(This piece is being written as a general followup to https://www.lankaecon.com/p/sri-lankas-fiscal-future-a-tightrope and https://www.themorning.lk/articles/DUxuO7UmvvRDpknk2q3L , as part of exploring Sri Lanka’s economic pathway. Everything here is my own view and opinion and doesn’t reflect the thoughts and views at Frontier Research - though any data and facts would still come from the same sources, Frontier takes a far more diverse set of views than one person’s alone)
At the risk of sounding repetitive, it is clear that Sri Lanka will have an absolutely critical 2024. Nowhere is this more obvious than in the upcoming election and whatever changes or lack thereof it brings. Given the overwhelming backdrop of the economic crisis, there’s no question that the elections will very much focus on this question. In many ways, this has already begun (and in even more ways, was always a part of the crisis as well), not only in terms of policy and political debate, but also in how sharply partisan public discourse has become.
Lets attempt to sidestep the landmines of partisan rhetoric here and attempt to talk through some of the economics for 2024 and beyond. Let's not try to be so bold as to claim unique or otherwise success in this goal, but rather hope that some additional context can still be placed on how one can be both optimistic about Sri Lanka’s long term (expecting things to be quite good) and still “pessimistic” (or rather, expecting a lot of pain) in the short-term. However, doing so will require a sidestep into the past once again. Although it is a story that has kept being repeated, it might be worth visiting it again in the context of where we are today.
A critical part of Sri Lanka’s past - growth driven by deficits
The technical explanation for Sri Lanka’s crisis (and one I myself have made in the past) is one of “twin-deficits” - at risk of oversimplification, spending more rupees than the government earns, spending more dollars than the country earns, and bridging these two gaps with rupee and dollar debt. There maybe plenty of disagreement on who is to blame, but I think there’s broad agreement on the broad story.
If we take these 3 aspects - rupee deficits, dollar deficits, and debt - we can see that the structure of the Sri Lankan economy was one where these two deficits were able to be run and where debt was readily available. I personally don’t think it’s necessarily very accurate to blame one factor over the others - if there was no debt to be had, the deficits might not have been run but if the deficits were not run, perhaps the debt might not have been available as well - but the end result is an economic structure where all three of these combine. This combination results in a situation where economic decisions are all made in a context where deficits continue to be run and debt continues to keep the system going.
What does it mean for the deficits to keep running? On the rupee side, it effectively means higher incomes for many (if we consider the state service and the indirect employment impact of infrastructure development as a politically-biased form of welfare towards a big chunk of the working population) as well as reduced costs (both in terms of direct subsidies but also through the use of the state banking system to keep prices of utilities low and hence, anything else that depends on it the use of utilities). On the dollar side, it is both about having access to more and more imports (both for direct and indirect consumption - where fuel is the single biggest item) and having cheaper costs for all of these as well (through keeping exchange rates suppressed).
Such an economic structure can have powerful “positive” effects (I’m keeping positive in quotes since the temporary nature of these can make the label a little suspect). One direct impact is that incomes can end up higher and thereby, consumption can be too. Any inflationary pressures can be kept at bay by direct and indirect price controls (and shortages can be prevented by the government essentially paying the gap - energy is a good example here) and this can further feed into consumption. One other point is that all this can combine with the reduced cost of production to help businesses as well. All this also means that many people can have a significantly better quality of life than otherwise - and this can be true across the socioeconomic spectrum. In my view, it is this model that allowed for the expansion of electrification, for the lowering of Sri Lanka’s poverty rates over time, and for many other socially and economically desirable objectives. Essentially, the deficits can be considered an “injection” into Sri Lanka’s economy.
