Can the South Asian economy break with the past and find a path to stability?

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(THE CONVERSATION) Sri Lanka has a new president and a new prime minister – but a change in the leadership of the crisis-hit South Asian nation will not on its own solve the country’s serious economic problems.

Ranil Wickremesinghe – who on July 20, 2022 was elected by lawmakers to replace runaway former President Gotabaya Rajapaksa – and his appointed Prime Minister Dinesh Gunawardena inherit an economy struggling with record inflation of up to 59%, a currency that has lost almost half its value since March 2022 and severe shortages of basic necessities such as food and fuel. Almost all economic activity in the country has come to a standstill.

The government’s deficit is so large that it cannot afford to pay civil servants, and the central bank has almost no foreign exchange – needed to finance imports and repay foreign debt.

In short, Sri Lanka is facing an unprecedented economic crisis, which is putting enormous pressure on the new leadership to act quickly to put things right.

As an economist and former official of the Central Bank of Sri Lanka, I think the way forward will be difficult. The country will have to break with past policies and practices that have plunged it into a financial hole while implementing reforms to get the economy back on track. In particular, there are four key economic challenges that the new government will have to address, although they are all interconnected.

Responding to the immediate needs of Sri Lankans

To avoid the fate of his now exiled predecessor, Gotabaya Rajapaksa, President Wickremesinghe will have to address the immediate needs of his people.

After being sworn in, Wickremesinghe said his priority was to ensure people could eat three meals a day.

As food inflation reached 76%, the prices of many basic foodstuffs rose more significantly – rice by 160%, wheat flour by 200% and sugar by 164%. To put this into context, a preschool teacher earning minimum wage would need more than a day’s pay to buy one kilogram (2.2 pounds) of sugar and one kilogram of wheat or rice flour. A bottle of cooking gas, if they were lucky enough to find one, would cost more than half a month’s salary.

The cost of living ranks among other pressing issues. The reopening of closed schools and universities is another priority. The other urgent need is the restoration of transport services. With no fuel to buy, private bus services are in limbo and public transport has become an adventure, with passengers hanging from doors and windows and even sitting inside the luggage compartment.

Restoring transport and electricity services requires foreign currency to import fuel, but support from the International Monetary Fund, which provides financial aid to struggling economies through loans, is months away. Unless the new president can persuade his regional powers – India and China – to provide more aid, economic hardship will continue and life in Sri Lanka will not be normal.

In the past, Sri Lanka was able to rely on tourism to bring income to the island nation. But that will be impossible as long as social unrest continues and shortages of essential goods limit the country’s ability to serve visitors. Meanwhile, remittances from Sri Lankans abroad have also suffered from a lack of confidence in the national currency, known as the rupee.

As Wickremesinghe noted, things will get worse before they get better.

Balance the budget

Next on the president’s to-do list will likely be to find a way to reduce the budget deficit. Last year, spending was 240% of revenue, and 91% more was needed to pay down debt. Money printing covered much of this gap but only exacerbated inflation.

The main reason for Sri Lanka’s current crisis is decades of fiscal mismanagement, with too much spending and too little revenue.

Solving this problem will require a combination of higher taxes and major budget cuts. But the budget gap is too big to completely eliminate the need to print money. The best we can hope for is aggressive reduction.

Restructure Sri Lanka’s Huge Debt

Such fiscal reforms will likely be needed to address another challenge Sri Lanka faces: external debt.

Sri Lanka has racked up around $51 billion in foreign debt over the past few decades, but has virtually no foreign currency with which to pay it off. The government suspended payments on the external debt in April, sending it into default.

At the end of 2021, around 45% of the debt was owed to private investors, while the rest belonged to countries and multinational institutions. The Asian Development Bank held the largest share, at 16%, while Japan, China and the World Bank held 10% each.

For Sri Lanka to emerge from its crisis, it will need significant assistance from the IMF. But the IMF requires assurances that Sri Lanka’s debt sustainability is restored before lending it money.

And other international organizations, such as the World Bank, will not be willing to lend more to Sri Lanka until the country signs an agreement with the IMF. And US lawmakers have recently suggested that IMF support will depend on increasing the independence of Sri Lanka’s central bank, fighting corruption and promoting the rule of law.

While the G-7 countries, the group of major economies including Japan, seem willing to help Sri Lanka in its efforts to restructure its debt, some bondholders – like the Caribbean-based Hamilton Reserve Bank , which holds just $250 million – have already filed a lawsuit to claim their dues.

In May, Sri Lanka took a first step towards restructuring its debt, but it could take several months before the country is able to successfully negotiate with its creditors to ensure debt sustainability.

Build public support for reforms

Wickremesinghe’s greatest and least enviable challenge, however, is less about economics and more about the politics of addressing it.

He will not be able to do much for the economy of Sri Lanka until he succeeds in establishing political stability. And right now, Sri Lanka remains in turmoil.

Wickremesinghe, who was previously appointed prime minister by his ousted predecessor, will need a broad mandate and the backing of opposition politicians if he is to radically change Sri Lanka’s politics. Upon his election, he immediately urged his rivals to join him and “work together to bring the country out of crisis”, adding: “Our divisions are now over”.

He will also have to respond to protesters’ demands for the reduction of executive powers while introducing strong anti-corruption measures and strengthening democratic institutions.

Still, many doubt Wickremesinghe’s ability to unite Sri Lanka and question his tenure to fulfill the remaining term of the presidency. He has been the target of protesters since his nomination for the presidency. And a confrontation between the armed forces and the demonstrators shortly after Wickremesinghe took power does not bode well.

Recovering an economy so deeply in crisis will take time. It is believed that inflation in Sri Lanka has not peaked yet and the people will continue to face economic hardship for some time.

But political stability will be needed before Sri Lanka can emerge from its economic slump. The tax reforms expected by the IMF will be painful and will only be viable with public support and that of all major political parties in the Sri Lankan Parliament.

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