Last year, soon after taking power as president of Sri Lanka, Maithripala Sirisena requested a US$4 billion loan from the IMF to restructure its debt repayments. The bailout package was rejected by the IMF. It warned the government instead to rationalise the tax system and arrest growing inflation.

Yet, despite the bleak economic situation, the government decided to increase salaries and pensions for public servants, cut taxes for farmers and increase subsidies. It is therefore unsurprising that the government faced an imminent balance of payments crisis. The IMF finally decided to provide a bailout package of US$1.5 billion — considerably less than the US$4 billion initially requested by Sri Lanka — to boost Sri Lanka’s falling foreign exchange reserves in March 2016.

Following the end of the Sri Lankan civil war in 2009, the country experienced persistent high growth of 8 percent and a comfortable foreign exchange reserve. However, these all changed in late 2014. So what went wrong?

Sri Lanka’s positive postwar economic growth was based on two factors. First, in the postwar period Sri Lanka received massive investment in infrastructure and other reconstruction activities. The second factor is the sudden spurt in workers’ remittances, which contributed to foreign exchange reserves. Peace also boosted investor confidence.

Unfortunately, the government’s populist posture prevented it from implementing any structural reforms to expand the tax base or end its generous subsidy regime, resulting in a massive debt burden.

Debt servicing for projects that are not earning returns have further added to Sri Lanka’s financial woes.

The country’s outstanding debt rose 12 percent to 8.27 trillion rupees (about US$57 billion) in the first nine months of 2015 and foreign debt increased by around 5 percent to 3.27 trillion rupees (US$22 billion).

As the trade balance suffered, Sri Lanka’s macroeconomic indicators faltered. The fluctuating rupee undermined investor confidence contributing to capital flight, while foreign exchange reserves fell to US$6.3 billion in January this year. The GDP growth rate reduced to 4.5 percent in 2014 from a high of 9.1 percent in 2012. Massive money printing, which was intended to alleviate the budget deficit, only exacerbated Sri Lanka’s economic woes and the budget deficit climbed to 7.2 percent in 2015.

A decrease in the growth of remittances from 9.5 percent in 2014 to just 0.8 percent in November 2015 only made matters worse. This was due to the crash in oil prices and political turmoil in the Middle East, where most overseas Sri Lankan workers are employed. The Sri Lankan rupee also depreciated 8.8 percent to the US dollar making imports costly. By October 2015, the trade deficit had increased by 2.5 percent to US$6.9 billion, mostly due to an increase in non-oil imports.

The government tried several measures to overcome the impending crisis. For example, Sri Lanka issued 10-year sovereign bonds worth US$2.15 billion — US$1.7 billion from development bonds and US$1.5 billion from currency swaps with India. Sri Lanka’s central bank also increased the statutory reserve ratio — that is, the proportion of customer deposits that commercial banks must hold in reserve — to help combat inflation.

In addition, it issued short-term bonds to overcome the revenue deficit. This policy came under severe criticism by the opposition. For its part, the government accused the previous Rajapaksa regime of being responsible for the country’s 9.5 trillion rupee (US$65 billion) debt.

The government’s problems have been compounded as it faces a resurgent Mahinda Rajapaksa, who is preparing for a comeback and still enjoys considerable popularity. To survive, it has to keep both the people and the party leaders happy. To this end, the government increased the perks for the 225 members of parliament, creating an additional financial burden to the tune of 39.4 million rupees per month (US$270,000) and 472.8 million rupees (US$3.2 million) a year.

In July last year, the Central Bank of Sri Lanka entered into an agreement with the Reserve Bank of India (RBI) for a currency swap agreement. As a result, Sri Lanka’s central bank was allowed to withdraw up to US$1.1 billion for a maximum period of six months.

The deal is in addition to the existing RBI currency swap provision that is available for all the South Asian Association for Regional Cooperation (SAARC) countries under the 2012 ‘Framework on Currency Swap Arrangement for SAARC Member Countries’.

Currency swaps under the SAARC agreement have a maximum ceiling of US$2 billion. To help Sri Lanka meet the imminent balance of payment crisis, the Indian government also approved an interim currency swap amounting to US$700 million.

India’s participation was partly motivated by a desire to strengthen ties with Sri Lanka to counter possible Chinese influence. When advocating the currency swaps to the Sri Lankan government, the RBI argued that the deal would help to mitigate ‘possible currency volatility in the spirit of strengthening India’s bilateral relations and economic ties with Sri Lanka.’

However, Sri Lanka needs to go beyond just currency swaps to revitalise its flagging economy. In the recent past, Sri Lanka has taken steps to increase taxes to raise revenue. The value-added tax, for example, was increased by 15 percent and the government removed tax concessions on telecommunication services, private education and health services. However, it is yet to expand the tax base and reduce subsidies.

It appears that Sri Lanka is in for some tough negotiations with the IMF. It has to address the structural issues, bring in financial reform to expand the tax base, reduce unnecessary expenditure and address the budget deficit. In addition, it must do all these in a difficult political climate. It will be difficult for the government to avoid giving in to its populist impulses, especially when the opposition is waiting in the wings.

(East Asia Forum)