Sri Lanka’s constitutional crisis: Risks to the economy and growth

By M Yusuf

‘No one knows who is in charge’ was the subtitle of a story in the Economist on Sri Lanka’s coup. It quoted a lawyer who said “we went from one prime minister to two prime ministers to no prime minister in a span of 20 days”.

A previous essay dealt with refinance risks on foreign debt, the other concerns are the currency and growth. Risks to the external position have increased; immediate threats include the loss of GSP+ or the suspension of the IMF program (currently delayed).

Currency

Rising global interest rates were causing foreign capital outflows from the debt and equity markets for some months. This has accelerated since the coup. The rating downgrade (on the 20th) may now trigger a fresh round of exits.  

Local players were also wary even pre-26 October but concerns have now worsened and there appears to be a breakdown of confidence. Bankers report that exporters are holding on to dollars while money changers say they experience a shortage of dollars.

Pressure on the currency will remain due to capital outflows and analysts fear trade pressure will increase. The Central Bank infused a further Rs. 90 b in liquidity to the market through a cut in the reserve ratio on the 16th .This can generate fresh credit-and new imports, causing the rupee to slide again. This will only ease when some clarity emerges on the political front or with a significant tightening of monetary policy. 

The rupee has depreciated by 12.5% since early September (from 160 to 180) but the recent slide is not yet fully reflected in retail prices, which usually lag by a couple of months. Sharp increases in prices are expected over the next few months with negative impact on the cost of living and poverty. 

Impact on growth

The immediate effects (reduced tourism, higher inflation, delayed or cancelled investments) are negative but elevated political risks feed into other types of risk damaging the country risk profile, which has long term implications for investment, thus growth. 

Country risk includes financial [loan default or unfavourable loan restructuring], economic [Inflation, International liquidity ratios, current account balance] and political risks [radical political change or instability]. 

The crisis has elevated both financial and economic risks. Investors will view deterioration in the rule of law, a weakening of political institutions or a disorderly transfer of power as increasing political risk. 

The Yahapalanaya Government squandered its first two years failing to implement any economic reforms. Indeed, its policies compounded the problems it inherited: increasing public spending, budget deficits and debt. Money printing to bridge deficits caused the currency to collapse and belatedly increasing taxes to address the deficit (instead of cutting expenditure) inflicted further pain, causing widespread anger. Policy confusion destroyed business confidence. 

Samaraweera attempted some reform but benefits (in terms of investments, jobs, lower inflation) were yet to flow. It is therefore not surprising that many wished a return to the greater predictability of the old regime. 

The crisis has made things worse but Rajapaksa has promised a speedy restoration of the economy by returning to the policies of the past. Can this succeed?

Between 2009 and 2012 the country experienced a boom but there are two reasons to doubt a repetition of that success: inherent limitations of this growth model and changed circumstances since 2009. 

Rapid growth post-2009 was driven by:

a) Under-utilised productive capacity of the northern and east coming into production. Once utilisation reaches normalcy growth slows.

b) Post-conflict construction and reconstruction.

c) Consumption-caused by reductions in import taxes, post-war consumer confidence, a favourable exchange rate and increased government spending.    

The limitations of (a) and (b) are obvious. Domestic consumption is limited by market size and spending power.

Growth accelerated for three years (2010-2012, average 8.5%) but then dropped in the next two years (2013-14, average 4.2%) as the principal drivers were exhausted. 

Can a renewed big infrastructure push re-ignite growth? 

Closing infrastructure gaps in less developed countries can revive growth but a study by Warner(2014) covering 124 lower and middle income countries shows ‘big-push’ investment drives only provide an initial boost that are then followed by slumps rather than booms. Reasons include:

I. Poor project selection. On-the-shelf projects that are pulled off-the-shelf once a major increase in spending is announced. These have the advantage of being previously evaluated and thus quick to implement, but most likely were left on-the-shelf because of low impact.

II. Such projects often have favoured constituencies within the bureaucracy.

III. Easy availability of financing. A government that rationally analyses investments when money is tight has less incentive to do so when money is loose. Special interest group pressure can be more influential as other constraints become less binding, such as the budget.

IV. Diminishing returns to additional capital. 

Moreover, Keefer and Knack (2007) show evidence that public investment is “dramatically higher in governments with low-quality governance and limited political checks and balances.” They attribute this to the fact that public investment is conducive for rent-seeking.

