Sri Lankan elections, held on 21^st September 2024, were the first after the country declared bankruptcy in 2022 amidst devaluation of the Sri Lankan rupee, soaring inflation, and shortage of necessities such as food and fuel. Widespread protest forced the then President Gotabaya Rajapaksa to resign, bringing an end to the fifteen-year-long rule of the Rajapaksa clan. After Rajapaksa’s ouster, the interim leader Ranil Wickremesinghe negotiated an IMF bailout program, which required the government to undertake strict austerity measures to cut government spending and increase revenue. The government increased taxation and reduced subsidies that resulted in tax and electricity price hikes. While the measures were unpopular with the public, they stabilized the currency, built up foreign exchange reserves, and lowered inflation. However, this was only a temporary fix. Unless the underlying issues are addressed, it is not the end of worries for Sri Lanka.

Besides the influence of international events such as the COVID-19 pandemic and the Ukraine War, the Sri Lankan economic crisis has at least three local causes: the Sinhalese-Tamil ethnic discord that has defined Sri Lanka’s domestic political landscape for almost the entirety of its existence since 1948; the populist economic policies of Gotabaya Rajapaksa; and despite its traditionally non-aligned stance and strategic location, Sri Lanka’s inability to fully capitalize on the regional power competition between India and China.

The Island State and the Major Powers

India and China have been competing for influence in the “Indo-Pacific” through investments in the economies and security of the region's smaller states. These states hedge between both powers to maximize their benefits. The U.S. is not immune to developments in the region either. It aims to work with its network of allies to create a “free and open Indo-Pacific that is more connected, prosperous, secure and resilient”; a strategy to counter China’s growing sphere of influence in the Indian Ocean.

China seeks to secure its interests and expand its regional and global influence through its Belt and Road Initiative (BRI). Under the BRI, China invests in shipping ports and infrastructure projects in states across continents. But through this strategy (coined by some U.S. researchers as the String of Pearls), China appears to encircle and contain India in the region by dominating small states in its backyard. This is seen as a security threat not just by India, but the U.S. as well. Sri Lanka is valuable to all major powers because of its proximity to critical shipping routes in the Indian Ocean. But to the U.S., Sri Lanka’s geostrategic position makes it a vital component of the U.S. Indo-Pacific Strategy as well.

The Sinhalese-Tamil Conflict

The roots of the conflict can be traced back to the British colonial rule that lasted until 1948. The Tamils enjoyed a preferential status under the British ‘divide and rule’ strategy, where the British sought to solidify their power by exploiting existing divisions within the societies they colonized. The Tamils as an ethnic community also existed in other British colonies such as India, South Africa, and Singapore. English-language schools were built in Tamil majority districts. Learning the English language gave Tamils greater opportunity for social mobility. They populated higher education, civil services and other professions, greatly outnumbering their Sinhalese counterparts.

This continued post-independence until 1956 until the then Sinhalese Prime Minister S. W. R. D. Bandaranaike passed the “Sinhala Only Act” making Sinhalese the only official language and systematically obstructing hiring and promotion of Tamils in the government services. To be granted admission in higher education, Tamils had to score higher than their Sinhalese counterparts. The cultural and religious heritage was not spared; Buddhism became state religion, and Buddhist places of worship were built in Tamil majority towns. In 1956, Tamils accounted for 30% of the bureaucracy and 40% of the armed forced. By 1970 the figures were reduced to 5% and 1% respectively.

The conflict was a sensitive subject for India-Sri Lanka relationship which was strained because of the events of the 1980s. In 2009, when Mahinda Rajapaksa (the then President and Gotabaya Rajapaksa’s elder brother) wanted to carry out a military offensive to eliminate the Tamil Tigers, India declined to support because of sympathy towards the Tamil population, and fear of troubles from its own huge Tamil community in its southern state of Tamil Nadu. The United States also pulled away citing concerns about human rights atrocities. China, however, provided ammunitions and weapons worth $37 million along with six F7 fighter jets and many antiaircraft guns. Its non-military aid ballooned from mere millions to a whopping $1 billion in 2008. China’s assistance was not limited to the civil war, it diplomatically supported Sri Lanka in the UN, proactively blocking even any statement to be passed regarding the government atrocities committed against the Tamil Tigers.

