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Nathan Hunt: This is the Essential Podcast from S&P Global. My name is Nathan Hunt. Last November, Talal Rafi, an economist at the Deloitte Economics Institute came on the podcast to talk about Sri Lanka. At the time, an economic crisis had precipitated a political crisis in the island nation.

A series of decisions by the government of former President, Gotabaya Rajapaksa had devastated the economy and Rajapaksa was injected from office following mass protests. The new President, Ranil Wickremesinghe negotiated a bailout from the International Monetary Fund. But so often in the fund's history, the money came with conditions attached. Today, I welcome Talal back to the broadcast to discuss the latest economic developments in Sri Lanka. Talal welcome back.

Talal Rafi: Thanks a lot for having me, Nathan. It's nice to be back on the show.

Nathan Hunt: Talal, when we last talked about Sri Lanka, the situation was quite grim. For the benefit of our listeners, can you review the causes of the crisis that led to the downfall of the former government?

Talal Rafi: So everything started off with the famous 2019 tax cuts. So let's remember that Sri Lanka had one of the lowest government revenue to GDP ratios in the world at 12% in 2019. But after the tax cuts, it came down to 8%, which makes it one of the lowest in the world. This immediately led to the rating agencies downgrading Sri Lanka as a nation lost access to capital markets.

And so this was a time when we were out of the capital markets with no access and then COVID hit. So our 3 main sources of foreign exchange earners were, tourism, remittances from Sri Lankan workers working abroad usually mostly in the Middle East and exports. So mostly the garment industry.

So tourism, remittances and exports were all three affected. So Sri Lanka was in a pretty bad situation. At the same time, another policy failure was the fertilizer ban. The Sri Lankan government decided to change the entire country's agricultural system into an organic system within 24 hours. So that was disastrous, which led to agricultural production going down by almost 50%.

And another policy disaster was Sri Lanka, as we know, now Sri Lanka being looked at as a textbook example of where the Modern Monetary Theory was put into practice. So the Central Bank went on a printing spree because they lost access to -- the government lost access to international capital markets. And right now, it was -- the money base was almost expanded by 62%, which started to heap the inflation.

And this was at a time that the Sri Lankan government picked rupee to 203 rupees for a U.S. dollar. So when there was so much pressure going on, basically, what they did was by trying to hold this here, they were losing of precious reserves. So from a reserve high of around $7 billion in 2019, Sri Lanka came down to just USD 50 million when it defaulted.

So what happened was once the Central Bank floated the rupee it went into a free fall from almost 203 rupees to 360 in a very short time span. So another policy mistake was also not engaging the IMF early on because many experts as early as 2020 itself said the country should be going to the IMF because the debt was unsustainable.

So the government held it off for two years, making the situation absolutely worse and going in at the last minute. So this was just a run-up of very short-term policies that were taken, decisions taken by the previous government. But let me touch on to some of the structural issues. I mean, they also play a major role.

Sri Lanka has had a very long history of large fiscal deficits. So even if you look at a primary budget surplus, we've only attained that four times since 75 years. So that's how bad the financial discipline of Sri Lankan governments have been over seven decades. So mostly, it's been, one thing has been monetary financing, basically the Central Bank printing money and lending to the government or giving to the government. And so this has led to Sri Lanka consistently having higher inflation rate when compared to countries in the rest of the region.

So this also results in higher interest rates. As you know, interest rates have to be positive. I mean, for the real interest rates to be positive. So making the borrowing costs higher. The other way was also through debt, external borrowing and internal borrowing mostly from the local banks, which led to a crowding out effect.

So the private sector couldn't borrow because most of the money was being borrowed by the government. This was one thing. Second was populous policies, subsidies, many political parties came to power, promising subsidies like free rice, bread at a very low price, an increase of around 10,000 rupees for government service, free fertilizer, tax cuts. When political parties used this added to Sri Lanka's debt burden.

And also, we had a very bloated public service. Back in 2021, 86% of government revenue went to paying salaries and pensions of public sector workers. So that's a huge amount. For a country of 22 million, there are 1.4 million public sector workers. So this is huge and unsustainable. And the other thing is also protectionist policies. From '77 lower, the first country in South Asia to open its borders to liberalize its economy.

