On 18 May 2022, the small island nation of Sri Lanka officially defaulted on its debt for the first time since its founding in 1948, sending an ominous signal for its future. This was preceded by months of protests and violence that left hundreds injured and scores dead, including a member of the parliament. The country, popularly called the ‘Pearl of the Indian Ocean’ and famous for its mountainous tea plantations, miles of sandy beaches, and the hospitality of its people, has now turned into a living hell for its inhabitants with rolling power cuts, shortages of staples—including food, essential medicine, and fuel—and growing political instability.
Civil War and the Origins of Public Debt
Soon after Sri Lanka’s (formerly called Ceylon) independence from Britain in 1948, ethnic tensions between the Buddhist majority Sinhalese (who made up nearly three quarters of the population) and the Hindu minority Tamils, which had been simmering during colonial rule, began to reach a boiling point. It accelerated with Prime Minister SWRD Bandaranaike’s passing of the ‘Sinhala Only Act‘ in 1956, which made Sinhala the only official language of the nation. It plunged the country into violence with widespread riots between Tamil-speaking minorities who felt discriminated against and the Sinhalese. Bandaranaike himself was killed by an extremist Buddhist monk and was succeeded as prime minister by his wife, Sirimavo Bandaranaike. Under her rule, discrimination against Tamils was further intensified with the policy of standardization, which required Tamil students to gain a higher qualifying mark than Sinhalese students to gain admission to universities. During this period, political parties representing Tamil interests began to lose ground to more radical militant groups seeking to create an independent Tamil state. Prominent among them was the Liberation Tigers of Tamil Eelam (LTTE), led by V Prabhakaran.
The burning of the Jaffna Public Library in May 1981 in the Tamil majority city of Jaffna proved to be a turning point in ethnic tensions, culminating in the start of a destructive civil war in 1983 led by the LTTE. Over the ensuing two decades, till the end of the war in 2009, Sri Lanka suffered the loss of more than 100,000 civilians, soldiers, and militants, with hundreds of thousands displaced in the northern part. The economic cost was also immense, estimated at around $200 billion, with large opportunity costs in the form of lower tourist arrivals and dampened foreign investment due to the instability. This prolonged and costly conflict also caused the government to build up large amounts of unsustainable external debt and run continuous budgetary deficits, further negatively impacted by the global financial crisis of 2008.
Yet, the bulk of the growth in unsustainable external debt took place in the decade after the end of the war as the government of then president M Rajapaksa embarked on large-scale, multi-billion-dollar infrastructure and development projects across the island with the goal of stimulating economic growth and investment. However, most of those projects turned out to be taken on a political basis as they proved to be unviable economically and came to be viewed as ‘white elephants.’ One prominent example was that of the Hambantota port in Hambantota, the home district of the Rajapaksa political family, which ended up being leased to a Chinese company for 99 years after the loan could not be repaid. These unproductive projects, coupled with large deficit spending, caused Sri Lanka’s external debt to double between 2010-19.
Terrorism, Tax Cuts, and a Pandemic
Although most of the burden of Sri Lanka’s present-day crisis can be put on the financial mismanagement and unproductive projects of past governments, external events from 2019 onwards also played a prominent role in accelerating the crisis and adding further pressure to an already unsustainable debt burden. The first of these was the series of coordinated Islamist terrorist attacks on churches and luxury hotels on April 21, 2019 in the commercial capital, Colombo. It was the deadliest terrorist attack in Sri Lanka’s history, killing nearly 300 people and injuring more than 500. It also negatively impacted the vital tourism industry, a large source of foreign exchange and employment, with tourism revenue falling by nearly 20%, negatively impacting the balance of payments and tax revenue. Shortly following this, Gotabaya Rajapaksa, brother of Mahinda, became president, riding on nationalist and pro-security sentiments following the attacks, and placed members of the Rajapaksa family into his cabinet.
