Sobering lessons from Sri Lanka and Pakistan

The economic crisis in Sri Lanka has been in the making for several years. Hence all of it cannot be blamed purely on the pandemic or on the war in Ukraine. These two factors were external to the Sri Lankan economy and certainly had an impact. But they are only a convenient political alibi. While it is true that the pandemic caused tourism revenue to drop to nearly zero. Even the inward remittances declined sharply, as Sri Lankan non-resident workers from elsewhere lost their jobs and incomes and were unable to maintain the pace of an annual inflow of nearly 8 billion dollars.

With a double whammy from tourism and remittances the economy was badly hit.  The spike in oil prices on an economy totally dependent on imported oil has been more than the proverbial last straw. But the devastation and chaos that we see now was in the making for several years.  These external macro shocks were able to derail the economy because of the inherent steady decline in the resilience of the economy over many years.  If the economy has not developed resilience in terms of a low and manageable fiscal deficit, or comfortable forex reserves, or low inflation and moderate taxation, then the slightest of shocks, whether external or internal can lead to an economic crisis.

The decline in economic resilience has been caused mainly by populist economic policies and complacency by one and all of ignoring the worsening macroeconomic parameters. For instance, a wider fiscal deficit during normal growth times, is ignored by justifying it as a growth inducing necessity. Such a fiscal deficit can be caused by either an increase in expenditure or by reducing taxes. And this is what the Rajpaska government did in 2019. The newly elected government in 2019 announced a series of populist tax cuts, reducing value added tax by half and eliminating capital gains tax.

The governance at the top was very unusual to say the least. Four brothers became the President, the Prime Minister, Ministers for Finance and Agriculture, and a fifth minister for sports was a nephew. How can one expect sound democratic governance in an atmosphere of nepotism like this?  Dissent and disagreement are essential elements of democratic discourse, and when that is suppressed one can be sure of a decline.

Sri Lanka’s fiscal recklessness had begun even earlier.  It has had to declare a default on a whopping 51-billion-dollar foreign debt, with a base GDP size of about 80 billion. In relative terms this is a huge default and will surely dent its country rating, and future debt raising capacity. The default is being justified as interim while Sri Lanka negotiates emergency funding from the IMF. Sri Lanka had chosen the risky path of floating a sovereign dollar bond and since 2007 accumulated bond debt of more than 12 billion dollars. 

Populism and large welfare spending is rising. We can’t ignore what happens to economic resilience when fiscal caution is thrown to the winds.

Of this amount 4.5 billion is due to be paid this year (i.e. redeemed) but the country’s foreign exchange reserves are down to just 2 billion. Under normal conditions the country would have been able to raise new debt to pay old debt. But no foreign lender today will touch Sri Lanka willingly, given its twin deficits (fiscal and current account), inflation of more than 19 percent and country-wide daily power outage for 13 hours. The path to raising forex by floating sovereign dollar bonds is seductive but can quickly turn ugly. Sri Lanka is not the first country to experience being left in the lurch by foreign bond investors. It might turn out to be as bad as Argentina’s foreign exchange crisis. It is a cautionary tale for India’s own plans to float a sovereign dollar bond. If you are borrowing in someone else’s currency, you don’t have the freedom to repudiate nor to print yourself out of the debt hole.

While Sri Lanka is in dire straits, with food and forex shortages, country-wide unrest, with the entire cabinet resigning, and now dependence on aid from donors like India, the situation in Pakistan is equally instructive. The historic ouster of Imran Khan’s government was mainly the culmination of spendthrift policies, economic mismanagement, high inflation of 15 percent and unsustainable debt accumulation. The charges and countercharges of an international conspiracy is additional smoke and mirrors. The popular mandate of Khan unfortunately led to populist policies.

Punjab’s debt to State GDP ratio is already at 53 percent as against the 20 recommended by fiscal responsibility norms

An opposition party member of parliament Nafisa Shah accused Khan of having “destroyed political culture, weakened parliament and institutions”. In a perceptive piece, journalist Marvi Sirmed warns that it would be foolish to conclude that democracy has prevailed in Pakistan and Imran Khan’s ouster is proof of that. She asserts that it is mostly the army’s doing and it will take quite some time for political parties to become truly independent of the army’s influence. The fact remains that unlike neighbouring India or also Bangladesh, Pakistan has suffered economic mismanagement and the high inflation is but one manifestation of that. Excessive dependence on debt whether from IMF or China are also a factor.

Populism and fiscal recklessness have no happy ending. India’s 1991 crisis itself was the culmination of profligate fiscal policies tipped over by the gulf war of 1990, high oil prices leading to a full-fledged currency crisis. Thankfully since then, despite many external macro shocks such as the East Asian crisis of 1997, the dot com bust and 9/11, the Lehman crash, or presently the pandemic and Ukraine, India’s macro has been resilient and hence crises have been avoided.  But that should be no reason for complacence.

Some of the debt and deficit policies pursued by individual State governments are becoming unsustainable if not outright crisis prone. Punjab’s debt to State GDP ratio is already at 53 percent as against the 20 recommended by fiscal responsibility norms. The Centre’s debt to GDP ratio declined steadily from 63.9 percent in 2006 to 47 percent just before the pandemic i.e. in 2019 since then it has risen steeply and is now at 61.7 percent. Interest payments are 45 percent of revenue receipts in 2021. Some States want to discard the national pension scheme in favor of fiscally irresponsible “defined benefits” schemes. Populism and large welfare spending is rising. We can’t ignore what happens to economic resilience when fiscal caution is thrown to the winds.

(Dr.Ajit Ranade is a noted economist)