This narrative fits Sri Lanka’s post-war experience. The public investment drive provided an initial boost but did not deliver sustained growth. 

To be a driver of growth the infrastructure must increase the productivity of the economy-and be matched by private investment that utilises it effectively. In Sri Lanka expectations that the initial public investment drive will pull in private investment to deliver sustainable growth did not materialise.

Further, financing an infrastructure drive (unless done privately or through savings) requires debt but raising debt is also now more difficult than in 2009 because:

a) Sri Lanka’s domestic finances are now much worse than they were in 2007, when the first international commercial borrowing took place.

b) Global conditions have tightened and interest rates have risen.

c) The investments made have failed to generate returns to service the associated debt, so new debt is needed to repay old debt leading to increased indebtedness-a weaker balance sheet.

d) Positive sentiments post-conflict replaced by negative sentiment following the coup and deeper questions around institutions.

Sri Lanka’s international commercial borrowings commenced in 2007 and accelerated after 2010 when the country graduated to a low-middle income country in 2010 (when it has less access to concessional borrowings). Post 2010 borrowings were supported by favourable international trends; low interest rates and a rising investor appetite for emerging market debt.

“In such a demand-driven easy financing landscape, governments may be tempted to borrow large sums. Such funds also have the advantage of being free of conditions and lengthy processes that typically govern multilateral funding.” (Weerakoon, 2017)

External debt grew rapidly; by a factor of 3.5x between 2007 and 2017 and its profile changed.  “As Sri Lanka accelerated its public investment programme by tapping commercial loans, the external debt profile underwent a swift change with the share of non-concessional foreign debt rising to 50% in 2012 from a negligible 7% in 2006. The debt-financed infrastructure push provided only a short-term boost to growth, while earnings from exports of goods and services stagnated.” (Weerakoon, 2017)

Reverting to this model as promised by Rajapaksa is not only more difficult now-at best it will only provide another short-term boost. It is also risky. Debt is 77.6% of GDP and the country is accumulating fresh debt to repay older debt-a vicious cycle termed the ‘debt-trap’.

Sri Lanka has a growth problem but the engine of the past is exhausted. After the brief post-war boom, growth has reverted back to the long-term average (4%) in each of the four years from 2013-2016. Post-conflict countries expect to experience a sustained “peace dividend” but Sri Lanka’s was surprisingly limited both in scale and duration. 

To solve this conundrum, the University of Harvard conducted a detailed diagnostic study of Sri Lanka’s economy in 2016-18 that found: 

“Sri Lanka’s growth history suggests a particular vulnerability to macroeconomic shocks that threatens the sustainability of even modest growth. Sri Lanka maintains a significant trade deficit in goods and services that has driven recurring balance of payments crises….Therefore, Sri Lanka’s growth problem includes the need to break this cycle, which has been the combined result of a persistent trade deficit, low overall levels of foreign investment”

“To sustain higher growth, exports need to expand faster to cover the growth of imports. but exports are not growing fast enough because they have not diversified beyond a set of traditional goods (tea, rubber products and garments). Sri Lanka’s growth problem reflects a failure to discover and enter new, higher-productivity industries where Sri Lanka can compete internationally and afford higher wages.”

Since the early 2000’s Sri Lanka’s trade liberalisation slowed and then reversed. A policy paper by the World Bank ‘Increase in Protectionism and Its Impact on Sri Lanka’s Performance in Global Markets’ shows that today, through the proliferation of a variety of para-tariffs, Sri Lanka’s tariff policies are just as protective as they had been more than 20 years earlier. The economy has turned inwards, exports have declined from 33.3% of GDP in 2000 to 12.7% in 2016.

Reforms to re-orient the economy to exports are needed, the study identifies key constraints to attracting investment for exports include red tape “overlapping government bodies rely on disordered rules and deals when interacting with the private sector”, “access to land, water and wastewater infrastructure, transportation infrastructure, and deep policy uncertainty”.  

The Yahapalanaya regime is belatedly trying to address these issues but results can only flow in a couple of years’ time. 

There are no quick remedies that can return the country to speedy sustainable growth and prospects are now dimmer-the coup carries long-term growth consequences that are difficult to quantify but may last for years. Some recent studies (Meyersson, 2015)  show that a successful coup lowered growth in income per capita by as much as 1-1.3% per year over a decade.

Restoring investor confidence in institutions and the rule of law will help minimise the long-term impact. This means both sides must work to bring a quick resolution within a constitutional framework as soon as possible.