Soon afterwards, the new government embarked on an expansionary fiscal program, cutting personal and corporate taxes, causing budget deficits to soar and the central bank to print record amounts of money to fund increasing spending. This lowered already low tax revenue and put pressure on the government to service the ever-increasing debts. This situation was further compounded by the start of the global COVID-19 pandemic and resulting lockdowns. The already dampened tourism sector took a big hit as tourist arrivals stalled significantly, depriving the government of valuable foreign currency and making thousands jobless. As a result of rapid money creation, inflation spiraled out of control and the government failed to keep the currency pegged to the USD, with the currency depreciating to new lows. As a result, foreign workers started to remit money through unofficial channels, causing Sri Lankan banks to run out of vital foreign currency. Furthermore, the government’s decision in April 2021 to ban the use of inorganic fertilizers caused a large drop in tea production, one of its largest export sectors.
Lastly, the outbreak of the Russo-Ukrainian war in early 2022 caused a significant rise in food and fuel prices worldwide, already heightened by the pandemic. During this period, Sri Lanka’s crucial foreign reserves plummeted from $7.6 billion in 2019 to a paltry sum of $50 million in May 2022, and with debts worth $7 billion coming due this year, Sri Lanka finally defaulted on payments in May 2022.
The Effects of the Economic Crisis
An unprecedented economic and political crisis has plunged the once prosperous country into chaos. Inflation, especially in staple food prices, has skyrocketed to a record 54.6% in July 2022, stretching the thin wallets of ordinary citizens. Continuous currency depreciation combined with dwindling foreign reserves has resulted in shortages in electricity, fuel, and cooking gas due to a fall in imports and endless lines for fuel, food, and medicine are now a common sight. Furthermore, the education of millions of students has also been hampered due to acute shortages of paper and ink, resulting in school shutdowns and the postponement of examinations. The healthcare sector has also fallen into disarray, with increasingly scarce essential medicines and rolling power cuts hampering crucial surgeries and operations. The government, in a desperate move, has also introduced a four-day work week for government employees to have a day off to grow their own food as supplies continue to run out. In addition, the United Nations estimates four out of five people in the country of 22 million are currently forced to skip meals.
The economic crisis has further plunged the country into political uncertainty, with the entire cabinet resigning en masse along with Prime Minister Mahinda Rajapaksa, amidst mass rioting and violent protests across the island. His replacement, Ranil Wickremesinghe, an opposition member and six-time premier, has been unable to win public confidence with protests remaining unabated. The export industry, a vital source of foreign currency, has also been badly affected, with foreign buyers shifting textile and tea orders to neighboring countries such as India. According to UNICEF, Sri Lanka now has South Asia’s second highest child malnutrition rate, only behind war-torn Afghanistan, underpinning the severity of the current crisis with no signs of receding.
Ramifications of the Crisis Globally
The ongoing crisis in Sri Lanka may serve as a wake-up call to other similar developing countries across the region and globally. Developing countries across Asia and Africa are facing the consequences of the three-pronged challenges of the pandemic: rising food and energy costs due to the war in Ukraine and higher debt servicing burdens due to the rise in global interest rates. According to the World Bank, about 60% of all low-income countries are at risk of needing to restructure their debts in order to avoid default and, furthermore, as many as a dozen developing countries could prove unable to service their debts within the next year, representing the largest spate of debt crisis in developing economies in a generation.
Developing countries are especially vulnerable due to the large amounts of variable interest loans they have taken, which are now increasing as central banks around the world tighten monetary policies. A particularly vulnerable country in the South Asian region is Pakistan, which is also facing a deteriorating economic and political crisis. Like Sri Lanka, it has pursued debt-driven populist policies by building large-scale projects, subsidies, and welfare schemes for the poor and is now facing tens of billions of dollars of debt repayment over the next few years amidst rising imports, depreciation and dwindling foreign currency reserves. It is also facing a looming political crisis, with its recently ousted prime minister, Imran Khan, threatening agitation and protests over holding fresh elections. Pakistan now seems to be hanging by a thread and may very well default and descend into chaos.
The present economic crisis and bankruptcy of Sri Lanka were the culmination of decades of financial mismanagement, ill-conceived debt-driven unviable projects, and external events from 2019 onwards. Only time will tell whether Sri Lanka will see the light at the end of the tunnel and recover, or whether it is only the first domino to fall.