• Low-interest regime outcome was total economic collapse
• Economic crisis was direct result of populist economic policies
• Slow growth recovery in the short run is the better option
• SL must prioritise nutrition, health, and education of children
• Poor households and middle class most impacted by taxes
• A stable economy without periodic shocks fosters growth
• Consumption cut-down is inevitable in an economic crisis
• The second half of 2023 was much better than 2022

Despite every stratum of society being in economic distress, there is no painless way out of the crisis, asserted Institute of Policy Studies of Sri Lanka (IPS) Research Fellow Dr. Asanka Wijesinghe, in an interview with The Sunday Morning.

“Before the current International Monetary Fund (IMF) Extended Fund Facility (EFF), Sri Lanka tried to maintain a low-interest regime, coupled with low taxes and artificially-low exchange rates. The outcome was total economic collapse,” he noted, emphasising that for a bankrupt country, a slow growth recovery in the short run due to strict fiscal policy was a better option than a continued fiscal imbalance, which would cause a much deeper output loss.

In this backdrop, even as people adopt various coping mechanisms, with consumption cut-down being inevitable, Dr. Wijesinghe called for the prioritisation of nutrition, health, and education.

“Sri Lanka’s growth potential is intricately tied to preventing child malnutrition and ensuring continuous education. Unfortunately, data shows that schooling has been affected by the economic crisis and parents are struggling to provide nutritional food for their children. The effects have not manifested right now, but the toll on Sri Lanka’s human capital will be visible in future,” he warned.

In the course of the interview, he also spoke on survival, revival, and reforms, as Sri Lanka prepares for polls – which will probably be preceded by populist promises – later in the year.

Following are excerpts of the interview:

2024 dawned with a series of key commodity price hikes. How will this impact people’s overall quality of life?

New taxes inevitably reduce the number of goods and services a person can purchase as, on average, income growth is currently weak. The poorest income groups spend a large portion of their income on food and basic amenities. This implies that the available space to absorb price shocks without sacrificing consumption is disproportionately narrower among poor households. 

The impact is not solely on poor households. Taxes on fuel and gas and the rise in transport costs and amenities like water might affect the middle class more as they consume these goods and services more. Special commodity levies have been imposed on various food items like imported fruits and dairy products. The middle class consumes them more. Overall, taxes have a direct negative impact on the quality of life as disposable income – available money after paying taxes – goes down with the rise of tax. The outcome is a reduced life quality. 

There is another layer to this question. Sri Lanka plunged into a deep economic crisis post-2019. Reduced Government revenue that caused credit downgrading and an external debt default, a contracting economy, and galloping inflation were the manifestations of the crisis. Increased Government revenue became a precondition for economic stabilisation and sustainable growth trajectory. There is a consensus on this among economists.

If revenue is high enough to achieve debt sustainability and deliver vital Government services like education and health, the Government will not need to borrow excessively or print money. Suppose that inflation is anchored through a person paying more tax. Then, the net income effect can be positive. A stable economy which does not encounter periodic shocks like we faced in 2022-2023 fosters growth. In the long run, the growth effect can be positive. 

There has been a continuing decline in people’s purchasing power since the economic crisis began. How can people tighten their belts further and in which areas do you see them making sacrifices to make ends meet?

This is a challenging question. In an economic crisis, people adopt various coping mechanisms. Consumption cut-down is inevitable in a crisis. However, nutrition, health, and education of children should be a priority. Sri Lanka’s growth potential in future is intricately tied to preventing child malnutrition and ensuring continuous education. Unfortunately, data shows that schooling has been affected by the economic crisis and parents are struggling to provide nutritional food for their children. The effects have not manifested right now, but the toll on Sri Lanka’s human capital will be visible in future.

The Household Income and Expenditure Survey (HIES) data for 2022 is still not available. This dataset will provide rich information on the effect of the economic crisis on consumption. However, researchers have done surveys which are small in sample size compared to HIES. The Department of Census and Statistics (DCS) recently released a report based on a household survey it conducted. These surveys show that people have reduced consumption or followed various coping strategies. 

Evidence exists of a drastic cut down of meals and food items like fruits. The consumption of meat, fish, eggs, and dhal has also decreased. The DCS survey shows households falling into indebtedness, postponement of medical treatments, and impact on education. These observations are consistent with international research evidence on households’ coping mechanisms in economic shocks. 

