COVID-19 outbreaks likely to wane growth momentum

A deterioration of the health situation in the second half of 2021 due to delays in vaccination pushed the government to impose containment measures from October. The vaccine rollout has experienced delays due to shipment suspensions from India grappling with the Delta variant in May 2021. This economic drag could persist for at least the first half of 2022. While the three major GDP components – Agriculture, Industry, and Services – have recorded expansions from a low base, the economy has not reached pre-COVID-19 levels. The manufacturing sector (15.5% of GDP) should continue to improve and has been supported by strong external demand from its major trade partners (U.S. and Europe), notably for textiles (50% of exports). However, PMI figures have shown the industry’s vulnerability to factory disruptions linked to the spread of COVID-19 among employees, hampering production and employment. Unemployment remains high and weighs on household consumption (70% of GDP). Agriculture (8.3%) has been highly affected by the government-approved ban on chemical fertilizers and agro-pesticides imposed in April 2021. Although it was removed a few months later, farmers would face difficulties in 2022. Still, the government will not reinstate subsidies for chemical fertilizers to promote organic agriculture. Tourism (11% of GDP) is unlikely to recover anytime soon due to the border restrictions: tourist arrivals dropped by 61.7 in 2021 compared to 2020. To support the recovery, the government extended the coronavirus debt moratorium until December 2021, especially for the tourism industry. However, the central bank signaled monetary policy tightening in August 2021 and January 2022 by increasing the deposit and lending facility rates to 5.5% and 6.5%, respectively, due to intense inflationary pressures, which will constrain lending.

Public finances in distress 

With a wide deficit, Sri Lanka’s public finances should remain weak and, thus, face tighter external financing conditions. Public debt is sky-high and weighs on the budget: over 70% of government revenues were spent on interest payments in the first half of 2021. External dependence is high: half of the debt is denominated in foreign currencies and therefore exposed to an increased risk of depreciation. The main creditors are China (10% of debt stock), ADB (13%), Japan (10%), World Bank (9%), and Market Borrowings (47%). Foreign exchange reserves got low (1 month of imports as of October 2021) after the repayment of international sovereign bonds. This prompted the government to obtain a currency loan from China and currency swaps from Bangladesh and India in 2021. The special drawing rights (SDR) allocation from the IMF (USD 797 million) also temporarily mitigates the depletion of foreign exchange reserves. They should remain in distress as other bond repayments are scheduled for 2022. An increase in workers’ remittances (8.8%GDP) and exports, which reached pre-COVID-19 levels in 2021, should continue to offset the impact of weak tourism revenues on the current account. The trade balance should remain in deficit, as exports have not recovered as fast as imports, despite indefinite import restrictions to mitigate the foreign exchange crisis. 

The Rajapaksa clan consolidates its power 

Gotabaya Rajapaksa, popular for ending the civil war in 2009, has ruled since 2019. His nationalist and security agenda is symptomatic of the persistent ethnic tensions in Sri Lanka: he had the support of the Sinhalese ethnic majority but received few Tamil votes. Parliamentary elections in August 2020 resulted in the victory of Sri Lanka Podujana Peramuna (SLLP), the President’s party, which secured a two-thirds majority. The appointment as prime minister of his brother and former President Mahinda Rajapaksa, who had adopted a nationalist, centralist, and authoritarian line between 2005 and 2015, has raised fears that the previous government’s achievements in terms of corruption, separation of powers, and press freedom would be reversed. The SLLP passed the 20th Amendment on October 2020, expanding the President’s immunity and allowing the President to appoint anyone to the government without approbation from the parliament: Rajapaksa appointed his brother as Finance Minister, tightening the family’s grip over power.

Externally, the Rajapaksa clan is under international scrutiny. The Office of the UN High Commissioner for Human Rights was mandated to collect evidence of crimes during Sri Lanka’s civil war, which ended with defeating the separatist Tamil Tigers and a spate of civilian deaths. Relations with China may deepen again in the coming years. For instance, China is heavily involved in Sri Lanka's development of the Colombo Port City Economic Commission Act. However, the question of dependence on this financing arose: the authorities failed to repay and were forced to cede the port of Hambantota to China for 99 years in 2017.