However, there’s one issue (outside of the obvious - where the money comes from) here that I see - all of this encourages consumption and imports (given Sri Lanka directly or indirectly imports most of its consumption). This can give a powerful incentive for individuals, businesses, and politicians to align themselves with this same trend. For individuals, it can make more sense to work in an industry that benefits from this consumption. For businesses, it can make more sense to take business decisions that allow them to benefit from the consumption. For politicians, it can make more sense to push more of this economic pattern as well as tie themselves closer to these policies as well. This can then strengthen the pattern once more. I personally feel that this is a key reason why Sri Lanka’s export growth has been poor - there have simply been very few incentives towards it and very strong incentives away from it.
Without debt, this growth pathway was always doomed to failure
The only way this system can keep going however, is if there is money to keep it going. It doesn’t matter how “good” it is, if there is no money to finance it, it simply cannot be done. Here, there was one overall factor that really helped Sri Lanka keep going with these deficits in my view, and that was the expansion of global liquidity since the late 80s that led to huge amounts of money pouring into developing countries. Why invest in a developed country if returns are low, when you can borrow at cheap rates and invest in a developing country for a great return? This pattern expanded in the aftermath of the Global Financial Crisis as global rates were at effectively zero - there’s no coincidence that Sri Lanka’s golden age of sovereign debt was post-GFC as well.
However, Sri Lanka took the deficits too far. So much so, that the country even failed to see a proper post-conflict growth boom as is common for many others. Sri Lanka’s growth peaked in 2012 and slowed down ever since, as the size of the deficits started becoming way too large even for the highly liquid global markets to keep financing at the same rate (incidentally, Sri Lanka’s growth rate slowing sharply from 2013 is a point that rarely gets noticed - the growth slowdown actually started under the second MR regime itself).
At its most simple level, if there’s a leak in your boat, you try to patch it first. Sri Lanka attempted to do this, and there was some broad success from 2013 to 2019 - though there were many missteps along the way with the global liquidity still being sloshy enough to allow these mistakes to continue unpunished. However, the slowdown in growth combined with the sociopolitical backlash following the Easter Sunday attacks (and undoubtedly many other factors) and we ended up with a new government by end-2019.
Many pages have been written about how the tax cuts took a country which was running on debt and took away one of the few sources of non-debt money it had, so there’s probably no need to repeat too much just yet. The pandemic also meant that tourism didn’t really recover after 2020 (2020’s fall wasn’t too problematic since imports also fell during 2020, but imports recovered in 2021 although tourism and critically, remittances didn’t). However, on the dollar side the bigger factor was probably Sri Lanka losing access to the cheap money that we had lived on - and being limited to just a little being given by China (and later India) - enough to barely survive, but definitely not to run a functioning economy with.
The recovery from the crash - the rise itself in reverse
The immediate impact of the lack of debt was that the deficits can’t exist at the same rate, and they have to basically contract. This means that the “injection” we saw into the economy slows down and overall can even reverse - a “withdrawal” from the economy instead to pay back at least a tiny bit of the cost of the injections. Raising revenue through tax increases and containing expenditure will be how the rupee deficit falls, while the adjustment of prices that allowed the dollar deficit to be subsidized will be how the dollar deficit falls.
Of course, the problem is that this doesn’t happen in a vacuum. Reversing the injections means first that the benefits of the injections themselves start to reverse, and then that the negatives of the withdrawals start to be felt. The benefits of the rupee deficit - the higher incomes, the growth in consumption, the reduced prices all go away. The benefits of the dollar deficit - more and cheaper imports and the quality of life improvements afforded by them, all go away as well.
This is of course, likely an inevitable overall consequence of this pathway. If we had benefits financed through debt, the lack of the debt means the benefits themselves no longer can exist in the same way as well. This is why the short-term still likely remains quite painful in my view, though less painful than the crash of 2022 - especially since there are still other aspects that compensate somewhat.
While one could theoretically argue away consumption by calling it “excess”, some of the benefits were also far more socioeconomically beneficial as well. The pain would also be on those benefits too. For example, Sri Lanka’s rapid electrification would be affected by the utility pricing adjustments - which would undoubtedly affect quality of life substantially (though the specifics will take time to be seen - data points like disconnections are still not significantly higher than past years despite media attention).
