Sri Lanka Crisis | Why India has fared better than its neighbour

Sri Lanka’s biggest macroeconomic mismanagement was the central bank’s failure to handle the impossible trinity — the truism that a fixed exchange rate, free capital flows, and sovereign monetary policy cannot co-exist. It tried to maintain a soft peg with the US dollar alongside the other two arms of the trinity. A flexible exchange rate normally acts as a shock absorber in the face of an external crisis. Without this option, the central bank had to keep defending the peg, resulting in a sharp decline in forex reserves.

Colombo’s response was to clamp down on imports and keep borrowing overseas to meet its external obligations. But the loss of forex earnings from tourism (since the 2019 terror attacks, and later compounded by COVID-19-related travel restrictions) led to a sharp fall in the central bank’s forex reserves from $10 billion in 2019 to $2 billion at present.

During the same period, India’s forex reserves rose from $200 billion to $600 billion. A number of factors helped. The government’s multiple structural reforms and the Reserve Bank of India’s steady hand allowed foreign investments to flow in even during the pandemic. The central bank provided liquidity support to the economy during the pandemic, and allowed the rupee to depreciate as per market forces. A weaker rupee helped the competitiveness of exports, and also allowed remittances to keep flowing in. While India’s forex reserves have dipped in the past few months after the Ukraine crisis, it is still substantial enough to provide import cover of 11 months. In comparison, Sri Lanka’s import cover is barely of a few weeks.

Sri Lanka also missed reforming its economy when it should have. It has a whopping 527 public sector enterprises (PSEs) compared to India’s 277 central PSEs. India has been trying to reduce the inefficient public sector’s role in the economy, and encourage private investments. Sri Lanka’s approach has been to persist with a loss-making public sector. Its government has been plagued by corruption, and Transparency International places it at 17 ranks behind India on corruption perceptions.

While both countries have favoured infrastructure development in recent years, in Sri Lanka it attracts the highest FDI among all sectors, but in India it is not among the top five destination sectors for foreign investments. This skewed position of infrastructure in Sri Lanka meant that foreign capital (mainly Chinese) poured into a sector that could not generate commensurate returns. India’s balanced approach towards FDI that gives equal importance to services, IT, telecom, etc. and more recently electronics and pharma (under the production linked incentives scheme) has resulted in greater economic stability.

Finally, the straw that broke the camel’s back in Sri Lanka was the ban on import of chemical fertilisers leading to a collapse in food production. In India, while organic farming has been talked about, the approach has been to pilot it at a few places and not blindly plunge into it. India’s agriculture sector has been a source of strength during the turbulence of the last couple of years.

Three lessons emerge. First, economic policy cannot be complacent, and should avoid extravagance during good times. It is important to be always cautious, increase reserves, and build resilience against shocks such as COVID-19 or the recent surge in oil prices. Second, structural reforms are not a one-time option. India has done well to continuously reform the economy before, during, and after each crisis. Third, a well-diversified economy such as India’s is a strong bulwark against the unexpected.

Rudra Sensarma is Professor of Economics, Indian Institute of Management Kozhikode. Twitter: @RudraSensarma. Views are personal, and do not represent the stand of this publication.