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Nathan Hunt: This is the essential podcast from S&P Global. My name is Nathan Hunt. During the recent mini budget crisis in the United Kingdom, the Economist, Lawrence Summers, blasted the government of former Prime Minister, Liz Truss saying it was behaving like an emerging economy. I'm not sure that's fair to emerging economies. Actual emerging market economies are faced with much more challenging conditions than the United Kingdom.

Credit is readily available, but fiscal discipline is demanded. A healthy tax base is necessary, but taxes are considered an impediment to growth. Tariffs are expected to be low or nonexistent, but domestic industries can't compete with cheap imports. They need to raise the standard of living without using fossil fuels for cheap energy.

Emerging market economies rarely navigate these delicate contradictions effectively. In fact, it's not clear that they can. And when something goes wrong, the International Monetary Fund imposes conditions that are politically unpopular because they cause real economic pain to understand how this dynamic has played out in 1 emerging economy that of Sri Lanka, I am joined today by Talal Rafi.

Talal is a Senior Global Management Consultant at Deloitte, a member of the expert Network of the World Economic Forum. Talal has written extensively on Sri Lanka, and I'm thrilled that he has joined me today on the podcast. Talal, welcome.

Talal Rafi: Thanks, Nathan. It's a pleasure to be here.

Nathan Hunt: Talal, let's start by getting up to date. What is happening in Sri Lanka right now economically?

Talal Rafi: Good question. We can start off with the tax cuts that were initiated by the former President in 2019. What happened was taxes were reduced and at the same time, because of new tax policies, the tax base also reduced drastically. So this led to the global rating agencies downgrading Sri Lanka, and we were cut out of international capital markets. So the intention may have been good, like have tax cuts so that industries can grow. But what followed was a global pandemic COVID-19.

So that severely affected Sri Lanka, especially when it comes to the tourism sector and remittances from workers working abroad, Sri Lankans working abroad like in the Middle East or Western countries, who are sending back remittances. When they started losing their jobs, Sri Lanka was going into an economic turmoil.

Also, some of the policies followed by, for example, the central bank, they wanted to follow the Modern Monetary Theory. So even famously, the former Central Bank governor said, printing money does not cause inflation. So that was kind of like the wrong policies that got there and also keeping the rupee to 203 when the informal markets were selling it at a much higher rate, resulted in most people living abroad sending remittances back through other channels, mostly informal channels.

And also a very critical thing was refusing to go to the IMF. Even 2 years back in 2020, a lot of economics and others were telling the country that the debt was unsustainable, but the previous government refused to go to the IMF. So these compounded the issue. So currently, where has this brought us, obviously, we have defaulted. And that's the first time in Sri Lanka's history, defaulting.

And at the same time, negotiations have been started with the IMF and there's a staff level agreement. So currently, the key condition of the IMF is that there has to be debt restructuring. So for that, we have 3 types of creditors the multilaterals usually whom we don't restructure, but the bilaterals, mainly China is the largest player there and then followed by Japan and India. And of course, the international bondholders.

So talks are ongoing, but China, everybody's eyes on China. So if you look at the example of Zambia, it was because of China being reluctant there as they usually prefer to refinance their debt. So that was 1 thing. The other thing is IMF condition for having a primary budget surplus of 2.3% by 2025. Currently very negative territory as far as the primary budget deficit of minus 4%.

So 6% fiscal consolidation is a very daunting task, a very tall client but that's what the government has got itself into. And so 1 of the 2 things the government has tried to do is raising taxes. So corporate taxes have been raised up to 30% and personal income taxes starting from 6% right up to 36% and also an increase in VAT.

But currently, the situation is still not completely stable. I mean there is fuel shortage. I mean car is only allowed 20 liters a week. And at the same time, there is mounting inflation, 70% inflation for this year, 90% when it comes to food inflation. So most of the products like food items have tripled.

Nathan Hunt: So Talal, a lot of this can seem very high level, right? We're talking about the IMF, we're talking about fiscal and monetary policies. We're talking about foreign debt holders, bilateral debt holders in China, Japan, et cetera. Let's take this down to the level of the individual Sri Lankan, what is their experience today? What are they dealing with?

