Sri Lanka’s Credit Crunch

The island is paying a steep price for a turn against democracy.

May 30, 2016

Sri Lanka sought a $1.5 billion bailout from the International Monetary Fund last month after saddling itself with billions of dollars in Chinese loans. This is a reality check for reformers who hoped that last year’s election of the liberal-minded Maithripala Sirisena as President would alleviate fiscal woes.

Sri Lanka’s economic growth slowed to 4.8% last year after averaging near 7% under former President Mahinda Rajapaksa. Investors are running for the exits, selling $577 million in rupee bonds in the first quarter. The central bank depleted foreign-exchange reserves by a third to keep the rupee from plunging, while exports and remittances dropped.

Much of the blame lies with Mr. Rajapaksa. He appointed three of his brothers to head important ministries while leading the finance, defense and public-works ministries himself. Together the brothers controlled 70% of Sri Lanka’s budget. A Rajapaksa crony directing the central bank fueled public spending by printing money and driving inflation to around 15%.

China proved a willing partner on the Rajapaksa family’s designs. Eager for access to Sri Lanka’s ports, Beijing filled the funding void left by the U.S. and longtime ally India during the island’s decades-long civil war. In 2007, Mr. Rajapaksa signed a $1.5 billion deal, amounting to nearly 2% of GDP, to construct an airport and port near his hometown of Hambantota. Chinese companies China Harbour Engineering Company and Sinohydro Corporation built the main port facilities.

But the Chinese credit came with high interest rates and minimal safeguards against misuse. Sri Lankan officials now say that the Hambantota projects began without sufficient analysis or competitive bidding. The airport stopped offering regular flights three years after opening, and the port now sees less than one ship per day. Other projects include a $21 million national performing-arts theatre, $104 million telecommunications tower and a $1.4 billion port city in Colombo. Chinese loans total $8 billion, representing nearly 10% of GDP.

After the opposition accused Mr. Rajapaksa and his family of receiving kickbacks, allegations they denied, voters drove him out of office last year. Now the authorities say they are trying to retrieve billions of dollars in Rajapaksa wealth abroad.

All of this means that the current administration has inherited more rot than it initially suspected. Sri Lanka’s foreign debt tripled to 94% of GDP from 2010 to 2015, and interest payments on Chinese debt alone cost $30 million per year.

The new government wants to privatize some state-owned enterprises, which hold an estimated $15 billion in liabilities, and slash subsidies for electricity and fuel, as it recently did for flour and fertilizer. It also wants to simplify the tax system by eliminating exemptions, holidays and special rates, while implementing information technology to curb discretionary tax measures.

But Colombo’s decision to raise the value-added tax to 15% from 11% will hurt businesses. A better alternative is tackling government corruption and stopping tax evasion.

The lesson from Sri Lanka’s problems is that rule by strongmen like Mr. Rajapaksa may accelerate growth in the short term but have terrible consequences later, as the bill for grandiose projects and nepotistic business practices comes due. There’s a warning here for other states seeking to exchange democratic accountability for the promise of authoritarian efficiency.