Baba’s Explainer – IMF’s staff-level agreement with Sri Lanka

  • IASbaba
  • September 6, 2022
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  • GS-2: India and its neighbourhood
  • GS-2: Important International institutions, agencies and fora- their structure, mandate.
  • GS-3: Economic challenges

Context: The International Monetary Fund (IMF) on September 1 announced a staff-level agreement with Sri Lanka, months after the island nation’s economic crisis intensified this year, following a serious Balance of Payments problem.

What has been happening in Sri Lanka?
  • Protests started in the capital, Colombo, in April 2022 and spread across the country.
  • People have been struggling with daily power cuts and shortages of basics such as fuel, food and medicines.
  • Inflation is running at more than 50%.
  • The country doesn’t have enough fuel for essential services like buses, trains and medical vehicles, and it doesn’t have enough foreign currency to import more. This lack of fuel has caused petrol and diesel prices to rise dramatically.
  • In late June, the government banned the sale of petrol and diesel for non-essential vehicles for two weeks. Sales of fuel remain severely restricted.
  • Schools have closed, and people have been asked to work from home to help conserve supplies.
  • President Rajapaksa resigned after fleeing to Singapore. Before stepping down he made Prime Minister Ranil Wickremesinghe acting president.
  • Mr Wickremesinghe declared a state of emergency across the country and imposed a curfew in the western province while he tries to stabilise the situation.
What happens when a country runs out of money?
  • Sri Lanka is unable to buy the goods it needs from abroad.
  • And in May, 2022 it failed to make an interest payment on its foreign debt for the first time in its history.
  • Failure to pay debt interest can damage a country’s reputation with investors, making it harder for it to borrow the money it needs on international markets.
  • This can further harm confidence in its currency and economy.
  • The country owes more than $51bn (£39bn) to foreign lenders, including $6.5bn to China, which has begun discussions about restructuring its loans.
    • The G7 group of countries – Canada, France, Germany, Italy, Japan, UK and the US – had said it supports Sri Lanka’s attempts to reduce its debt repayments.
  • The International Monetary Fund (IMF) is also in discussion for a loan. But it would require a stable government that could raise interest rates and taxes to help fund the deal.
  • Mr Wickremesinghe had already said the government would print money to pay employees’ salaries, but warned this would be likely to boost inflation and lead to further price hikes.
    • He also said state-owned Sri Lankan Airlines could be privatised.
    • The country has asked Russia and Qatar to supply it with oil at low prices to help reduce the cost of petrol.
What led to the economic crisis?
  • The government blamed the Covid pandemic, which badly affected Sri Lanka’s tourist trade – one of its biggest foreign currency earners.
  • It also says tourists were frightened off by a series of deadly bomb attacks in 2019.
  • However, many experts blame President Rajapaksa’s poor economic mismanagement.
  • At the end of its civil war in 2009, Sri Lanka chose to focus on providing goods to its domestic market, instead of trying to boost foreign trade.
  • This meant its income from exports to other countries remained low, while the bill for imports kept growing.
  • Sri Lanka now imports $3bn (£2.3bn) more than it exports every year, and that is why it has run out of foreign currency.
  • At the end of 2019, Sri Lanka had $7.6bn (£5.8bn) in foreign currency reserves, which have dropped to around $250m (£210m).
  • Mr Rajapaksa was also criticised for big tax cuts he introduced in 2019, which lost the government income of more than $1.4bn (£1.13bn) a year.
  • When Sri Lanka’s foreign currency shortages became a serious problem in early 2021, the government tried to limit them by banning imports of chemical fertiliser.It told farmers to use locally sourced organic fertilisers instead. This led to widespread crop failure. Sri Lanka had to supplement its food stocks from abroad, which made its foreign currency shortage even worse.
What is the latest IMF deal reached with Sri Lankan government?
  • The IMF says it has reached a preliminary agreement with Sri Lanka on a four-year, $2.9bn bailout package aimed at restoring economic stability and debt sustainability for the crisis-ridden country.
    • Ahead of opening negotiations with the IMF in April, Sri Lanka pre-emptively declared it would default on its $51 bn debt, of which $ 2 billion is due this year, and the rest over the next six years.
  • The package must now be approved by the IMF’s board of directors.
  • However, even though the IMF has agreed to support Sri Lanka, it is conditional on many factors. Sri Lanka must take a series of immediate measures that IMF has deemed necessary to fix fiscal lapses and structural weaknesses — such as raising fiscal revenue, safeguarding financial stability and reducing corruption vulnerabilities.
  • Apart from making domestic policy changes to strengthen the economy, Sri Lanka must also restructure its debt with its multiple lenders.