The worry is about the households that are already sitting on the threshold of poverty lines. They live paycheck to paycheck or experience wide income fluctuations if they are in the informal sector. There are only a few coping mechanisms at their disposal, rather than cutting down consumption. They are dragged down below the poverty line. 

Given the current economic conditions, can there be any improvement in the foreseeable future? When will the people experience any relief?

Compared to 2022, the second half of 2023 was much better. We saw a stabilisation of the economy. Inflation was brought down and interest rates also dropped. More importantly, sudden shoot-ups of the exchange rate which affected the price of imported goods were controlled. 

The rupee gained some value. Statistics show that GDP contraction stopped and started to grow. Sri Lanka could build some foreign reserves and maintain the required imports. Changes in the exchange rate regime and the influx of dollars from multilateral institutes like the IMF acted as a positive feedback loop, increasing remittances.

At the moment we can see that an economic catastrophe, a much worse one than Sri Lanka experienced in 2022 and in the first half of 2023, has been averted. It is a significant improvement. What if inflation continued to be 70-75%? Or if GDP continues to plummet? We have seen such countries in the world. 

One can say that people are not experiencing an improvement in life quality or are worse off compared to pre-2019. For example, prices are high in the market; even meeting the basic needs of life is an excruciating task; imported fruits and other food items are sold at exorbitant prices and the tax burden is heavy. If you want to buy a car, it is impossible given the import restrictions. 

Every stratum of society is in economic distress. Sri Lanka had to embark on cost-reflective pricing for basic amenities and fuel. Sudden exchange rate corrections also increased the price of goods and services. Some of these price adjustments were long overdue and one-time. When income starts to catch up, people will realise improvements in their living conditions. 

Households will realise an improvement in the sense of growth from the 2019 level if Sri Lanka maintains positive GDP growth in the coming years from 2024. If a 5-6% growth rate is maintained, the 2027-2030 period will bring some relief to Sri Lanka. Such positive growth in the medium term will be necessary to bring a noticeable improvement in households’ consumption and income. 

How will the drop in quality of life and declining purchasing power impact the overall economy?

Let’s take high inflation, which reduces purchasing power. High inflation and policy responses to anchor inflation increase the borrowing cost of firms and individuals. Research evidence shows that rising inflation has a contractionary effect on bank lending. The outcome is that economic activities are suppressed.

For example, reduced lending may affect housing construction and construction employment. These negative shocks are transmitted throughout the economy through linkages. Reduced life quality means reduced consumption. It affects the producers. 

A drop in quality of life prompts outward migration, generating long-term negative economic impacts. Mass migration of skilled professionals and mid-level managers erodes the country’s economic potential, given that Sri Lanka is not open to foreign professionals. The shortage of the required skills will put Sri Lanka in a low equilibrium of growth. 

How can some of the key sectors like goods and services and manufacturing survive amid these conditions?

Export-oriented manufacturing survived well in the economic crisis. Labour Force Survey data shows that employment and wages in export-oriented sectors like the ready-made garment industry were less affected in 2022 than in sectors like food, which cater to domestic demand. 

Export-oriented manufacturing does not depend on domestic demand, which plummets in a domestic economic crisis. Thus, in the long run, as an economy, Sri Lanka should produce for foreign markets. 

In response to the current crisis, firms will attempt to cut costs to be price competitive. They may attempt to cut wages, reduce working hours, and avoid overtime. However, increasing the efficiency of resource use would be the most viable solution to be price competitive. 

Basic services like education and health are mainly Government-funded. This is not a time to reduce the quality of these provisions. For example, students should be in school to acquire skills to be competitive workers in the future. People should be able to get timely medical treatments. People pay taxes now and Government revenue is rising. That revenue should be wisely allocated for education and health services. 

Aren’t the IMF conditions on revenue generation and the burden placed on the people at odds and in fact counterproductive when it comes to economic revival?

The given target is to achieve a surplus in the primary account; the primary account balance is revenue minus expenses without interest and loan payments. 

Sri Lanka can do two things. One is revenue consolidation or increasing Government revenue through taxes. The second is expenditure rationalisation or, in simple terms, cutting down expenditure. Sri Lanka’s tax revenue reached a historical low post-2019 due to ambitious tax reforms. Thus, it was necessary to increase Government revenue. 

