AUTHOR : SOUMYA BHOWMICK Courtesy Observer Research Foundation

Sri Lanka’s recent economic crisis and recovery efforts present a complex narrative marked by internal challenges and external shocks. The crisis, which began in 2019, was exacerbated by ill-advised tax cuts, a poorly managed shift to organic farming, and a series of devastating events such as the 2019 Easter bombings, the COVID-19 pandemic, and the Ukraine-Russia war. These factors severely impacted key economic sectors like agriculture and tourism, further straining the country’s depleted foreign exchange reserves. The country’s heavy reliance on foreign debt, particularly high-interest commercial loans, increased its vulnerability to external pressures. As the country transitioned to middle-income status, access to concessional funding declined, leading to a rise in International Sovereign Bonds (ISBs) with short repayment periods. By 2019, commercial loans comprised 56 per cent of Sri Lanka’s foreign debt, up from 2.5 per cent in 2007.

In June 2022, the United Nations warned of a potential “full-blown humanitarian emergency” in Sri Lanka, calling for USD 47 million in aid for the most vulnerable populations. Although the Sri Lankan economy is forecasted to grow moderately by 2.2 per cent in 2024, the country continues to grapple with high poverty rates, income disparity, and labour market issues. The World Bank’s latest biannual Sri Lanka Development Update highlights improvements in inflation, revenues, and a current account surplus driven by remittances and tourism. However, poverty remains high, with 25.9 per cent of the population below the poverty line in 2023. Labour force participation has also witnessed a decline, especially among women and in urban areas, due to the collapse of Micro, Small and Medium Enterprises (MSMEs).

Restructuring Sri Lanka’s debt, particularly with major creditors such as India and China, gives Colombo a certain amount of leverage in negotiations with the IMF and reflects shifting regional dynamics.

The polycrisis severely impacted MSMEs, leading to job losses and hampering recovery efforts. While some MSMEs adapted through digitalisation and flexible work practices, many resorted to layoffs and asset liquidation. Despite their resilience, MSMEs received minimal support from institutions or government stimulus packages. Governance inefficiencies and institutional weaknesses further constrained their growth. Sri Lanka’s path to recovery represents not only an economic challenge but also a geopolitical balancing act. With substantial international assistance, especially from India and strategic reforms, Sri Lanka aims to stabilise its economy, navigate complex international relationships, and achieve sustainable growth.

Geopolitical dynamics and economic recovery

Before the pandemic struck, Sri Lanka was already grappling with high debt levels and fiscal deficits, which constrained its economic management capabilities. The pandemic exacerbated these issues, severely impacting vital economic sectors and leading to a significant GDP contraction of 7.8 per cent in 2022. Inflation soared, and the nation’s foreign reserves dwindled, pushing Sri Lanka towards an economic emergency culminating in a historic financial crisis.

In response to the escalating crisis, the Sri Lankan government sought international help, securing a critical USD 3 billion bailout from the IMF in 2023. This Extended Fund Facility (EFF) aimed at stabilising the economy through a series of ambitious reforms designed to restore fiscal and debt sustainability. These reforms included enhancing the tax system to improve revenue collection, broadening the tax base, and implementing rigorous fiscal consolidation measures. The program also focused on restructuring major state-owned enterprises to reduce their financial burden on the economy. Debt restructuring was essential to the IMF’s intervention in the country. The aim was to reduce the unsustainable debt-to-GDP ratio through negotiations with domestic and international creditors, with the goal of charting a sustainable economic pathway by 2032.

Restructuring Sri Lanka’s debt, particularly with major creditors such as India and China, gives Colombo a certain amount of leverage in negotiations with the IMF and reflects shifting regional dynamics. Sri Lanka’s strategic importance to China, particularly concerning its trade and infrastructure connectivity in the Indian Ocean region under the Belt and Road Initiative (BRI), has intensified after India announced non-participation in the BRI.

China’s involvement in Sri Lanka has been contentious, notably highlighted by the Hambantota Port incident in 2017, where the China Merchants Port Holdings Company acquired an 85 per cent share in the port on a 99-year lease for USD 1.12 billion. That same year, multiple clashes broke out in southern Sri Lanka between protesters and government supporters opposing a port deal with China over concerns about the port area potentially becoming a ‘Chinese colony’. Buddhist clergy also voiced opposition, citing cultural and demographic threats posed by the partnership. However, then-Prime Minister Ranil Wickremesinghe defended the deal as necessary to alleviate the debt burden incurred from port construction under the previous administration.

India and Sri Lanka’s bilateral ties have witnessed an upswing in recent years, boasting the most significant trade relationship within the South Asian Association for Regional Cooperation (SAARC).

Recent events, particularly the suspension of Chinese energy projects in Sri Lanka’s Northern Province in 2021, signify a potential re-evaluation of China’s commitment to Sri Lanka. The halting of a project aimed at establishing hybrid energy plants on the Delft, Nagadeepa, and Analthivu islands (reportedly due to security concerns from India due to its proximity to the latter’s southern coastline) suggests a shift in Sri Lanka’s priorities and partnerships. While China’s embassy in Sri Lanka confirmed the suspension without naming India, it aligns with India’s previous protests against a Chinese firm winning a tender for renewable energy plants in the same region.

India and Sri Lanka’s bilateral ties have witnessed an upswing in recent years, boasting the most significant trade relationship within the South Asian Association for Regional Cooperation (SAARC). With India marginally surpassing China in 2022 to become Sri Lanka’s largest bilateral lender, the resolution of Sri Lanka’s debt relief talks necessitated equitable burden-sharing among creditor nations, with India now holding a more significant stake in the process.

India’s comprehensive support for Sri Lanka

India’s involvement in Sri Lanka’s recovery process underscores its specific economic and strategic interests in the island country. As the first bilateral creditor to provide financial assurances to the IMF, India was pivotal in facilitating the progress of Sri Lanka’s bailout program. It provided financial support totalling around USD 4 billion, which included multiple credit lines and currency assistance, showcasing India’s commitment to stabilising the region amid Sri Lanka’s economic downturn. Indian connectivity initiatives, such as Chennai-Jaffna flights and future ferry services, also underscore the importance of collaboration in bolstering regional connectivity and growth.

Moreover, India’s role has extended beyond financial assistance, emphasising diplomatic engagements as well as enhancing investments in critical sectors such as energy, tourism, and infrastructure to foster long-term development in Sri Lanka. The country’s location in the Indian Ocean is pivotal in India’s security strategy, particularly as a counterbalance to Chinese influence in the region. This strategic dimension is complemented by deep-rooted cultural ties, with initiatives to renovate Buddhist sites and promote religious tourism between the two countries. Cultural engagement also includes support for ethnic reconciliation in Sri Lanka, particularly regarding the Tamil community.

Sri Lanka’s journey from economic turmoil towards recovery reflects a multifaceted approach to stabilisation, integrating economic, strategic, and cultural dimensions through strategic partnerships and ambitious reforms aimed at achieving both short-term recovery and long-term sustainable growth. However, it also entails navigating a delicate path between satisfying international creditors, balancing geopolitical interests between India and China, and implementing inclusive economic policies to reduce poverty and stimulate growth. India’s proactive involvement, with substantial financial support and a focus on infrastructure development, signifies a shift in regional influence while potentially countering China’s BRI. In this way, Sri Lanka’s recovery trajectory will not only redefine its economic future but also shape regional power dynamics and cooperative frameworks.