  • The approval by the IMF’s board of directors is contingent on Sri Lanka’s international creditors — commercial lenders such as banks and asset managers, multilateral agencies, as well as bilateral creditors including China, Japan, and India — agreeing to restructure its debt.
  • Japan has offered to organise a creditors’ meeting for Sri Lanka, but China has yet to agree to the proposal.
  • The IMF package, to be paid in tranches over the next four years, is less than what India provided to Sri Lanka over four months.
  • But the expectation is that an IMF loan can boost the receiving country’s credit ratings, and the confidence of international creditors and investors, who may then chip in to provide further financial support.
  • President Ranil Wickremesinghe has said it will be 2024 before the country returns to its 2018 levels of prosperity. In the period between now and then, the government will need to take several belt-tightening measures — higher prices for utilities including electricity and fuel, and higher taxes.
What are the tightening measures undertaken/planned by the government?
  • Increasing Government revenues: The government has recently presented a slew of measures in the country’s budget aimed at increasing revenue to 15 per cent of GDP by 2025 from the 8.2 per cent at the end of 2021
  • Mandatory Tax registration: An increase in VAT from 12 to 15 per cent, and compulsory tax registration for everyone aged 18 years and older in order to widen personal income tax collections are among the measures.
  • Privatisation of PSUs: Some 50 state-owned enterprises are up for privatisation, apart from the big three — Ceylon Electricity Board, Ceylon Petroleum Corporation, and Sri Lankan Airlines — that are already in restructuring talks. The restructuring could yield up to $3 bn.
  • Reducing Retirement Age: The age of retirement in government and semi-government organisations has been brought down to 60 from 65 and 62 respectively. Those beyond the age of 60 and still working are to be let go at the end of the year. This would address the unrest and the unemployment in the youth.
  • Recapitalisation of Banks: In the banking sector, staff and depositors are to be offered 20 per cent shareholding in state banks to address recapitalisation requirements arising out of non-repayment of loans due to the economic meltdown.
  • Review on Defence Expenditure: Through the crisis, there were calls to cut defence expenditure, which had increased under former President Gotabaya Rajapaksa. While the budget is silent on cuts, there is an entry under the head of National Security 2030, proposing to “review” the defence strategy.
  • Welfare Provisions: In a move to address fears that the country’s social welfare system might be scrapped, the budget raised welfare payments to the farmers affected by the crisis, the elderly and disabled, and some categories of patients.
How is India helping Sri Lanka during this crisis period?
  • When Sri Lanka was struggling to find a way out of the economic crisis, it turned to New Delhi for help and the government responded with financial aid and more.
  • India has provided around $5 billion worth of assistance to Sri Lanka of which $3.8 billion has been provided in 2022.
  • In May, Sri Lanka received its first consignment of a $16 million humanitarian aid package from India and in June 2022, it sent more supplies with 14,700 metric tonnes (MT) of rice, 250 MT of milk powder, and 38 MT of medicines.
  • Sri Lanka is facing a severe shortage of fuel and India has been providing fuel.
    • In February 2022, the two countries signed an agreement for a $500 million supply of petroleum products from the Indian Oil Company through a credit line. This was expanded by a further $200 million in April
    • Two more ships of diesel and petrol to the neighbours were sent in July. Lanka has received more than 400,000 tonnes of fuel from India over three months
  • Kerala’s Trivandrum and Kochi airports are making provisions for more than 120 Sri Lanka-bound aircraft for technical landing so that they can refuel.
  • That’s not all. Many Sri Lankans, especially from the Tamil-dominated areas, have sought refuge in Tamil Nadu amid the crisis and their numbers are expected to increase.
How Sri Lanka became closer to China?
  • India and Sri Lanka have close cultural and economic ties that go back decades. The Tamils in Lanka have a lot in common with the people from Tamil Nadu – the cultures, religions, and practices are similar.
  • The Rajapaksa government—elected in 2005, adopted ruthless violence to end the civil war and proposed grand plans for the post-war economic recovery. China used this opportunity to develop personal relationships with the Rajapaksas by selling them arms, providing much-needed investments, aid and infrastructure projects, and protecting them from accusations of human rights violations.
    • This opportunism gave China significant leverage within the elites of the Sri Lankan polity.
    • This bonhomie helped China influence, bribe, and exploit the Sri Lankan bureaucracy, media, and political elites, directly and indirectly.
  • Also, after Mahinda Rajapaksa was elected president in 2005, Lanka started becoming close to China and depended on them for a huge infrastructure push.
