India’s ‘Neighbourhood First’ policy towards Sri Lanka was in line with Sri Lanka’s ‘India First’ foreign and security policy in 2020. India is Sri Lanka’s third largest export destination after the US and UK. More than 60% of Sri Lanka’s exports take advantage of the India-Sri Lanka Free Trade Agreement, which entered into force in March 2000. India is also a major investor in Sri Lanka. India’s development partnership with Colombo has always been demand-driven, with projects covering social infrastructure such as education, health, housing, access to clean water and sanitation, apart from industrial development. Concessional financing of about $2 billion has been provided to Sri Lanka through various sectors (for railway connectivity, infrastructure, supply of defense equipment, security, and counter-terrorism and solar projects, etc.) supported by the Government of India. Foreign direct investment (FDI) from India stood at around $1.7 billion in the years 2005 to 2019 and went into retail petroleum, hotels and tourism, real estate and manufacturing, apart from telecommunications, banking and financial services.
However, relations between the two neighbors seem to be deteriorating since the beginning of this year. In February, Sri Lanka withdrew from the trilateral partnership with India and Japan for its Eastern Container Terminal project at Colombo port, citing domestic issues. Later, the West Coast Terminal was offered to Adani Ports and Special Economic Zone Limited under a Public Private Partnership arrangement.
Last July, the Reserve Bank of India (RBI) signed a currency-swap agreement with the Central Bank of Sri Lanka (CBSL) for withdrawal of up to $400 million under the SAARC Currency Swap Framework 2019-22. CBSL entered into a scheduled facility settlement with RBI in February 2021. Even though the agreement was valid till 13 November 2022, India rejected any renewal in the absence of an International Monetary Fund program to address Sri Lanka’s current macroeconomic imbalances.
On 31 August 2021, Sri Lanka declared a state of economic emergency, as it is running out of foreign exchange reserves for essential imports such as food. In August 2021, CBSL was the first Asian central bank to raise policy rates after the COVID pandemic in response to rising inflation due to currency depreciation. Tourism, a big dollar earner for Sri Lanka, has suffered since the pandemic following the 2019 Easter Sunday terror attacks. Earnings fell from $3.6 billion in 2019 to $0.7 billion in 2020, while FDI inflows declined from $1.2 billion to $670 million in the same period.
Sri Lanka’s fragile liquidity position has put it at high risk of a debt crisis. Its public debt-to-GDP ratio stood at 109.7% in 2020, and its gross financing needs remain high at 18% of GDP, higher than most of its emerging economy peers. Following an international sovereign bond settlement of $1 billion in July 2021, its gross official reserves declined to $2.8 billion, which is equivalent to only 1.8 months of imports. The external debt-to-GDP ratio stood at 62% in 2020 and is mainly due to the public sector. Foreign currency debt of over $2.7 billion will be payable over the next two years.
As of June 2019, China’s debt to Sri Lanka’s public sector accounted for 15% of the central government’s external debt, making China the country’s largest bilateral creditor. Unable to repay its debt, in 2017, Sri Lanka lost the unviable Hambantota port to China for a 99-year lease. Nevertheless, Sri Lanka has increasingly relied on Chinese debt to cover its foreign debt burden. Several loans have been negotiated between Colombo and Chinese institutions, including a recent syndicated loan for $1.3 billion of budgetary support from the China Development Bank and a $1.5 billion currency swap agreement with the People’s Bank of China this March . China’s exports to Sri Lanka exceeded that of India in 2020 and stood at $3.8 billion (India’s exports were $3.2 billion). Due to Sri Lanka’s strategic location at the crossroads of major shipping routes, China has invested heavily in its infrastructure (estimated at $12 billion between 2006 and 2019). In May, Sri Lanka passed the Colombo Port City Economic Commission Act, which provides for a special economic zone around the port and a new economic commission to be funded by China.
Sri Lanka’s economic crisis could push it to align its policies with Beijing’s interests. This comes at a time when India is already at a diplomatic standstill with Afghanistan and Myanmar. Other South Asian countries such as Bangladesh, Nepal and Maldives are also turning to China to finance large-scale infrastructure projects. It will therefore be important for India to nurture a Neighborhood First policy with Sri Lanka, albeit with caution, to preserve its strategic interests in the Indian Ocean region. Colombo port is important for India as it handles 60% of India’s trans-shipment cargo. Regional platforms such as the Bay of Bengal Initiative for Multi-Sectoral Technical and Economic Cooperation and the Indian Ocean Rim Association to promote cooperation in common areas of interest such as technology driven agriculture and maritime sector development, IT and communication infrastructure, renewable energy can be taken advantage of. , and transportation and connectivity. The two countries can also cooperate in increasing private sector investment to create economic resilience.
Sreejita Nandi is an Economist at India Exim Bank / These are personal views of the author.
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