Thereby, the disagreement on the pain probably shouldn’t (at least in my opinion) on whether the costs are needed, but rather the pain can be better distributed. Broadly, I think there is a lot of pain being put on the biggest absolute beneficiaries of the old economic structure -the rich - but there is also a lot of pain being put on the small in absolute but relatively significant beneficiaries too - the poor. The fact then, that the poor are suffering is undoubtedly a key part of how we must understand the crisis and its recovery (though we probably shouldn’t overplay it either - “reduced calorie intake” is quite bad, but it's still different from absolute starvation). I have previously argued it's more a reflection of the unsustainability of the past pathway than the recovery from the crash that’s to blame, but in the end, the justification doesn’t really matter but the pathway forward.
What does the pathway forward look like?
Probably the biggest flashpoint on the pathway forward is the increase of VAT rates and the removal of many VAT exemptions. Even if some of the outrage on “essentials” being taxed is a little overblown in my view - many essential food items are still VAT exempt, though a few could be argued to be essentials will now be charged VAT - there’s no doubt that this isn’t a particularly progressive change to the tax policy (though VAT is probably not as regressive as immediately visible given how unequal Sri Lanka’s consumption is, because VAT replacing a more opaque tariff system is probably better, and because of how VAT can act to improve tax base widening outside of the VAT itself too).
However, I don’t think we can take this VAT change in isolation. This is not a change that is being done in a vacuum, but rather in the context of an economy that has begun economic expansion once again, albeit slowly. With local credit recovering, remittances remaining strong, and tourism growing quite well, some of the drivers of local growth are starting slowly. It’s entirely possible that these, combined with the powerful impact of the public salary hikes of 2024, more than offset the OVERALL impact of the tax changes for 2024 (there’s also the reduction of PAL on many of the newly VAT imposed items too - which again reduces the net impact). This doesn’t mean NO impact onto the economy, but rather something closer to “slower recovery” (The question of VAT likely can’t be addressed in its entirety here - I will likely return to it later).
Once again though, even if the overall impact is mitigated, that doesn’t necessarily mean the same for the equality of the change. Here, we must be generally cautious in my view - this is not an area with a whole lot of data on, and it's easy to get caught by anecdotes - both the positive and the negative. What data we DO have (the recent DCS survey results on the impacts of the economic crisis are useful here both in what it reveals and what it doesn’t - for example, overall household indebtedness has actually fallen from 2019, though number being indebted for food reasons has increased), suggests that the impacts of VAT changes are likely to be felt by the poor, but the continuation of some exemptions do limit the likelihood of an absolute disaster (limit, not entirely prevent). Overall, it feels like there will be pain that continues, and at least for some part of society, might even increase as well (though it may not be a clear consistent increase in pain even there). Obviously, questions of fairness aren’t answered well here - if the poor even have a CHANCE of their pain increasing, that isn’t a fair outcome in my view.
But is the pain “worth it” still? Does it lead to a “sustainable” economic pathway? Perhaps, but with a big caveat. Let's first look at how it CAN work before looking at the caveat.
Earlier, we went through how the structure of the economy in the past was that of deficits financed through debt. The pain we’re talking of can be thought of as an inevitable consequence (the overall pain, not necessarily in how it's distributed) of these deficits reducing, thereby it also then goes alongside the improvement of the underlying conditions. This can extend beyond the simple macroeconomic as well - an easy example is how the amount of graft and theft that would have happened through infrastructure development likely fell dramatically, simply due to the inability to finance large-scale infrastructure. The restructuring of our existing debt that happens parallelly to all this also can help create space for these reduced deficits (more accurately, surpluses by now) to accumulate in more long-term sustainability as well.