But after 2005, we saw a shift towards import substitution. So this led to a downfall of exports, so which started adding to Sri Lanka's debt repayment issues. As we had the most -- almost all the debt is in U.S. dollars. And lastly I would say, inconsistent policies. One of the things any businessman in Sri Lanka complains that every year or two policies have changed, tax rates are changed. Sometimes ministries, themselves are changed very frequently. So these all added to Sri Lanka defaulting last year. So this is just a summary of how we got here.

Nathan Hunt: There's a lot that's really interesting in that background you just gave me. Some of the stuff you're talking about, this is not unusual for emerging markets. What you have is deficit spending, you have political systems that are not necessarily thinking in terms of the long term, but are thinking in terms of the next election.

But you've also got a set of rather extremist ideas that have their followers but don't necessarily get adopted in the mainstream. So like very deep tax cuts in order to generate growth. You've got Modern Monetary Theory, which it tends to come up on this podcast very frequently and people are usually pretty dismissive at least mainstream economists like yourself are pretty dismissive of this. And then you've got organic farming. All of these feel like these weird quick-fix solutions to a larger underlying problem. If you were to define that underlying problem, what would it be?

Talal Rafi: If I can underline like, I mean, all three things, like I say, for example, if you look at the U.K., we had [ list trust ], so [indiscernible] (00:07:59) tried to bring in a very similar system. But then within, I think, around 6 weeks, she was ousted out. So the key difference here is the strong institutions.

So you see that U.K. has very strong institutions. So even with President Donald Trump, I mean people have done a lot worse, but they have very strong institutions that keep them in power. This was in a book that I just read, my last book was a professor on economics at MIT.

So he has written the key thing by nation sale is institutions. So lack of institutions will be the key thing. And also when there are lack of independent institutions, it leaves too much power in the hands of politicians and also a lack of democracy because most of the worst policy decisions were made in the previous government.

So that was also a time when the President took on too much power on teams after the 20th amendment. So basically, there was nobody to question the president. So I feel that all three issues you mentioned, the tax cuts, which were very not wise at all and Modern Monetary Theory, I mean, just it's been an absolute disaster for Sri Lanka.

I mean inflation hitting almost 70% to 80%. I mean now it's come down, but that was the peak. I mean, we could have become another Zimbabwe, but we have been saved. And organic farming, I mean, it's ridiculous. I mean, Bhutan had a 12-year program to become organic. And after 12 years, it failed. And now they've put another, I think, a decade long program to become organic. I mean, trying to change an entire country of 22 million into an organic system within 24 hours.

I think that lack of institutions and also too much collected power, which also mean that even knowledgeable advisers would have felt a bit intimidated to put themselves in front and give the correct advice. So I think institutions and lack of democracy and right thinking would be the reasons. I mean, this is my personal opinion. Yes.

Nathan Hunt: So Talal, I was reading a recent commentary by someone at Verite, I know you're familiar with them. And they were basically looking at the situation in Sri Lanka and saying that the fundamental problem is, as you say, governance, yes, but they were also drawing out corruption as an ongoing problem. How important do you think corruption is in holding back the Sri Lankan economy versus the just sort of the traditional good government democracy, where does that fit for you?

Talal Rafi: So I think that corruption plays a major role, but I also want to say that there are certain countries that are, especially in Transparency International's ratings lower than Sri Lanka on the ratings on corruption, but doing better. But corruption plays a major role here as well.

I mean that's one of the things that -- a key thing that is highlighted by the International Monetary Fund as well. I mean they are trying to do a sort of a diagnostic on corruption. I'm not the expert on corruption.

So that is something that's seen as key because corruption does not just mean that taking money or involved in practices where money is taken out of the system for personal gains. It's also the kind of decisions that are made, policies that can be changed. So this, in my opinion, play a larger role. That's why the IMF itself in its report has mentioned that as a key priority.

Nathan Hunt: Okay. So when you were on last time, we had set up some of the issues that had precipitated the political crisis in Sri Lanka. Since then, what is the current economic and political situation in the country?

Talal Rafi: Yes. So currently, we are nowhere out of the woods. But I just try to be as optimistic as possible, I try compare to last year. So things are much better. So currently, there is sort of what we can call macroeconomic stability. So that's coming back. Inflation is going down from a peak of around 70% to 80%. It's come down to the 20s.

So that's a big thing for a country like this. And so with that interest rates have also come down. I mean policy rates have been brought down by 250 basis points by the Central Bank. And so -- but still, there is a gap between the market rates that is due to uncertainty around the -- surrounding the domestic debt optimization as they call it.