Expenditure rationalisation takes time. For example, reducing wastage in the welfare system will take some time. Restructuring State-Owned Enterprises (SOEs) is similarly an excruciating task. This, coupled with low revenue generation, prompted revenue-based consolidation measures. 

Notably, administering an income tax on salaried workers is administratively easy and efficient. Whether there was an IMF condition or not, revenue increase became an inevitable requirement for the State post-2019. 

Theoretically, high levels of taxes might be counterproductive for economic growth. What is our comparison point? Restrictive fiscal policies indeed reduce economic growth. However, reduced economic growth might still be better than a catastrophic output loss caused by shocks from fiscal imbalances.

Before the current IMF EFF, Sri Lanka tried to maintain a low-interest regime, coupled with low taxes and artificially-low exchange rates. The outcome was total economic collapse. 

All in all, my understanding is that for a bankrupt country, a slow growth recovery in the short run due to strict fiscal policy is a better option than a continued fiscal imbalance, which causes a much deeper output loss. A slow growth recovery based on strong fiscal and monetary policies will pave the way for a sustainable high-growth trajectory in future. 

While it is important to make difficult policy choices in order to emerge from the crisis, how can the most vulnerable segments of society be protected amid such harsh conditions? How can we prevent more people sliding into poverty?

Targeted income support is the way forward in the short run. There should be income transfers to such households, enabling them to meet minimum caloric consumption. There are mechanisms in place now, though they are not perfect. The long-run effects of the economic crisis are much more severe. 

As I said earlier, it is imperative to maintain efficient and quality provision of education and health. People should not doubt the quality of these provisions as, under economic constraints, the propensity to drop out of schools, give up higher education, and postpone important treatments might be higher. Red flags on quality and inefficient service provision nudge these bad outcomes. 

The State has a significant role now. It is imperative to use tax money and provide high-quality education and health, otherwise the growth potential of Sri Lanka is at stake. Inequality and wealth gaps will rise in the long run as vulnerable communities drop out of the education system, which is the most important factor in upward social mobility.

Exams should be held on time, students should be given subsidies for transport as transport costs are much higher now, school meal programmes should be in place, and, in higher education, degrees should be completed within the due period.

There are many factors like high transport costs, lack of food, lack of stationery and shoes, and prolonged school and college duration due to disruptions that stop a child from going to school or force a university student to drop out. 

Will all these austerity measures help or hinder the lives of the people in the long term, given the massive impact on education and health and increasing migration? 

Revenue consolidation is necessary for long-term growth, although it decreases the present consumption level. Unfortunately, there is no painless way out of the crisis. Education and health sector funding depends on Government revenue. Fortunately, we do not see drastic funding cuts or mass layoffs in these sectors.

Some countries respond to economic crises by vastly reducing government provisions and services. See what is happening in Argentina. Austerity is something like that. Sri Lanka is not witnessing full-blown austerity as the country is keen on maintaining health and education provisions, producer subsidies like fertiliser subsidies, and basic income support. The State is still a major provider of employment. Austerity means dismantling most of these.

Mass migration from a bankrupt country which witnesses economic contraction is not abnormal. A positive growth in future will bring migration to a better equilibrium. Current reforms should continue if we want to see such a future. 

Do you see the public mood remaining pliable in the face of economic hardship, especially with elections coming up?

It depends on how the electorate compares the present economic conditions. If they compare the present with 2022, they will take the future of the reforms into account in the voting decisions rather than in a scenario of comparison with pre-2019. The election campaign trails will heavily focus on framing this comparison point. 

No matter who is in power, reforms are essential for economic revival. Do you see this being taken onboard when it comes to election campaigns, manifestos, and promises?

There is an opportunity for populist promises. That is the way politics works. However, significant deviations from the current reform schedule without risking a deeper economic crisis are extremely unlikely.  

If the political actors are sensitive to the economic realities, the populist promises will be toned down. They might do a cost-benefit analysis of resorting to populist politics as economic realities constrain their delivery. Such a gap costs politically in future. 

In addition, economically-informed voters, despite the reduced consumption now, have the incentive to scrutinise any populist promise, given that the economic crisis was a direct result of the prolonged populist economic policies.