Why Sri Lanka’s economy is in freefall
But plotting the rupee-dollar exchange rate shows that the country’s loose peg is a misnomer. For years, the exchange rate remained stable, roughly between 175 and 200 rupees per dollar because, as economist Noah Smith explains, the Sri Lankan central bank regularly sold dollars to support the value of the rupee.
Eventually, this long-standing intervention ended in the only possible way: from April this year, the rupee began to depreciate sharply. Within months, the exchange rate had fallen to 350 rupees to the dollar and the central bank’s dollar reserves had all but disappeared.
Sri Lanka defaulted on its external debt in May. We now know that rather than turn to the International Monetary Fund, whose bailout programs are conditional on strict policy reforms, he approached China for a new loan when its coffers were nearly empty. But that only increased his debt by another $3 billion ($4.4 billion) and ensured that his inevitable crisis would be even worse when it finally arrived.
China’s strategy vis-à-vis Sri Lanka (and other developing countries, such as Ethiopia) echoes the approach taken by both former colonial powers and rural lenders in developing countries. in development.
As Amit Bhaduri showed in a classic 1977 article in the Cambridge Journal of Economics, rural informal lenders generally do not worry about borrower default; they worry more about the borrower not defaulting because then they cannot make a bigger profit by confiscating his collateral (usually his land).
Consider Hambantota Port, the pet project of Mahinda Rajapaksa, President of Sri Lanka between 2005 and 2015 (and brother of Gotabaya Rajapaksa). Funded largely with Chinese money, the port opened in 2010 on Mahinda’s birthday. But when Sri Lanka subsequently failed to repay the debt, this “gift” became collateral to be confiscated. China now has a 99-year lease on the port.
How could a country long known for its maturity make so many mistakes? The short answer is that Sri Lanka’s politics have sown the seeds of the current economic crisis. The Rajapaksa-led government has grown increasingly authoritarian after defeating the Liberation Tigers of Tamil Eelam and ending Sri Lanka’s decades-long civil war in 2009. It has eroded the country’s democratic institutions , persecuted minorities and dismissed charges of war crimes.
Although authoritarianism usually ends up destroying an economy, some authoritarian governments have managed to provide economic growth and stability. For a short time, it seemed possible that the Rajapaksa government could fall into this category. But as he embraced populism, it soon became clear that crony capitalism would be Sri Lanka’s fate.
When the Rajapaksa government returned to power in 2019, it was riding a wave of support it sought to sustain with misguided economic handouts. But the public’s patience can only be bought for so long. Eventually, unsustainable policies hit a wall.
Without his pride, the last Rajapaksa government could have changed course. When he came to power and immediately announced major tax cuts, he was heavily criticized.
On October 30, 2019, for example, former finance minister Mangala Samaraweera warned, on Twitter, that “the Gota tax plan wants to put Sri Lanka on an express train to bankruptcy”. But Rajapaksa doubled down. When the government suddenly banned chemical fertilizer imports, the implications of this policy were all too predictable.
We don’t know where it will end. Even if the Rajapaksas do not regain control by proxy, there are other risks. The IMF cannot offer a bailout until there is a viable government to negotiate with.
But the Fund and the Paris Club of sovereign creditors will also have to be proactive, suspending some of their bureaucratic rules to help Sri Lanka through this acute phase of the crisis. Failing that, a spiraling humanitarian catastrophe is the most likely outcome.
Kaushik Basu, former chief economist of the World Bank and chief economic adviser to the Indian government, is a professor of economics at Cornell University and a nonresident senior fellow at the Brookings Institution.