The military offensive received support from the Sinhalese majority in the island but was internationally condemned for war crime and human rights atrocities. After the civil war ended, the Tamils demanded political devolution in Tamil majority areas of the north and the east, and a greater integration of the Tamils into the government system – a promise that not only never materialized but is also not a top electoral priority of any Sinhalese candidate. The decades long policy of systemic discrimination has led to a slump in bureaucratic and education institutions and brain drain, which adversely impacted economic development. But this was not the only cause for economic collapse.

Bringing an end to the civil war greatly boosted the popularity of the Rajapaksas as they continued to occupy office for the next fifteen years. During this tenure, the Rajapaksas not only continued the same trajectory, preferring ethnicity over meritocracy and professionalism, but benefited from the renewed relationship with China as well. China generously invested in Sri Lankan infrastructure but at the cost of a stagnant manufacturing sector.

Real estate and construction are considered part of the non-tradable sector because they do not have an export potential, thus do not contribute to foreign exchange earnings. While they offer short-term growth because of large initial investment and employment opportunities, this is insufficient for long-term growth. Employment opportunities are temporary and such projects are only able to generate returns after completion, and even in those circumstances take longer to just breakeven. Infrastructure development is essential for developing countries but for Sri Lanka this came at a neglect for working towards a labor-intensive manufacturing-based economy coupled with series of policy failures. Thus, the economic collapse was only a matter of time.

The Road to Economic Ruin

In a series of policy missteps, the first was to slash taxes. The consumption tax was reduced by 7%. The threshold for personal income and corporate income tax was almost doubled, effectively removing many from the tax net. This reduced the tax-to-GDP ratio to 8.3%, which was one of the lowest in the world. In 2020, the sovereign debt was near default and the foreign exchange reserves were depleting. Then the pandemic hit and tourism – a major source of revenue – dropped. But the policy blunders did not stop. The government artificially fixed the foreign exchange rate, which had an adverse impact on the second major source of revenue: remittances, as the Sri Lankan diaspora resorted to sending home money through unofficial means at profitable exchange rates. This further reduced the sources of foreign exchange reserves, which were again dangerously low by 2022. But instead of seeking assistance from the IMF – wary that the austerity measures would be unpopular with the public – the Rajapaksa Government started printing more money to finance the fiscal deficit. The 40% increase in money supply set the inflation skyrocketing to almost 50% in 2022. Eventually, the country defaulted.

And instead of benefiting from Chinese investments, Sri Lanka became a cautionary tale, symbolizing what the hazards of Chinese “dept trap diplomacy” look like. Thus, it was not surprising when big infrastructure projects like the Hambantota Port and the Mattala Rajapaksa International Airport did not generate expected returns. The failure to pay off debt resulted in handing over the port to China on a 99-year lease in 2017. However, the Hambantota Port was not merely an exchange for a debt not repaid; it was also of intelligence and strategic significance to China as part of its String of Pearls strategy.

When Sri Lanka was in a crisis in 2022 and looking for short-term reliefs through currency swaps and credit lines, China was reluctant to respond lest it set a precedent for other states under its debt to demand relief. The shared ethnic and historical ties with India have traditionally been a sore point due to the Sri Lankan treatment of its Tamil minority but presently, India saw a politically and economically vulnerable Sri Lanka as an opportunity to counter the Chinese influence. India came through with a $4 billion humanitarian and financial assistance, but it was hardly a sufficient measure to fix the crisis.

Sri Lanka’s Balancing Act

The road to economic recovery will be difficult for the new Sri Lankan Government. Now that Sri Lanka is entrapped, owing about 8 billion out of the total 100 billion USD in debt to China, distancing from China may sound tempting to Dissanayake but it will not be easy. Sri Lanka will require support from the major powers to bring in investments and restructure its debt. Regionally, Dissanayake needs to reconnect with India; a challenge that will require both governments to move on from the ghosts of the past. Internationally, it will also need to maintain cordial ties with the United States, which is crucial for support from international institutes such as the IMF for debt restructuring. Traditionally, the IMF has been skeptical of assisting states under Chinese debt due to the lack of transparency in China’s operations.

Locally, the Sri Lankan government will have to implement tough macroeconomic policies which will prove unpopular with the public. But for long-term economic stability, the government will have to boost the labor-intensive manufacturing sector to generate employment opportunities and provide better stability against economic shocks. To do so will require social cohesion, and therefore, dealing with the legacy of the civil war. Sri Lanka’s foreign policy will largely remain dependent on its domestic situation, with its needs steering its relationship with the major powers.