As there is short-term necessity to address these deficits (simply because there’s no other way to), one change that additionally comes into being would be the structural legislative changes alongside it. Some of these may be directly related to the deficits themselves - for example, the Parliamentary Budget Office Act - while others may be more about adjusting around the deficits to improve other aspects - for example, the Anti-Corruption Act. These two are particularly important ones to look out for - since the establishment and empowerment of strong independent institutions has the potential to be very impactful. The example of the Central Bank being defacto independent since April 2022 (and legally so since September 2023) is a great testament to the power of such institutions - even if one may disagree with the direction. Of course, the PBO and the new CIABOC aren’t functional yet, but looking out to see how they become established within the Sri Lankan system can have powerful long-term implications as well.
I personally believe that there is another important factor underlying as well, and that is that the structural incentives in the economy has likely changed, with the past structure of the economy now serving as a disincentive. The risk of “80% depreciation” or “70% inflation” is not something that will be forgotten completely, and I would feel this encourages more and more businesses, large and small, particularly small, to look at more export oriented avenues. In Sri Lanka’s current context, this can both serve as a more sustainable structure for the economy, that both allows the dollar deficits to be lower but also reduces the incentives of politicians to take policies to encourage consumption, and hence reduces the incentive for the rupee deficit to expand too.
The major caveat to this pathway is that it's quite some distance away still (and it's not necessarily the only way the long term pathway can materialize - service growth, remittance growth, agriculture growth, partial improvement in global liquidity are all factors that can go alongside this as well). This means that to get to the promise of this eventual pathway, the short-term pain and unfairness has to be borne.
Steeling through the pain towards the promise - will it happen?
Here, the responsibility lies squarely upon policymakers in my view. I don’t think merely telling people that the future can be good, or merely recognizing that the burden very much remains on the people achieves this purpose. The circumstances to achieve this must be set out by policymakers in varied ways.
One way is to find other ways to compensate people for economic pain. Whether this is through structural reform that helps or whether it's through finding places to reduce costs when possible is besides the picture. The easiest yet hardest solution here is probably taking strong anti-corruption measures - easy because it isn’t particularly expensive in financial terms, hard because the beneficiaries of corruption (not just at the top) will heavily resist it, making it quite expensive in sociopolitical and even administrative terms. The new CIABOC will have a huge role to play here.
Here, taking symbolic steps are useful as well as avoiding actions that look terrible. For example, the VAT increase going alongside a tax exemption for a project as Special Development Project looks terrible (even though the actual functioning of the specific exemption might take a few years to really matter, the timing is terrible regardless). Ironically, a change in governance would probably make it much easier to run the exact same policies as now, though intentions of course, can still differ.
I don’t think it’s realistic to expect massive change in governance structures given the continued forces that would oppose them, so I would be realistic on what actual results we can expect anytime soon. However, that doesn’t mean that there aren’t changes that can still be made. The Aswesuma programme is a good example - both in the goals being commendable, the rollout being very weak and messy, and some of the solutions including empowering the Welfare Benefits Board being something that steps CAN be taken towards, even if not easily.
All of this is also alongside a particularly fragile period for the Sri Lankan economy. The inability to run deficits also means that any short-term shocks aren’t able to be tided over - the increase in tariffs in 2023 are a good example here. With many local and global factors - debt, liquidity, credit, climate, geopolitics being probably the more alarming in the short-term - still looming over the country, it becomes especially important to build up as much space as possible in the system. Given that deficits are no longer possible, then this must come from other aspects.
Overall, I’m not going to expect a lot of the pain for 2024 to be adequately avoided. This isn’t a positive message for sure, but I also don’t see this mismanagement being something that is overly harmful for the long-run, though it would very much be quite damaging to those that would face it directly. I would still expect things to gradually improve, even for the poorest (though again, the immediate impact of VAT would still be felt), and for Sri Lanka to move towards its promise. That promise, I am still quite confident will be reached. If I look back at countries across history, it is difficult to find countries that don’t do well over long-term horizons, except in incredibly unique circumstances. Of course, the ideal is that it doesn’t take so long, and that the journey itself is painfree. However, I would be less utopian about Sri Lanka’s journey towards promise. It’ll be a painful journey, but the promise can still and hopefully still, compensate for the pain in between.