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Is Sri Lanka the Next Argentina?

Sri Lanka has long been prone to macroeconomic instability as a result of its deep social and political divisions. If the country's newly elected president, Gotabaya Rajapaksa, pursues policies that perpetuate these divisions, macroeconomic stability will remain elusive.

CAMBRIDGE – As Sri Lanka makes another crucial political transition, it faces a major risk of macroeconomic instability. Minimizing that risk will depend, above all, on whether the country’s newly elected president, Gotabaya Rajapaksa, can defy his reputation and embrace inclusive politics.

This idyllic island in the Indian Ocean was once a star performer. In the years following independence in 1948, progress on leading social indicators such as poverty, infant mortality, and primary education put Sri Lanka well ahead of its neighbors – India, Pakistan, and Bangladesh – and was the envy of much of the developing world. But, for several decades now, divisiveness and conflict have been the serpent in this paradise.

As a result, Sri Lanka has been strikingly prone to macroeconomic instability. According to data compiled by Carmen Reinhart and Christoph Trebesch, the country has spent nearly 70% of the last four decades in macroeconomic stabilization programs with the International Monetary Fund. In South Asia, only Pakistan has spent a greater proportion of this period under the IMF’s supervision. Bangladesh has had Fund programs around 50% of the time, and appears to have graduated from IMF tutelage in 2015. And India has had IMF programs only about 15% of the time, and none since 1995.

Macroeconomic instability reflects deeper social and political factors. According to the late Albert Hirschman, one of the leading thinkers on economic development, “It has long been obvious that the roots of inflation ... lie deep in the social and political structure in general, and in social and political conflict and conflict management in particular.” Even Milton Friedman, who famously said that inflation was “always and everywhere a monetary phenomenon,” conceded that it had deeper social causes.

Essentially, macroeconomic pathologies arise from conflicts over how to divide the economic pie. Unless these conflicts are resolved, they lead to unsustainable fiscal deficits, excessive foreign borrowing, inflation, and exchange-rate instability. Latin American macroeconomic irresponsibility, exemplified by Peronism in Argentina, involved favoring urban and government workers. Sub-Saharan Africa’s periodic crises, meanwhile, often reflect ethnic and regional conflicts. More generally, Dani Rodrik has shown that external shocks give rise to macroeconomic instability when a society’s mechanisms for burden-sharing do not work effectively.

Sri Lanka suffers from cleavages along many different lines, notably ideology, ethnicity, language, and religion. Michael Ondaatje’s gorgeously sensitive novel, Anil’s Ghost, captures the human, personal consequences of these conflicts.

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Arguably, Sri Lanka’s original sin was the assertion of linguistic dominance in enshrining Sinhala as the only official language in the 1956 constitution. By the 1970s, Sri Lanka was facing a communist insurgency. Then came the decades-long ethnic conflict involving the Tamils, which nearly tore the island asunder. After that war’s brutal conclusion in 2009, religious cleavages came to the fore, reflected in the Easter bombings earlier this year by Islamic extremists.

These conflicts have exacted a heavy economic toll. Societies with stable social and economic compacts between citizens and the state tend to have healthy rates of tax collection, reflecting a broad willingness to share the burden of paying for the services the state provides. But in Sri Lanka, the ratio of tax revenue to GDP is less than 12%, with income taxes accounting for less than a quarter; these are extraordinarily low figures given the country’s relative prosperity.

This revenue was manifestly insufficient to cover the government’s spending needs, especially toward the end of the civil war and afterwards. Sri Lanka therefore embarked on a binge of foreign borrowing in the early part of this century, propelling its debt-to-exports ratio to a whopping 270%. Moreover, this debt has become increasingly onerous, with the share of non-concessional borrowing rising from about 25% to close to 70%. The debt has already proved unmanageable, and Sri Lanka has had to pay a humiliating price, handing over the Hambantota port and land to China in order to settle some of it.

A final factor adding to Sri Lanka’s vulnerability has been a sharp deceleration in export growth since 2000, well before the collapse in world trade. In fact, Sri Lanka was deglobalizing for nearly a decade while the rest of the world was hyper-globalizing. That, too, was related to social conflict.

It remains to be seen what political direction Sri Lanka will take under Rajapaksa. But if the government pursues non-inclusive policies, this almost certainly will lead to weak resource mobilization, continuing dependence on external financing on onerous terms, low rates of foreign direct investment, and stagnant export growth. In these circumstances, macroeconomic stability will remain elusive.

The challenge for Sri Lanka’s new president is as simple as it is stark: to prevent South Asia’s one-time Scandinavia from becoming its Argentina.

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