Talal Rafi: The average Sri Lankan is going through a lot because on 1 hand, there is very high inflation, most of the savings have gone off. And at the same time, the prices of many goods are rising up because of a ForEx shortage, the government is severely restricting imports. So that means whatever ordinary things you can buy have almost doubled in prices.

And that's food inflation of 90%. I mean that's the formal channels. But informally, certain food items are even higher. And salaries have been mostly fixed. And in this situation, when you have like taxes coming in. So that's like something it's going to, in my opinion, cause political instability in the coming months.

But it's a tough thing that the Sri Lankan public have to taste, especially like, for example, with most of the salaries fixed, we -- according to some estimates, around half of the Sri Lankan population into moving into poverty levels.

Nathan Hunt: Now there already has been a great deal of political instability in Sri Lanka coming out of this crisis. What has been happening in the country politically?

Talal Rafi: Politically, I mean, as the world saw in July, former President was literally asked to leave with thousands of people marching into the presidential palace. So with that, there's a new president, I mean he was voted by parliament, not by the people. So I mean, he has the legitimacy. He is legally the President, but many people think that a general election is needed, just like what's happening in the U.K.

This was the former Prime Minister who is currently the President. And what happened was in 2019 or 2020 at the general election, his party only got 1 seat, and that was a bonus seat. So he lost his seat. So he came in through a bonus seat to Parliament and got elected as a President, I mean, it's 1 of the biggest miracles in Sri Lanka.

So sort of like a question of legitimacy. But especially among the upper class here in Colombo, he has considerable support. They prefer like if you saw in July when there were nearly 0.5 million people descending on to the presidential palace. There was a lot of instability. There was a fear of the country going into anarchy.

So most people prefer it that way. I mean, they don't want to come out and protest because if he leaves, we don't know what could be left. I mean there is like a strong move towards a leftist government, if it comes to. So these are some of the issues that Sri Lanka faces.

Nathan Hunt: Let's go back to some of the policies of former President, Rajapaksa. You talked about unfunded tax cuts, you talked about modern monetary theory. This isn't the first time that an emerging market economy has rebelled against the dictates of what we might call economic orthodoxy whether you agree with those policies or not, what was the government trying to accomplish with their economic policies?

Talal Rafi: To be very frank, Nathan, it's some of the policies they were following still baffles people, like, for example, the chemical fertilizer issue, like trying to change an entire country's agricultural system into organic within 24 hours or the modern monetary theory of printing money and saying in printing money doesn't cause inflation.

So I'm not really sure of what the intentions were. It's just like the whole thing would be a sort of, in my opinion, a lack of experience on the part of people who are advising the President. And also a thing that the world needs to learn is that one of the critical things Sri Lanka did was in after the 2020 elections, they passed an amendment, giving the President extraordinary powers.

So he has the power to do a number of different things, like from appointing as an example, police or the judiciary. So this kind of gave them unlimited power. So there were no checks and balances. So that is 1 critical area that Sri Lanka differs when you compare to other countries, mostly developed countries.

But the reasons could have been many. I mean, what I would say is like probably building political support, like they came in promising like on a very populous platform. So for example, as soon as he came, 50,000 graduates were absorbed due to the public sector. Sri Lanka already has 1.5 million people working for the government, which is extremely high and unsustainable.

And also another thing is the government shifted heavily towards import substitution. Another reason could be that many industrialists who fear an open market could have been supporting him. So [ these things ] could have been the reason for the President and his political party following or implementing some of his economic policies.

Nathan Hunt: You referenced populism in your last answer. And in the articles you've written, you've talked a lot about the sort of populist economic policies that have been pursued, Were those policies unique to the former President and his party or have they been pursued in Sri Lanka over time? And what has been the effect of that?

Talal Rafi: I would not say that though the previous government was a bit extreme populist policies have been ingrained in Sri Lankan politics for decades. I would even say that after we got independence from the British, about a decade [ end ] we started with the whole populist policies. For example, like in 1970 a political party promised free rice, extremely cheap price, and they were voted into power.

And then it was followed by another -- the same party, then they promised to bread at extremely low cost. At that time, I remember LKR 3.50. So this was extremely low. Nobody ever questioned where the money was going to come from. Well, we right now know that it came from 2022.