  • In 2011, the Hambantota port was inaugurated and China funded highways, ports, and airports across the country.
  • The elite capture also came at a cost for India and other major powers—such as the US and Japan.
    • The elites deterred influence and significant projects from other competitors at China’s behest.
    • On multiple instances, Chinese submarines started visiting Sri Lankan harbours, and China was also offered projects and an aircraft repair base—precariously close to India.
    • More recently in early 2021, the Sri Lankan government cancelled India and Japan’s East Container Terminal project, offered a few energy projects to China in the Jaffna peninsula,
  • However, the shiny infrastructural projects that were built on the basis of Chinese loans have proven to be castles of sand.
  • In 2020, Sri Lanka received another $3 billion from China, walking into what experts have called Beijing’s “debt trap” diplomacy.
  • Beijing is Sri Lanka’s biggest creditor and makes up 10 percent of its overall debt and 20 percent of its debt stock to China—the highest amongst its bilateral lenders.
    • Between 2000 and 2020, it extended close to $12 billion in loans to the Sri Lankan government, mostly for infrastructure projects, which the island nation could not pay off.
Why has China’s response during Sri Lanka’s economic crisis been lukewarm?
  • Ever since Sri Lanka plunged into a full-fledged economic crisis, China—the island state’s largest bilateral creditor and trade partner—has provided it with humanitarian assistance of a mere US$74 million.
  • China is also yet to decide on Sri Lanka’s request for loan restructuring and additional financial aid worth US$4 billion.
  • Then Sri Lankan President Gotabaya Rajapaksa sought Beijing’s help in December 2021 as he requested a debt restructuring in a meeting with China Foreign Minister Wang Yi. However, Beijing refused to budge.
  • Also, China has also opposed forgoing an amount of debt as suggested by the IMF. The island nation’s default and approaching the IMF thus came at a vast cost to Chinese influence and interests.
  • In 2018, Chinese investments in other South Asian countries equated to 16 percent of Pakistan’s GDP, 15 percent of Maldives’ GDP, and 8 percent of Bangladesh’s GDP. However, COVID-19 has taken a toll on the economy of the developing world including China. In this regard, China does not want to set a precedent for countries to bail out on BRI projects or request new loans and loan restructuring.
Is India gaining over China in island nation?
  • China’s South Asian strategy is shaped by two intertwined tactics—elite capture and extensive lending. In recent years, both of these tactics have come under severe stress given India’s attempts to win back the region, domestic compulsions and national interests of South Asian states, and the COVID-19 pandemic.
  • By stepping up in times of crisis, India has wrested some influence from China over Sri Lanka.
  • In January, after India provided initial credit, the two countries announced that they will jointly operate 61 giant oil tanks built during World War II in Trincomalee. India has been trying to access the British-era facility for three decades
  • In March, New Delhi inked a deal to set up hybrid power projects on islands in northern Sri Lanka, after China said in December that it was suspending its plans to build plants on three islands due to security issues.
    • In the same month, Colombo also scrapped an agreement with a Chinese firm to build a $12 million wind farm in the country, and instead offered the project to an Indian riva
  • India indeed has taken significant steps to mend bridges with Sri Lanka. It’s a win-win as New Delhi regains an old friend and keeps China on its toes.
What are the challenges that lie ahead for Sri Lankan Economy?
  • Political Consensus: In order to push through the reforms without opposition, Wickremesinghe has been trying to form an all-party government but this has so far proved elusive. 12 Members of Parliament from the ruling coalition are now in opposition ranks.
  • Geopolitical Rivalry: As India stepped up with lines of credit and other financial arrangements, it also managed to push through long pending projects in the country, such as the development of the Trincomalee oil tank farm. It is alleged that the country was becoming “the meat in an India-China sandwich”.
    • Chinese has publicly berated a “third party”(read India) for pushing Sri Lanka to cancel a Chinese renewable energy project in three islands off Jaffna peninsula. India had raised concerns that Chinese project in close proximity to the Tamil Nadu coast can be security concern for India.
  • However, President Wickremesinghe described India as “the net security provider in the area”, and said “all other countries can also be present as long as it doesn’t lead to rising tensions or increase rivalry between states”.

Mains Practice Question – Is India regaining its foot hold in the Sri Lanka in the aftermath of the support provided to the island country during its economic crisis?

Note: Write answers to this question in the comment section.

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