But at the same time, other things are flowing through. I mean, tourism, there's a huge pickup. Remittances from workers are coming in and foreign aid, especially from multilateral players and also foreign inflows into T-bills because you see T-bonds are still, there's not much clarity from the government about how it's going to be restructured.

But T-bills, the government has clearly said that only the T-bills owned by the Central Bank will be restructured. So that's amounting around 62%. So that may be a reason why foreigners are investing, flows are coming into T-bills. But at the same time, you see exports have declined. I mean the export sector in Sri Lanka is largely dominated by the garment sector, apparel sector.

So there is a dip by around 25%, but that's largely due to the economic slow growth in the U.S. and EU. Those are our main markets as far as garments goes. But at the same time, I think other things the government is kind of on the right path. And hopefully, we can attain it because if you look at it the IMF program, the targets, mostly it's fiscal consolidation.

So they want a primary budget surplus of 2.3% by the 2025. So right now, we are at minus 4% deficit. So a 6% fiscal consolidation in the next two years. It's very challenging. But I think -- the government is moving more towards a revenue-based fiscal consolidation. So gross financing needs from 34% to 13% by 2027 to 2022.

So with the bulk of the government's payments coming for T-bills, which have very high yields, I think one that's over those would be coming down. And also public debt, which is at 128%. So the target is to bring it down to 95% in the next 10 years. So with the external and domestic debt restructuring happening, hopefully, we can get this right.

And as they say, on average, a country which defaults has to restructure twice within the next 10 years. So hopefully, we restructure it properly so that we don't have to ever go into restructuring again.

Nathan Hunt: So I think it's important to clarify for our listeners that when the IMF offers a bailout, and in this case, I believe it was for $3 billion, they don't give billion right away. They basically give an initial disbursement of money and then they say, 6 months from now based on progress against certain targets, and these are the things you're talking about. We'll give you more money and then 6 months after that.

And so there is always basically this pressure on the government and on Sri Lankan society to meet the challenges that the IMF is setting up. Now we can be fundamentally in sympathy with what the IMF is asking the Sri Lankan government to do, but this is going to be challenging at the individual level.

What are going to be the effects on the Sri Lankan economy in the short term. Long term, obviously, better governance is a good thing. But what will be the short-term effects to the conditions that the IMF has put on this bailout.

Talal Rafi: So the short-term effects, it's going to be a tough pill to swallow. As you know, at this time when growth is last year itself, there was a contraction of around 7% and even this year. So with all those things going against us trying to have a fiscal consolidation of 6%, those are going to be quite challenging because especially the tax increases and more than that, the higher interest rates have had a very devastating effect on the business community, especially.

So these are tough times to go through. But as I always say, like India or Thailand, if we can go through these reforms, we have a good future after 3 to 4 years. So once proper medication is done, we can get it because we really need through this -- through the IMF program, some of the structural changes have to be done, like, for example, Central Bank independence.

So one of the biggest issues was monetary financing. So if that can be controlled, the Central Bank had to be independent of policymakers who usually put the interests of their own political parties rather than the country ahead. And also, more importantly, SOE reforms by SOE, I mean, state-owned enterprises.

As I mentioned, in 2021, 86% of government revenue went to paying salaries and pensions of state workers. So the IMF has the list of restructuring certain SOEs, I mean that's going to be the more challenging one because in Sri Lanka usually state-owned enterprises are seen as national assets. So there's always a sort of a outcry from the nationalist side. So that's going to be probably the president's biggest challenge to prioritize this, but this has to be done. Otherwise, there will be serious problems for the government's cash flow.

Nathan Hunt: The government is projecting a return to growth next year. That's not the estimation of independent observers, they think next year will also be a challenging year. But why are they optimistic about growth next year after what will be two years in which the economy contracted?

Talal Rafi: So one thing is, first of all, the government usually says that to keep the moral up and the support. So that is -- could be the obvious reason. But also, I see that Sri Lanka has been a very resilient nation throughout history. I mean we've come out of a war. I mean, this country has gone through a lot, war, tsunami, the COVID pandemic, the Easter attacks and a number of other crises like this economic crisis.

But we've always risen up once again. So resilience may be something the government is counting on. But also the other thing is that I think we hit the absolute rock bottom last year with around 12 hour power cuts, almost three weeks, the entire country went without fuel.

