rights.
Grant assistance from most EU member countries is also generally based on similar considerations. IF Sri Lanka moves in an authoritarian direction it is likely that EU and its member countries will reconsider their trade concessions and economic assistance to Sri Lanka.
Sixth, current crisis has caused the IMF has suspended the release of the sixth tranche ($252m.) of the assistance provided to Sri Lanka under the $1.5b. the Extended Fund Facility negotiated in 2016. The last official consultation between the IMF and the government in June this year was reported to have gone well and the IMF was due to release the sixth tranche around this time. IMF Does not give traditional development assistance the way that the World Bank, Asian Development Bank or donor countries give. IMF assistance supports the balance of payments and the foreign exchange reserves of the country. But the main value of IMF assistance is the signal that it gives to the international community of donors and investors that it has confidence in the country and its economic policies. By the same token, the suspension of IMF assistance sends the opposite signal that is detrimental to the economy.
Any shortfall in economic assistance from western countries will have to be made good with assistance mainly from China. Chinese assistance is not conditional on the recipient country observing human rights or democratic governance. In fact it may be the opposite because China is offering an authoritarian capitalist state-led market model as an alternative to the democratic capitalist model that western countries favour.
China recently gave a grant of about $250 million to President Sirisena to be disbursed over a three-year period for “social and economic development” projects. But such grants are the exception and not the rule. Chinese aid is mostly loans that must be paid back with interest. The interest rate varies and some are more concessional than others. The UNF government was compelled to handover the Hambantota Port and 15,000 acres of adjacent land on a 99-year lease to China because Sri Lanka did not have the foreign currency to service its foreign debt and China refused to ease the terms and conditions of the loans that were taken from that country including the $1.2 billion for the Hambantota Port. Moreover, Chinese loans are “tied” to Chinese companies being hired for the contracts, use of Chinese material and equipment, and in some cases Chinese labor as well. Many western donors have largely abandoned this type of aid to developing countries after they came under severe criticism in the 1970s and 1980s.
China has the capacity to replace western grants and loans with its own. But it cannot, as yet, replace the west as a major buyer of Sri Lankan exports. In 2017 China purchased $247m. (2.2%) worth of our exports compared to EU’s $3,301m. (29.1%) and USA’s $2,909m. (25.6%). It is useful to remember that these importing countries can easily substitute most of our exports such as garments and tea with supplies from our competitors.
On January 01, 2018 the dollar exchange rate was Rs 152.85. On October 26, 2018 it was Rs 172.70, a deprecation of 13%. That is a substantial depreciation. On November 30 the rupee price of the dollar stood at Rs 179.65, a deprecation of 4% over five weeks.
The deprecation of the rupee will increase the cost of imported consumer goods, pharmaceuticals, and petroleum products that affect transportation cost and push up the cost of living. The increase in prices of imported industrial inputs including fertilizer, construction material and machinery will increase the cost of production leading to loss of employment. Ad hoc price control, reductions in import tariffs or simply ordering suppliers and traders to reduce prices, a practice that our government, irrespective of party in power, indulge in misleads the public but is not a sustainable solution to stabilize the cost of living.
The depreciation of the rupee also seriously affects the rupee burden of servicing the foreign debt. For example, at the end of 2017 the total foreign debt was $51.8b or Rs 7,921b. at the then prevailing dollar exchange rate of Rs 152.85. The same dollar debt on October 26, 2018 was Rs 8,947b. an increase of Rs 1.0b (13%) purely on account of the rupee deprecation. In 2017 the government’s total tax revenue was Rs 1.7 billion or about 60% of the increase in the rupee value of the foreign debt in the first 10 months of this year. Using the same method, between October 26 and November 30, the rupee value of the foreign debt had risen by another Rs 183b. (2.0%). Such increases in the rupee value of the foreign debt is a major burden on the taxpayers because the government has to buy dollars at the prevailing exchange rate using tax rupees to pay the principal and interest on foreign loans.
It is very likely that the rupee will continue to depreciate if political instability continues although it is impossible to forecast what the exchange rate would be on any given future date.
The End Game: Restoring Political Stability
At the time of this writing (Sunday December 02 morning) no credible solution has been found to resolve the political crisis. The longer it lasts the worse it would be for the economy. But the solution is not economic but political.
The theoretically possible solutions include the following:
1. The Mahinda Rajapaksa camp produces a majority in parliament before the Supreme Court hears the case and gives its verdict. But so far this has not happened but not for lack of trying, especially if the stories about massive bribes that have been offered or taken are to be believed.
2. President Maithripala Sirisena reaches an accommodation with the UNP. The UNP appears to stand firm that it wants Ranil Wickremesinghe back as PM. If Sirisena gives in, he loses face. But in politics the least expected often happens. If this option is to bear fruition, what is needed is a face saving explanation that both Sirisena and Wickremesinghe can live with.
3. The third option would be for the stand off to continue and the Supreme Court to give its verdict. It is interesting to note that in this chaotic situation both the Legislative Branch (Parliament) as well as the Executive Branch (Presidency) of government have been discredited in the eyes of the public. So far it is the third branch, the Judiciary, that has emerged with its integrity intact. There is much speculation about how the seven-judge bench would decide. In the highly politicized environment, people are second-guessing about “UNP judges”, “Pohottuwa (SLPP) Judges” and “neutral” judges. The present author does not personally know any of these judges and is not familiar with their political background. In a democracy they are entitled, like every citizen, to their personal political opinion. But on this occasion they will serve the country well and go down in history as heroes who saved the nation from peril if they were to simply act as judges and return a verdict that they sincerely believe is in accordance with the Constitution, rule of law, and democratic governance.