Learn These Lanka Lessons

Source: The post is based on an article “Learn These Lanka Lessons” published in the Times of India on 16^th July 2022.

Syllabus: GS 2 Indian Economy; Issues and Challenges pertaining to growth and development

Relevance: Lesson’s to be learn from the Sri Lanka’s Crisis

News: In recent months, Sri Lanka has run out of fuel, millions are going hungry, the healthcare system is near collapse, inflation is soaring, the currency has crashed, and the debt-laden economy is bankrupt.

What are the causes of Sri Lanka’s Crisis?

At the heart of Sri Lanka’s crisis is the twin deficit problem which is related to unsustainable fiscal and current account deficits.

In fact, India’s own balance of payments crisis of 1991 and near crisis in 2013 were the result of India’s spiralling twin deficits.

Sri Lanka’s fiscal problems:

First, in the recent past, the government reduced the value added tax by half and abolished the capital gains tax. It eroded an already narrow tax base.

Second, there was a massive expenditure outgo on subsidies.

Other causes

The Central Bank of Sri Lanka (CBSL) deferred monetary tightening even as inflation soared and the currency also plummeted. This happened ostensibly under pressure from the government.

Sri Lanka has avoided taking IMF assistance and tried to find an alternative. A stigma attached to IMF assistance still persists in Asia. However, taking alternative help proved to be costly and time-consuming for the Sri Lankan government.

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Why is it unlikely to have a similar crisis in India in the coming future?

There are big differences between the external situation of India then and now.

First, at that time, there was a pressure built up in the exchange rate. Today, the exchange rate is tracking fundamentals more closely.

Second, at that time, India’s macro situation was fragile because of year-on-year high fiscal and current account deficits. Today there is more credibility on the fiscal front and the expected CAD of over 3% this year will hopefully be a one off.

Third, India’s war-chest of reserves are at a very good position at $600 billion. India lacked such a level of reserves at that time.

What are the lessons that can be learned from the Sri Lanka’s Crisis? 

The countries should diversify sources of foreign exchange earnings to avoid becoming hostage to problems in one sector or one geography.

Careful borrowing: Although, at present, the countries are forced to borrow bilateral loans due to dwindling multilateral sources of debt, the governments should borrow from countries that follow the Paris Club norms of responsible lending.

The governments shouldn’t float sovereign dollar bonds because the commercial entities within an economy already borrow in foreign currency. It is dangerous because a government can inflate away its domestic debt by printing money. But it cannot print dollars.

Sri Lanka’s crisis is also a reminder of the importance of timing of public policies. For example, it was a good step that the Sri Lankan government decided to encourage organic farming, but it should have been preceded by a campaign to educate farmers. Moreover, it should’ve been implemented after building buffer stocks to insure against possible production declines in the initial years.

Emerging and developing countries are at the mercy of a global order which has been shaped by advanced economic policies and priorities. Therefore, these countries should build their own safety-nets and do responsible economic management in order to protect themselves and prevent being hostage to vote bank politics.