So when you hit the rock bottom, I think the only way is to go up. So as Sri Lankan's, we are quite optimistic, but at the same time, there are indicators that are showing a positive. Like I said, inflation has come down, so interest rates are also coming down. And also the market rates to come down once the domestic debt optimization is announced, there will be much more clarity and the risk premium will be going down. So we kind of expect, I don't know about growth, but there will certainly be a boost for the economy this year.

Nathan Hunt: Do you feel like in your conversations with people in the country, do you feel like there is the willingness, as you talk about resilience, is there the willingness there to make the hard decisions in order to meet the IMF goals and have better governance return to a state of growth.

Talal Rafi: So most of the people, it also depends on who we talk to. Most people who have some kind of background on economics are very supportive, especially like the liberal classes in Colombo. So they are quite supportive. But what we see is that when we go to others who have a lack of information. So that is where the resistance comes from because the primary reason is because political parties, especially a party that's rising in popularity, which is Communist in outlook, there is a lot of misinformation about the IMF.

Leftist generally in Sri Lanka, in many developing countries, don't look at the IMF and neoliberal policies favorably. So this kind of like sometimes what we can even call a fake news has been having a very bad effects. I mean when they come in and criticize, this is a time when many people are emotional, A lot of people have lost jobs.

So it's very easy to influence people and say that the IMF is the cause of all this. There's an agenda behind it. So I believe that there's a lot of misinformation. But when clearly explained, a lot of people understand. I mean, it's very easy to understand. I mean like there is a -- we have a problem, a large fiscal deficit. I mean we have a problem with our industries focused more to inward rather than export oriented. So these are some issues. But I think lack of information is the primary cause.

Nathan Hunt: So as you said earlier, the inflation rate in Sri Lanka is coming down. A huge amount of inflation in the country has been driven by energy prices, fuel prices. Are you confident that a corner has been turned here and that inflation will continue to come down maybe into the single digits over the course of the year?

Talal Rafi: Yes, because inflation has come down to the 20s from a very high number, I mean, almost 70%. But I'm confident because earlier, many were estimating that we'll have single-digit inflation by the end of this year. But now many organizations, experts are predicting single-digit inflation by the end of July.

So inflation coming down. But a major reason is because of the base effect. I mean, prices were quite high in June last year as well. So that is playing the bigger role here. So if you're comparing prices to probably the beginning of the crises, I mean, the cost of living is quite high, but due to the base effect then, also, there is a very reduced aggregate demand here and global supply prices have gone down. So there are a number of different factors playing into it. But by the looks of it, I think inflation will come down into single digits soon because the base effect is also quite positive towards that side.

Nathan Hunt: I'd love to talk a little bit more about the independence of the central bank. As you say, inflation still remains a little concerningly high, but the Central Bank of Sri Lanka is now cutting interest rates. How do you think that will play with the IMF and other creditors?

Talal Rafi: I think -- because even in March, for example, the IMF, the Central Bank governor said that there was -- actually the Central Bank had raised interest rates by 100 basis points. So the governor was saying, the IMF actually wanted a 200 basis point increase, but the government has kind of negotiated to 100.

So I think I'm really not sure about how -- what happened internally on what the comments from the IMF was for the current reduction by 250 basis points. But from the March, [ February ] we find that the IMF was more favorable of high interest rates because they had clearly wanted a 200 basis point increase, but the government, Central Bank here only gave a 100 basis point increase.

But I think the thinking here is also that they want to focus the economy more on the growth part because once inflation is kind of coming down because a lot of -- especially the small medium enterprises are suffering a lot due to higher interest rates. So I think the thinking was to kind of give them a bit of breathing space. So that would be a primary reason because at the same time now for us to repay our debt everything the economy also has to be put in a where we can function businesses can function.

Nathan Hunt: Speaking about small and medium enterprises, a recent article from the economist suggests that the middle class is actually leaving Sri Lanka in high numbers to work elsewhere, looking for opportunities elsewhere. Is this a cause concern? Or do you anticipate that potentially remittances, which are important in several emerging market economies will aid in Sri Lanka's recovery.

Talal Rafi: So talking about the middle class leaving in Sri Lanka we use term I guess brain drain is a very major part of concern because one thing is like in the short term, I mean, even the government, the ministry in charge of it is encouraging a lot of people to a work. I mean, there are talks with countries such as Japan, South Korea, almost take agreements with them to send workers there.

