As Sri Lanka braces for a perfect economic storm, has China overtaken India in the race to provide a lifeline?

Saddled with billions of dollars of debt and a junk credit rating, Sri Lanka is caught in a perfect economic storm, with near-empty foreign exchange coffers; a sliding currency; shortages of food, medicine and cooking gas; as well as Covid-19 cases hitting record highs. And now the island of 22 million people is staring at the spectre of default.

Finance minister Basil Rajapaksa in September conceded that Sri Lanka faces "a severe foreign exchange crisis". After making a US$1 billion bond payment in July, its forex reserves stood at US$2.8 billion, which covers just two months of imports - and a further US$1.5 billion in foreign debt matures next year. Sri Lanka is at a one-year default probability of 28 per cent, according to a Bloomberg gauge; any nation rated over 1.5 per cent is seen as being at high risk of failure to pay. Fitch Ratings notes the government will have to pony up US$29 billion between now and 2026 to service debt repayments.

The opposition says the only way to avert financial disaster is a bailout from the International Monetary Fund (IMF), and the agency - which played a key role in helping Sri Lanka overcome balance of payment crises in 2009 and 2015 - says it "stands ready to discuss options". An IMF rescue, however, would involve stringent financial terms and would be a humiliation for the country's strongman president, Gotabaya Rajapaksa, who rode to power in 2019 on promises of restoring prosperity.

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Gotabaya - the brother of finance minister Basil - believes "home-grown remedies" along with help from "all-weather friend" China and its closest neighbour, India, along with other friendly countries such a Bangladesh, can fix the problems. But opposition parliamentarian Harsha de Silva dismisses such solutions as "band-aids that won't provide the rigorous fiscal and monetary framework" to restore economic health or foreign investor confidence. "They'd just be kicking the can down the road," he said.

If Sri Lanka doesn't turn to the IMF for a lifeline, China is the only country with the financial means to offer help on the scale it needs, observers agree. China, which values Sri Lanka as a critical Indian Ocean shipping hub, has emerged as the island's lender of last resort and eclipsed India as the largest exporter. The Chinese have also become Sri Lanka's largest foreign investor and biggest bilateral creditor, holding 15 per cent of its external debt.

Indian diplomats say New Delhi, despite concerns over Beijing's mushrooming presence, doesn't have the deep pockets to solve Sri Lanka's myriad problems. "What India can give is a drop in the ocean compared to what Sri Lanka needs," said one, speaking on condition of anonymity.

But while Sri Lanka received US$1.5 billion from China in a March currency swap agreement, some analysts doubt Beijing will want to keep bailing out Colombo in the long term - while opposition MPs are raising the question of what China will seek in return if it does. After Sri Lanka couldn't service its debt in 2018, it lost the Chinese-built Hambantota Port to Beijing for a 99-year lease, fuelling Indian worries that the facility could emerge as a Chinese naval outpost.

On Thursday, India's Adani Group agreed to a US$700 million investment to build a deep-sea container terminal next to a Chinese-run jetty in Colombo. The development is seen as an Indian effort to counter China's advantage in Colombo, which occupies a strategic location in the Indian Ocean between the hubs of Singapore and Dubai. The informal Quad grouping of India, the United States, Japan and Australia counts Sri Lanka as a vital hub in pushing back against rising Chinese assertiveness in the Indo-Pacific.

Sri Lanka's economy was hammered by pandemic-induced lockdowns and restrictions, with Covid-19 hitting just as the all-important tourism sector was recovering from the 2019 Easter Sunday terrorist attacks that killed more than 260 people in churches and hotels. As tourism earnings nosedived again and fiscal and policy missteps multiplied, the economy shrank 3.6 per cent last year, its deepest ever recession.

"Sri Lanka's gone from what was a crisis to a completely catastrophic state of affairs," ex-central bank deputy governor W.A. Wijewardena said.

The fall in hard-currency earnings meant the government needed to cut import costs, so it banned the arrival of cars, air conditioners, beer, clothing, and cosmetics. Then, in a move stunning farmers, President Rajapaksa in April declared Sri Lanka would become the world's first 100 per cent organic food producer. He banned imports of chemical fertilisers and pesticides, saying agrochemicals were killing people and declaring the country would develop organic substitutes.