And another political party a leader promised free fertilizer, and he was elected into power. And the current President, his party formed an alliance to win the 2015 election. One of the key promises was a salary hike of LKR 10,000 for the public sector workers. And the last President, of course, as we know, the tax cuts were promise.

So populist policies of promises have been ingrained in Sri Lankan politics. And also not just subsidies, but also absorbing people into the government. For example, from 2005 to 2015, the state sector almost doubled in size from 700,000 to 1.5 million. And currently paying salaries and wages of Sri Lankan state sector employees, you wouldn't believe it absorbs 86% of government revenue.

So there's just another 71% goes to paying debt. So even salaries, pensions and repayment of debt takes 150% or 151% of government revenues. So we are already running a 50% fiscal deficit with nothing to show less money for capital expenditure. That's how deep it has come.

And also, silicas a history of fiscal deficits. I don't think we have ever had a fiscal surplus. I mean even as I mentioned before, first time Sri Lanka got a primary budget surplus was in 2017 and 2018 after 4 decades. So that's pretty much how bad the situation is. And this has also led to the Central Bank financing the treasury. So Sri Lanka, when compared to the rest of the region has a pretty -- I would say, in the single digit but steady inflation over the past decades.

Nathan Hunt: Talal, as you know, 1 of the things that has developed over particularly, I'd say, the last 5 or 10 years in emerging economies is China offering credit to those emerging economies for different initiatives, belt and road initiatives, stuff like that. What is the role of China in Sri Lanka?

Talal Rafi: As far as China, that's a good question and a very important question at this time. China plays a very big role. I would say even would be the most influential country here as far as like controlling Sri Lanka's economic growth. Because the -- a little bit of history behind that, prior to 2005 or before the mid-2020s sorry, 2000s. Sri Lanka, debt was sustainable, I mean most of the loans were from multi-laterals, which had extremely low interest rates and long grace periods.

But after 2005, especially after the end of the war in 2009, Sri Lanka moved heavily towards China. One of the reasons was that after the was the West was -- the government went against the West especially they were looking into the ending of the war, if there were any possible crimes committed.

So -- and at the same time, it was also very attempting for the Sri Lankan government to go to China because China, there's no strings attached, unconditional money comes in. So there's no accountability. You can do whatever you want with the money, unlike if you're borrowing from the World Bank or the IMF or anyone else.

So this sort of heavily shifted Sri Lanka towards that and this also meant that there was a lot of spending on non-tradable sectors. And also on vanity projects like, for example, the Colombo Lotus Tower came in with Chinese money, the Hambantota Port as the world knows where Sri Lanka could not pay back and had to give it to a Chinese state-owned enterprise on a 99-year lease.

And also [ a port ] which is far away from any urban settlement. So these are some of the projects that got us into the debt. Also, the other thing is that, I mean, the -- and once we started borrowing from China, the cost borrowing costs went up, Chinese loans have higher -- much higher interest rates, especially when you compare to a country like Japan, which has been lending to us for most loans at 1% or even less than that.

So that's [ primary ] goal with China. But I believe that even the future -- I mean, it's -- China will be a major player because currently, when it comes to negotiating debt restructuring, the -- every 3 Sri Lankan and even the creditors, they're all looking at what China's next move would be.

Nathan Hunt: The indebtedness of Sri Lanka is fairly typical for emerging middle-income countries. What are the good and the bad side of sovereign debt for a country like Sri Lanka?

Talal Rafi: So when it comes to sovereign debt, I would say that there are some positives, like, for example, it has helped drive economic growth, though in sectors that haven't brought in long-term benefits. But for a country such as Sri Lanka as I was mentioning before, there is a lack of financial discipline. Like even currently we're going to the IMF for the 17th time. So we've gone to the IMF 16 times before. And what is like interesting is that we've only completed 9 of the programs.

7 of the programs -- I mean, the government just decided to simply walk out of those programs. So that's the kind of situation varying. So with that, I would say that for countries such as Sri Lanka and with that kind of a mindset, the bad side [ are more ] the negatives. Like, for example, when the government, especially on the domestic front, borrows more, there's a process of crowding-out effect. So it costs us less money for the private sector to borrow and the costs are much higher.

