Written by Kithmina V. Hewage.

Since the conclusion of a near three-decade-long conflict in 2008, Sri Lanka has experienced rapid economic growth, albeit at a cost. Heavy investments in infrastructure and state-led growth, facilitated by a debt-financed development strategy (funded mainly through Chinese loans), combined with weak performances in tax and export revenue, and foreign direct investment (FDI) flows has created fiscal instability and the need for significant reform. Since the election of a new coalition government in 2015 however, the country has shifted its focus towards liberalizing the economy and spurring growth through its export sector and FDI flows.

…the economic stakes of isolating China were too high and the government has since resorted to a more balanced foreign policy that attempts to positively engage both super powers equally.

The shift in focus on the economic front occurred concurrently with a shift towards a more cooperative and engaging foreign policy with international partners, especially those from western nations and India. Realistically, however, the island cannot afford to isolate China due to its existing economic linkages. Sri Lanka’s economic conditions combined with its current foreign policy objectives therefore require the island-nation to carefully curate a balance between China and India.

Debt, Growth, and Sovereignty

Sri Lanka’s fiscal position is one of the primary factors underpinning its economic and foreign policies. During the final stages of the war and its immediate aftermath, in the absence of traditional donors from OECD countries (due to allegations of war crimes), China filled a vacuum and financed Sri Lanka’s infrastructure development drive. For example, a new expressway between Colombo and the Katunayake international airport, the Hambantota Port Project, the Mattala Aiport, and several other infrastructure projects across the country were funded by Chinese loans. China became an even more prominent source of finance when Sri Lanka graduated to Middle-income status, disqualifying it from concessional finance. The government continued its state-led, infrastructure investment driven growth strategy by accessing loans at commercial rates from Chinese funding sources.

Sri Lanka’s external debt rose from $10.6 billion dollars in 2006 to a staggering $25.3 billion by the end of 2016. Approximately 13 percent of this debt, or $3.3 billion, is owed to China and almost all of it has been accumulated in the last ten years. Worryingly for Sri Lanka, at the same time as its growing debt, the state’s export sector has also performed poorly, due to a plethora of internal and external factors. Consequently, even though the economy experienced a short-term, post-conflict boom, it is currently facing a watershed moment in its macroeconomic position. Critically, in the medium-term, Sri Lanka’s external debt service repayments are bunched up between 2019 and 2022. The high risk of refinancing large volumes of external debt has, therefore, required better management of public finances.

To reduce its debt burden, Sri Lanka is currently pursuing debt-to-equity swaps by liquidating its assets. This has created further opportunities for China to be involved with Sri Lankan economic affairs. For instance, Sri Lanka recently agreed to a 99-year lease worth $1.1 billion by granting a Chinese state-run enterprise a 70 percent stake in the management and operations of the Hambantota harbour. The agreement has also provided an industrial zone for Chinese investments spanning 15,000 acres.

Growing Chinese influence in Sri Lankan economic affairs, and Chinese management of strategic assets such as the international harbour has created consternation among Indian policy makers. In response, therefore, Sri Lanka has attempted to create similar opportunities for Indian investments in the country. For example, the two countries agreed to pursue a joint venture to redevelop and operate an oil storage facility in Trincomalee. Similarly, some reports suggest that India is looking to pursue a similar investment opportunity to operate and manage the Mattala International Airport – situated just a few kilometres away from the Hambantora harbour.

FTA Trifecta

The Sri Lankan government has given prominence to negotiating a trifecta of comprehensive free trade agreements (FTAs) with India, China, and Singapore. These FTAs form a key component of the country’s national trade policy introduced in 2017. The Singapore-Sri Lanka FTA (SSLFTA) was the first to be signed among the three and was the first FTA signed by Sri Lanka for almost ten years. Notably, the chapters on investment and services trade are expected to be the lynchpins of this agreement to incentivise Singaporean investment into Sri Lanka. Moreover, the FTA recognises the need for Sri Lanka to diversify its basket of exports and its export destinations, currently overly dependent on the European Union and the USA.

On the other hand, the FTAs with India and China are mostly driven by an economic desire to increase market access for Sri Lankan exports. As a state with a population of just 21 million, Sri Lanka hopes that access to larger markets such as India and China through FTAs would increase the allure of the country as an investment destination, especially those looking to gain entry to these large markets. Concurrent negotiations with the two regional superpowers was also prompted by the political need to balance the interests of both states, rather than marginalising one at the expense of the other. Domestically, however, FTA negotiations with China and India face significant political pressures as protectionist special interest groups have somewhat successfully made use of a historic trust deficit with India and growing scepticism about China’s interests.

Balancing Interests

Under President Mahinda Rajapaksha, Sri Lanka’s foreign policy was heavily tilted in favour of China and in its infancy the current government attempted to renew relations with India and the west at the expense of China. However, the economic stakes of isolating China were too high and the government has since resorted to a more balanced foreign policy that attempts to positively engage both super powers equally. China continues to be a key financier of its development while India remains a vital regional ally.

There remains significant concern among the populace regarding a potential loss of sovereignty due to growing Chinese and Indian involvement. However, from an economic standpoint, combined with an outward-oriented development strategy, good relations with both countries is vital for Sri Lanka’s growth, both in terms of accessing larger markets and also as a source of investment. Therefore, the onus is on the Sri Lankan government to assuage fears, both local and foreign, by communicating its economic and political priorities in a manner that strategically benefits the country.

Kithmina Hewage is a Research Officer at the Institute of Policy Studies of Sri Lanka (IPS) and a member of the World Economic Forum’s Expert Network. The views expressed in this article are the author’s own and do not represent any organization to which he is affiliated. He tweets at @kvh0117. Image credit: CC by Nimal Skandhakumar/Flickr.

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