Will a Marxist government put Sri Lanka’s economic recovery at risk?
Sri Lanka has made a truly remarkable turnaround since an uprising in 2022, but if the island nation is to achieve sustained and equitable growth, its new government has no room for mistakes, says Chris Dorrell
Amid rampant inflation, fuel shortages and the country’s first debt default since independence, demonstrators forced Sri Lanka’s President Gotabaya Rajapaksa to flee into exile in the dead of night.
TV cameras broadcast images of protestors swimming in the Presidential pool around the world.
That was 2022. Fast forward a couple of years, and Sri Lanka’s star is on the rise. Growth has returned, inflation is under control and the country declared an end to its debt default at the end of last year.
Investors were all in. The rupee was the top performing emerging market currency against the dollar last year while the Sri Lankan stock market climbed just under 50 per cent.
So, how did this island nation turn itself around?
First, it’s worth briefly recapping how the crisis emerged. Put simply, Sri Lanka ran out of money. This is generally regarded as a Bad Thing.
Its position reflected deep structural imbalances in the economy as well as unpredictable external shocks and government incompetence.
The most deep-rooted issue was that Sri Lanka ran large current account deficits for a number of years. This meant that it was importing more from the rest of the world than it exported, a deficit financed through borrowing from abroad.
There were then a succession of external shocks, including the Easter Bombings in 2019 and the Covid-19 pandemic, which contributed to a slump in tourism and a sharp drop in remittances.
Tourism is one of Sri Lanka’s largest earners of foreign currency, and so its foreign reserves came under severe pressure as the number of visitors plummeted.
The war in Ukraine also pushed up the cost of energy, forcing Sri Lanka to spend more and more on importing even as its main sources of income were struggling.
All of this came to a head in 2022, at which point the country’s foreign reserves had fallen 99 per cent compared to 2019.
With no reserves left to pay for its imports, there were severe food and fuel shortages, made worse by the government’s decision in 2021 to ban imported fertilisers.
People waited in queues for days to access fuel while many skipped meals as food prices rocketed. The lack of reserves also meant that the government also defaulted on its debt. Not good.
After President Rajapaksa fled, the Prime Minister Ranil Wickremesinghe formed an emergency government.
“Our economy has completely collapsed,” he told Parliament. Full marks for candour.
Wickremesinghe quickly called for support from the IMF and quickly raised taxes, with a big hike to VAT forming the centrepiece of his budget.
“Our economy has completely collapsed,” the President told Parliament. Full marks for candour.
He also slashed state subsidies for energy usage while cutting away some of the many tax exemptions in the system.
These were effectively requirements for Sri Lanka to receive a $3bn loan from the IMF to help the country rebuild following the crisis.
There’s some signs that Wickremesinghe’s measures have worked.
Tax intake as a percentage of GDP has increased by two thirds – although it remains low at 13 per cent – and last year the government ran its first fiscal surplus since 1977.
Tourism has also recovered strongly since the pandemic, with the government aiming to attract 4m visitors to the country by 2030.
The post-pandemic rebound in tourism and the revived flow in remittances has helped its foreign reserves recover to more than $6bn at the end of 2024, up from less than $2bn in 2022.
Crisis over?
There’s no doubt that many of the macroeconomic indicators have been improving at a much faster pace than many analysts expected.
Last year the economy grew five per cent. In a note last week, IMF staff wrote: “In a mere 18 months (Sri Lanka has) recovered just under half of the output lost from the peak in 2018 to the nadir in 2023.”
Inflation is also back under control, having reached a peak of 70 per cent in 2022. In fact, prices have fallen for the past seven months, although inflation is expected to return to positive territory later this year.
But many commentators feel that the poorest sections of the population have borne the brunt of the adjustment costs and voters in last September’s presidential election did not thank Wickremesinghe for his stabilisation efforts.
Outsider Anura Kumara Dissanayake, a former Marxist and a long-time anti-corruption campaigner, won the presidential election, riding a wave of dissatisfaction against the status quo.
Dissanayake’s victory was the first time someone from outside Sri Lanka’s major political parties has won an election. In the parliamentary elections that followed, his National People’s Power party won a landslide.
This prompted some concern in financial markets that the new left-wing President might backslide on some of the measures put in place by his predecessor.
But while Dissanayake promised to renegotiate with the IMF, his first Budget – delivered in February – committed to running a current surplus of 2.3 per cent of GDP, in line with the IMF’s requirements.
“In terms of the overall numbers, the Budget is staying within the IMF parameters,” said Thilina Panduwawala, head of research at Colombo’s Frontier Research.
Sri Lanka needs to meet these parameters to secure the next $333m portion of the IMF’s bailout package, the last tranche of which was dispersed in March.
Sri Lanka’s economy has recovered much faster than experts predicted, even if ordinary people have yet to feel much of the benefit.
In an article published in Sri Lankan newspapers last week, Peter Breuer and Martha Tesfaye Woldemichael at the IMF praised Sri Lanka’s success thus far, while sounding a note of caution.
“The macroeconomic turnaround is remarkable even as many households are yet to feel the impact,” they wrote.
“The path to stable and inclusive growth and fiscal and debt sustainability remains narrow. There is no room for policy errors.”