What Sri Lanka can learn from India’s rise after the 1991 economic crisis

On July 14, 1789, an angry mob attacked the Bastille, the Paris state prison that had come to represent the dictatorial regime of the then monarchy. The event gave rise to one of Europe’s greatest revolutions, the French Revolution, which overthrew the monarchy by establishing a republic based on the ideas of “Liberté, égalite, fraternité” (freedom, equality and fraternity).

More than 200 years later, July saw another country, this time in Asia, set to have its Bastille moment. On July 9, hordes of people stormed the official residence of Sri Lankan President Gotabaya Rajapaksa to demand his resignation amid a growing economic crisis in the island nation. In videos and images that have gone viral, Sri Lankan protesters can be seen jumping into the pool to swim, taking over the kitchen, using the gym and even sleeping on the president’s bed in the state house from the colonial era. Crowds had also set fire to the house of Prime Minister Ranil Wickremesinghe.

The protests also left several people injured. AFP quoted a spokesman for Colombo’s main hospital as saying three people were being treated for gunshot wounds. The incident forced Rajapaksa to announce he would resign.

Why are Sri Lankans angry?

Sri Lanka is experiencing its worst economic crisis in 70 years. It struggles to import essentials like medicine, fuel and food and also faces rampant inflation. Its foreign exchange reserves have run out. The government was in talks with the International Monetary Fund (IMF) for a $3 billion bailout.

Since it did not have enough foreign currency to pay for imports, including fuel, it announced a halt to non-essential private fuel sales until July 10, becoming the first country to do so in years. 1970. A few days ago, Sri Lankan officials said the country had less than a week’s supply of fuel left to run essential services such as medical vehicles, trains and buses. Schools have been closed and its workforce is now working from home.

Shortages of fuel and food led to runaway inflation. Year-on-year inflation in Sri Lanka hit a record high of 54.6% in June. Widespread power cuts and unavailability of essential medicines have brought its health infrastructure to the brink of collapse.

Sri Lanka’s economic crisis has been exacerbated by deep tax cuts promised by President Gotabaya Rajapaksa as part of his campaign in the 2019 presidential elections. It was signed into law just before the pandemic hit, which has further destroyed parts of its economy. Being an economy that mainly depended on tourism, horrific church bombings in 2019 spooked tourists before the pandemic wiped out tourism completely. For a declining economy, the final nail in the coffin was the switch to organic farming which reduced yield, causing food shortages in the country.

In a 2019 working paper, the Asian Development Bank said: “Sri Lanka is a classic twin-deficit economy. Twin deficits signal that a country’s national expenditure exceeds its national income and that its production of tradable goods and services is insufficient.

The country also defaulted on its debt for the first time in its history. The one-month grace period to repay $78 million in unpaid debt interest expired on Wednesday. Sri Lanka’s central bank governor P Nandalal Weerasinghe said Sri Lanka was in “preventive default”. Defaults occur when a government fails to honor part or all of its debt to its creditors. Failure to pay has a negative impact on a country’s reputation with investors.

“Our position is very clear, we have said that until they come to the restructuring [of our debts], we will not be able to pay. This is what you call a preemptive default. There may be technical definitions…on their side they may consider it a defect. Our position is very clear, until there is debt restructuring, we cannot repay,” Weerasinghe said.

Any country that defaults finds it difficult to borrow in international markets, reducing the value of its economy and currency. Sri Lanka aims to restructure its debt to foreign creditors, worth more than $50 billion, so that its repayment can be easily managed.

The island nation’s current situation is reminiscent of what India went through in the 1990s. Except India managed to save the day before it reached a Bastille-like situation.

What happened in India in the 90s?

While it is widely believed that the Gulf War that began in 1990 and the resulting oil price shock brought India to its knees, in reality it is more than a decade of recklessness that drove the economy to the brink of collapse. India’s twin deficits have grown steadily over the 10 years leading to the liberalization of the Indian economy.

Between 1980-81 and 1990-91, India’s domestic public debt rose from 40% of GDP to 55%. External public debt fell from 8.7% of GDP to 12.7%, while exports then represented less than 8% of India’s GDP. The liberalization of imports, which had started from 1976, had resulted in a rapid growth of imports, mainly of capital goods and intermediate goods, but it had not been counterbalanced by a commensurate increase in growth exports.

Domestically, political constraints have resulted in a rapidly rising food and export subsidy bill. The situation has further worsened due to factors such as increased burden of interest payments due to larger primary deficit and higher cost of borrowing, job growth and wages in the public sector, financial support to loss-making public sector enterprises and weak growth in public revenues.

In 1991, India was on the brink of sovereign default. The Gulf War also led to a decline in remittances from Indian workers abroad. India’s foreign exchange reserve fell alarmingly and stood at less than $6 billion, a figure that could only meet about two weeks of the country’s import demand.

The biggest challenge facing the then Prime Minister, Narasimha Rao, was to save India from the embarrassment of a sovereign default, which India had not faced until then.

The country took two immediate steps to escape economic quicksand. First, he devalued the Indian rupee to make exports more competitive. The Reserve Bank of India (RBI) and the government have opted for a two-step devaluation of the Indian currency. The rupee was first devalued by around 9% against other major currencies on July 1, 1991. This was followed by another round of devaluations by 11% two days later.

The second major step taken by the Rao government was to pledge gold holdings to increase foreign exchange reserves. The RBI pledged India’s gold reserves to the Bank of England in four batches between July 4 and July 18, 1991. India thus raised $400 million. In May of the same year, the State Bank of India had also sold 20 tonnes of gold to the Union Bank of Switzerland, raising around $200 million. The IMF came to the rescue with emergency loans worth $2 billion in two batches earlier that year.

Lessons from the historic budget

When presenting the 1991-92 Union Budget, then Finance Minister Manmohan Singh said: “’No power on earth can stop an idea whose time has come.’ I suggest…that India’s emergence as a major economic power in the world happens to be one such idea. Let the whole world hear it loud and clear. India is now wide awake. We will vanquish. We will vanquish.

Singh’s budget was a reiteration of several structural reforms the government had undertaken in previous weeks. It announced sweeping changes to its licensing policies and introduced a new trade policy to boost exports. After the huge devaluation of the rupee, the government ended its export subsidy policy. The private sector was allowed to import and it removed the mandate to channel imports through state-owned enterprises.

On the eve of the 1991 budget, India announced its new industrial policy. It allowed automatic approval of foreign direct investment up to 51% – the previous cap was 40% for foreign equity investment. It abolished the Raj licensing regime and made it easier for companies to enter and restructure by allowing mergers and consolidations.

Until then, the government took care of producing everything from watches to cars. The new industrial policy limited the public sector monopoly to a handful of strategic sectors. The budget allowed private sector participation in mutual funds and relaxed investment standards for non-residents. Corporate tax rates were increased by 5 percentage points to 45% and a withholding tax was announced for financial transactions such as bank deposits. The prices of fertilizers, petrol and cooking gas were increased and the sugar subsidy was removed.

From being on the verge of collapse to making exports competitive, India’s journey has been long and arduous. How long it will take for Sri Lanka to recover its economy, only time will tell.