And also, when they constantly start borrowing, especially from the Central Bank, this caused a steady inflation. And also most of the borrowings, like, for example, the government from 2015 to 2019, over 80% of their borrowings was to pay debt from the past. So there is very little taken to kind of develop the country. But this was true like earlier from 2005 onwards, when Sri Lanka's debt was very low. So back then when the borrowings came in, the debt started accumulating. It was spent on projects. But right now, it's just recurring expenditure.

Nathan Hunt: Talal, I want to return to the quote from Lawrence Summers that I started with, where he was talking about the U.K. was behaving like an emerging economy. When you followed the controversy around the mini budget, did you see parallels with the policies of President, Rajapaksa with what the Prime Minister, Liz Truss at the time was trying to accomplish?

Talal Rafi: Yes. Actually, I was even sharing on social media handles that, the U.K. government was following Sri Lanka here, exactly. And the final thing was that it was exactly, I mean, all -- they had to go and save us just look at Sri Lanka and just don't do it. But there were 2 key differences, which I noted with the U.K. and Sri Lanka, back there, I mean, when the Prime Minister had her mini budget and with massive tax cuts, there was a strong opposition from economics, policymakers from industrialists and the wealthy.

But when it comes to Sri Lanka, it was mostly cheered on. Though there were some economics and opposition members who said not to go for these tax cuts. And the other critical thing is like we have to understand the role politics plays in economics because, as I mentioned, in Britain, it's a constitutional monarchy, but also, the Prime Minister's powers are limited and she is answerable to Parliament.

But here, as I mentioned before, the President had too much power, and there was very little stopping him. So that kind of -- could have saved the U.K. and couldn't save Sri Lanka.

Nathan Hunt: You had mentioned earlier the decision to ban chemical fertilizers under the former President, his decision to move to sort of an all organic model. What was the government justification for this decision? And what were the results of it?

Talal Rafi: I mean, I honestly don't know how to explain this -- the decision because not even a basic analysis was done when doing this. I think the reasoning -- a number of reasonings were given to this. One was that they felt that they were wrongly advised that chemical fertilizers were causing health issues like kidney failures and others.

But at the same time, the other thing was there was also a thing that many developed countries, the consumers preferred organic food. And so if Sri Lanka moves in to that sector, we might be able to capture the markets. But what they feel was this was a very niche market. And even if that was the right thing to do, we cannot change an entire country within 24 hours.

For example, all they had to do was do a probably a simple Google search of Bhutan. Sorry if I get the timeline strong, but I think from 2008 to 2020, Bhutan had a program to change the country to organic, and it failed after 12 years and they put a new program from 2020 to 2035, another 15-year program.

While Sri Lanka, they wanted to change the entire country to organic within 24 hours by completely stopping chemical fertilizers. So the fix have been devastating, like agricultural output halved, fell by 50%. And this critically hit rice production on which Sri Lankans depend mostly and also tea exports at a time when foreign exchange was very low. So this also hit the tea industry very hard. Further straining the reserves. So that's some of the effects of the decision to ban chemical fertilizers.

Nathan Hunt: So the former government fell in very dramatic fashion over the summer, there is a new government in place. What reforms would you hope to see this new government undertake in order to overcome the crisis?

Talal Rafi: Sure. I mean there's a -- that's a very good question. There's a lot to do here. But I'll just try to touch on probably some of the important things, but the first thing, in my opinion, to stop this, I mean, we can correct ourselves, but my worry is that we may fall into this yet again.

The first thing would be an independent Central Bank because when the Central Bank does not have the authority to stand against the treasury, it results in monetary financing. And so one of the things is that state-owned enterprises in Sri Lanka have very less accountability. And there is a lack of transparency as well.

So with -- for example, there was a study done by a think tank of 500 state-owned enterprises, even though there is a right to information act here, they could only obtain information for 50 of those SOEs. So it's -- with that kind of a situation, most of them have a sort of a blank check from the treasury and the treasury, of course, expects the Central Bank to finance it.

This has cost inflation and continuous fiscal deficit. So an independent central bank is very important. The second is we need to restructure state-owned enterprises. As I mentioned, 86% of government revenue goes to a public sector workers. And also 1 in 6 working age Sri Lankans men and women work for the government. So this is extremely unsustainable.

So state-owned enterprises have to be restructured and also certain SOEs have to be privatized. I really don't see the need for the government to own enterprises, especially with commercial interest like in the hotel industry or retail. So there has to be a thing for them to move out.

