Sri Lanka’s economy hemmed in by COVID-19 and geopolitical tensions

The unprecedented disruptions of COVID-19 are causing a geopolitical reset — and as the global order is redrawn, small emerging market economies like Sri Lanka are vulnerable to the fallout. Sri Lanka straddles vital shipping routes and is at the centre of diplomatic spats between China and the United States, who called on Sri Lanka to make ‘difficult but necessary choices’ over its growing economic and political ties to China.

In December 2020, a US grant offer of US$ 480 million under its Millennium Challenge Corporation was withdrawn and any further assistance under the US Coronavirus Aid, Relief, and Economic Security Act has been made conditional on Sri Lanka containing China’s influence. China in turn denounced what it considers as US pressure on countries ‘to pick sides’. The challenges are many for Sri Lanka’s newly elected government to sidestep global rivalries and maintain its stated stance of a neutral foreign policy.

The economic fallout of the COVID-19 pandemic is not helping. Sri Lanka’s economy was already weak, weighed down by persistently low growth averaging under 3 per cent, high public debt nearing 90 per cent of GDP and large fiscal deficits of near 7 per cent of GDP at the end of 2019. With foreign debt settlements averaging US$4 billion per year due in 2020–2023 — primarily in the form of international sovereign bonds — Sri Lanka’s ability to implement fiscal and monetary stimulus, without generating further macroeconomic imbalances, is severely constrained.

Sri Lanka had early success in battling COVID-19, recording only 3000 cases and 11 deaths by the end of September 2020. This helped to revive economic activities. But a second and more severe wave of infections has seen those numbers spike sharply to over 43,000 infections and 204 deaths as the year drew to an end.

Dealing with Sri Lanka’s foreign debt settlements remains the most critical priority for now. Despite sovereign credit rating downgrades, the government remains confident of meeting all repayments without resorting to a conditional arrangement with the International Monetary Fund. This is in keeping with the government’s stated intentions of moving away from foreign loans to foreign investment, with the latter already earmarked to raise an estimated US$2.5 billion in 2021. For Sri Lanka’s debt-burdened economy, the strategy makes good sense. Yet it will also pose fresh challenges in dealing with rivalries closer to home, such as that between China and India.

While the Chinese debt trap narrative can be disabused, China does remain Sri Lanka’s largest bilateral creditor, owning 9.6 per cent of total outstanding foreign debt at the end of 2019. India’s share is a much smaller 2.4 per cent. Sri Lanka made an early appeal to both countries to provide debt relief and hard currency to shore up its foreign exchange reserves. China and India responded swiftly and positively — China granted a US$500 million loan top up and India provided a US$400 million swap arrangement. Sri Lanka is reportedly seeking an additional US$2.5 billion swap funding from both.

Such assistance will not be devoid of China and India’s competing interests. Sri Lanka will have to look at its past missteps in balancing their regional interests and avoid a repeat. Indeed, China’s pervading presence and India’s response to it is acknowledged by Sri Lankan Prime Minister Mahinda Rajapaksa himself as a key factor behind his unexpected presidential election defeat in 2015.

This time around, Sri Lanka is emphasising an Asia-centric outlook in its political, economic and strategic positioning. Tellingly, it also assures an ‘India first’ strategic and security policy within this realignment. How it will work in the harsh light of Sri Lanka’s economic reality is yet to be determined.

For now, Chinese investments into Sri Lanka are speeding ahead. The China Harbour Engineering Company (CHEC) that built the Colombo Port City signed its first US$1 billion agreement in December 2020. This was on the back of approval to set up a US$300 million Chinese tire factory in close proximity to the Hambantota Port. At the same time, a decision on whether India will be allowed to operate a terminal at the Port of Colombo that the previous government had agreed to is still pending, despite a recent high level visit by the External Affairs Minister.

Balancing these tensions and trade-offs will test Sri Lanka’s political and diplomatic skills. Fresh hostilities between China and India on renewed border conflicts, India’s decision to withdraw from the Regional Comprehensive Economic Partnership negotiations — which China played a leading role in — and rising battles over technology all point to a hardening geopolitical stand-off. In this environment of escalating big power rivalries and unrelenting pressure on the economy from COVID-19, 2021 promises to be yet another testing year for Sri Lanka. This is particularly so as the global economy and international power relations are being reset in fundamental ways.

*Dushni Weerakoon is the Executive Director and Head of Macroeconomic Policy Research at the Institute of Policy Studies of Sri Lanka.