The president saved US$400 million on the import bill, but domestically, economic costs have been huge, threatening Sri Lanka's prized tea industry - another big forex earner. Moreover, tea farmers say organic tea costs far more to produce, and the market is limited.

"This is what happens when you make family decisions and don't take professional advice," MP de Silva said.

The Rajapaksa clan, in power for most of the past two decades, re-established their grip in 2019 after a brief opposition interregnum. Those in top positions include Gotabaya, 72; Mahinda, 75, who is prime minister; and 70-year-old Basil, widely seen as the "brains" of the family, who took the reins at the finance ministry in July. Eldest brother Chamal, 78, is irrigation minister and a couple of next-generation Rajapaksas are also ministers, making the authoritarian government a family affair.

President Rajapaksa's fertiliser and pesticide ban has also sparked fears of a wider crop disaster. Cinnamon and pepper, other important forex earners, are already in trouble, as are staples such as rice. Late last month, Sri Lanka - which is food-import dependent - declared a state of emergency over food shortages and fixed food prices at below cost.

The move has created food black markets, with farmers and traders refusing to sell stocks because the government-set prices aren't viable. Furthermore, many farmers are saying they will not plant crops without fertilisers and pesticides over worries they may fail.

Sri Lankans already report long queues to buy essentials such as milk powder, sugar, and cooking oil, but the government says these are the result of people socially distancing for Covid-19.

"You don't change an agricultural system overnight, you do it over time. We're only starting to feel the repercussions. We've put food security at risk," said Wijewardena, formerly of the central bank.

In another disastrous move, eroding the government's already skimpy revenue base, Rajapaksa, after being elected president in November 2019, slashed corporate taxes and nearly halved the value-added tax. He billed the step as a generator of investments and jobs - but the central bank ended up printing money to pay state workers, repay maturing bonds, finance the deficit, and keep interest rates down. The move has inevitably stoked inflation and undermined the rupee's strength.

"Money will be printed until the ink in the country is finished," opposition legislator Mujibur Rahman remarked.

China's Sri Lanka links got a boost with the end of the civil war in 2009, when Sri Lanka was under fire from the West for alleged human rights abuses against the ethnic Tamil minority. Mahinda, then president, turned to Beijing, which did not share the West's qualms and invested in constructing roads, railways, and other infrastructure. New Delhi's ties with Sri Lanka have been complicated by the large Indian Tamil community; India has traditionally supported Sri Lanka's Tamil community, which has yet to see closure for alleged war crimes.

Further weighing on the economy is the threat of losing a vital European Union trade concession: the Generalised System of Preferences Plus, or GSP+, due to what critics say is a fresh decline in human rights under President Rajapaksa. During his time as defence minister, he ruthlessly crushed the Tamil Tiger separatists, earning the nickname "The Terminator" from his family. An EU fact-finding mission arrived in Colombo last Monday, and being stripped of the concession could trigger big export losses and deal another blow to forex earnings.

Observers say the Rajapaksa brothers have found adjusting to peacetime difficult. "You had Mahinda who was a political street-fighter and Gotabaya who gave military orders," said an Indian government official who was posted to Sri Lanka, adding that finance minister Basil, who is well regarded for his pragmatism, "is possibly best-equipped to sort out this mess" and nudge Sri Lanka towards the IMF.

New Delhi's "Neighbourhood First Policy" was put in place to burnish ties with the likes of Sri Lanka, while Colombo has reciprocated with its "India First" foreign and security policy. But that traditional relationship, founded on close political, cultural, religious, economic, and military ties, has run adrift amid China's growing influence.

"We feel Sri Lanka has taken a fork in the road," an ex-Indian envoy to the region said.

While India remains deeply concerned about Chinese encirclement, "we can't compete with China on the financial level, we're not in that league. But we need to build up a narrative of being the country there for them on other levels," the Indian government official said.

This article originally appeared on the South China Morning Post (SCMP).

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