And improving the tax policies. As I mentioned, Sri Lanka has one of the lowest government revenues to GDP in the world at around 8%. It was 12% after the tax cut, it's come down to 8%. This was not the case. I mean, in the mid-1990s, Sri Lanka was like a developed country on average, gaining about 20% government revenue to GDP. But this has dropped down to 8%.

And also the tax base is extremely low. Less than 1% of the population come under the income tax range, which is -- which is quite poor. So the wealthy need to start paying taxes and the rates have to be hiked a bit, but gradually, I mean, considering the current situation.

But on the other side, for the long-term growth, I also feel that we need to shift towards an export-oriented economy. Like Sri Lanka is one of the highest tariff rates in the region, for a small country trying to subside every product is nearly impossible. With the economics of scale lacking, it's either going to be high cost or lower quality, if they're going to try to do everything.

And so joining global supply chains would be 1 area for Sri Lankan fixing because even if you look at, for example, manufacturing superpowers, such as China, it cannot produce an iPhone on its own. It needs components from, I think, 43 different countries and the value addition is at least 7% done in China, but it still creates 1.3 million jobs in China.

But for this, we need export-focused foreign direct investments. And for that Sri Lanka needs more FTAs. We only have 3 FTAs and so, for example, a country such as Vietnam has 26. So more treated agreements are needed and foreign tax investments ease of doing business has to be improved, like we ranked 99th in the world when it comes to ease of doing business, like around 2 weeks to register a business and a year to close down the business.

So these are impairments for -- especially when a foreign investor looks into the country and 162nd when it comes to law enforcement, according to the World Bank, it takes 4 years to solve a business case. So these are some of the issues and also labor reforms are much needed. I mean some of the labor laws in the country are almost 7 decades old.

So -- and Sri Lanka has 1 of the highest retrenchment costs in the world. So these are a number of areas we need to work on. But most importantly, I think more understanding is needed from the public side as well to go through with these reforms.

Nathan Hunt: So I want to return to the individual Sri Lankan that I asked you about earlier, what you're describing these reforms that sound very necessary are still going to be incredibly painful in a country that is already experiencing profound economic pain. Can the government realistically pursue these policies and stay in power in Sri Lanka?

Talal Rafi: So that's a good question. It's -- in my opinion, it's going to be really tough because for decades and decades, Sri Lanka has been used to populist policies. And there is always this lack of understanding on how economics works, especially like there is a sort of an understanding, especially in Colombo and other areas where you have professionals and educated people.

But outside with the lack of economic understanding and with a lot of fake news and false information going around, it's going to be a bit difficult to go through with some of these things. Like, for example, when I mentioned we have 1 of the lowest government revenue to GDP in the world. But then hiking up the taxes has caused a big backlash against the government.

So there has to be sort of consensus among the opposition parties and with many of the key stakeholders. But in my opinion, I think this can be done, but there has to be clear communication and transparency from the government. And there also has to be a give-and-take policy. Like for example, most of the people have been burdened with taxes. But there is also this thing that the government has to reduce unnecessary wastage.

One area critically would be like at a time when half of the population is finding it hard to have 3 proper meals a day. We still have, for example, the Sri Lankan Airlines, which is running huge losses. So some people say that it's pride to keep our own airlines. But like our neighbor just north of us, has just sold out their national airline.

So I don't see -- I mean, Sri Lankan Airlines is the national carrier is having a loss of nearly LKR 100 million a day. So that's the kind of loss. If this money can be transferred to develop better social safety nets, a lot of poor people can be provided food and other items. So there has to be a sort of a give and take, which I feel is lacking. I mean the government has promised that they are going to go ahead with SOEs restructurings.

But I don't see that happening as fast as implementing taxes. So the -- as I mentioned before, there has to be a give and take policy and broader public understanding and support is also needed for these critical and very tough reforms to take place.

Nathan Hunt: Talal, thank you so much for joining me today. It has been such a pleasure to talk to you and to learn more about Sri Lanka.

Talal Rafi: Thank you so much, Nathan. It's absolute pleasure to be here.

Nathan Hunt: The essential podcast is produced by Patrick Moroney with assistance from Kurt Burger and Kyle May. 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.