In the short term, this is quite good because we need the foreign exchange. But in the long term, I think this is going to have very grave consequences because this is going to affect Sri Lanka not just in the next few years, but decades or even generations down the line because people were going, migrating, especially countries such as Canada, Australia, the U.S., U.K.

These are some of the best mines in the country. So when things do come back right even, you don't have the correct people, the human talent to take the country forward. So this is going to affect Sri Lanka in a very bad way in the long term. But like gradually, the goal should be to have an economy that functions without the need for remittances if you look at, for example, Japan, before the Second World War started, a lot of Japanese used to work outside.

There was remittances coming in. I mean that's why you see the Western Coast of Latin America, you find a lot of Japanese there. So -- but gradually, once Japan became an economic power house, there was no need for Japanese to go out. So like that similarly, I think in the long term, it's not a wise policy to let out the best of us to move out of the country because we won't have the proper talent to help us grow as a nation.

Nathan Hunt: Talal, a final question. One, interesting factor that has been happening, particularly in the last two years as geopolitical tensions hit existing trade routes is some emerging market economies have found a way to sort of negotiate between geopolitical centers of influence.

I'm thinking about Vietnam, in particular, has been very successful and enjoyed a healthy growth rate. Do you think that there is a space for Sri Lanka to basically engage in favorable trade relationships and become potentially a manufacturing hub like Vietnam, like areas of Indonesia and experienced similar growth rates. Do you have that optimism?

Talal Rafi: Yes, quite optimistic about it. If we can get the correct policies and liberalize our trade. Like just to give you an example, even in South Asia, Sri Lanka has a very, very unique position. I mean Sri Lanka is the only country, which has good relationships with almost all the countries in South Asia. So whether it's -- we have a free trade agreement with Pakistan and India.

We are also trying to do an FTA with China. So Chinese businesses, which want to find the base through which to enter the Indian market or vice versa. So Sri Lanka is in quite a good position here. And also we are on -- towards the best, we have the Gulf countries very right on towards the East. ASEAN countries, Singapore, Thailand. So we are in quite a good position to do that.

But we need to liberalize our trade. We are one of the most protected countries in the world. So to do that, we need export-driven foreign direct investment. So we need more free trade agreements. So that would definitely be one thing. But as far as Sri Lanka, one other opportunity Sri Lanka is being right next to India. So India is, as you know, set to grow very rapidly.

Like for example, we have very similar culture, almost the same. We have a shared language with India. And India, by 2035 itself according to some projections will be a $5 trillion economy. Not only that, I mean, even if you take, for example, the southern state, just one state in India, which has around 6% of the population, I'm talking about Tamil Nadu. So the language of Tamil Nadu is spoken by around the 1/3 of Sri Lankans.

So Tamil Nadu's economy itself is as big as Pakistan's economy. So this is just one state in India. And they are saying it's growing at one of the very high rate. So Apple is moving its parts of its supply chain production from China to Tamil Nadu. So at the current rate, the some projections say that it continues by 2050, this state, which has around 6% of India's population could have an economy that's larger than Russia's.

So situated just within a few kilometers from Sri Lanka, we have a very huge opportunity. I mean even to piggyback on India success. So that's what very frequently, in most of the talks I say that you know we have to prioritize our relationships. So like, for example, China I mean it's a friend. I mean, we have borrowed from them. I mean they have helped us out a lot.

But we also have other friends. We need to prioritize relationships because our export basket, the countries which buy our products are the U.S. and the EU. So we have to have excellent relationships with the West. And Japan is a long-term standing trend. But also as far as Sri Lanka goes, I think like how certain countries, like, for example, Mexico, relationships with the U.S. might be the biggest priority. I think Sri Lanka, as far as the economic part of the foreign policy goes, I think focusing a bit more on India would be a great way to drive ourselves in the 21st century.

Nathan Hunt: Well, Talal, I hope that we will be able to get you back in in another six months or a year to discuss how things have gone, how they've developed. It's always fascinating to talk to you. Thank you so much for joining me on the podcast.

Talal Rafi: Thank you so much, Nathan and in six months, I'll have even better news. Thank you so much for having me. It's a pleasure.

Nathan Hunt: The Essential Podcast is produced by Patrick Moroney. At S&P Global, we accelerate progress in the world by providing intelligence that is essential for companies, governments and individuals to make decisions with conviction from the majestic heights of 55 Water Street in Manhattan. I'm Nathan Hunt. Thank you for listening.

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