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Comprehensive Reforms Vital to Maximise Foreign Aid

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Photo courtesy of The Conversation

There is good news on the foreign aid front. Foreign aid from official donors reached an all-time high at $179 billion in 2021 as developed countries increased their assistance to developing countries hit by the Covid-19 economic shock. Moreover, emerging donors like India and China are playing an increasing role in foreign aid. India’s well-timed help to Sri Lanka, grappling with a crippling economic crisis, has been welcomed by the people of Sri Lanka and praised internationally. But it also provokes an important development policy question – can Indian aid to crisis hit developing countries like Sri Lanka be made more effective?

Sri Lanka’s crippling economic crisis

This is by far the worst economic crisis since Sri Lanka’s independence from British rule in 1948. The default on external debt obligations in mid-April 2022 and a dollar shortage to pay for essential imports (food, fuel and medicines) has brought unprecedented economic misery to a country that was once on the cusp of upper middle income status. About three quarters of a million additional people may become the new poor, reversing decades of admirable gains in poverty reduction. Inflation has soared to over 60%, raising food and fuel prices that have created shortages and food insecurity for the population. Many families are down to one meal a day and there is a risk of malnutrition among children. Reflecting contractions across economic sectors, the economy may contract by at least -6 to -8% in 2022.

In simple terms, Sri Lanka’s present economic crisis can be explained by external shocks (such as the Covid-19 pandemic and the Russia-Ukraine conflict) and poor macroeconomic management by former president Gotabaya Rajapaksa’s government. Reference is made to the 2019 tax cuts, fostering an already bloated public sector, the ban on chemical fertilizers, increasing red tape regulation and the inexplicable delay in going to the IMF. To sort out its balance of payments problems, Sri Lanka has been negotiating an IMF programme of $3-4 billion since May 2022. But this process will take some time as the country needs to whittle down its external debt of $51 billion to sustainable levels and get assurances from its creditors before it can reach an IMF agreement. Meanwhile, it has been seeking bridging finance to provide dollars for essential imports of food, fuel and medicines from friendly countries. This has proved particularly challenging as 60% of the world’s poorest countries are also experiencing debt distress while a possible second global recession in three years could dampen advanced economies’ enthusiasm to support Sri Lanka.

Upscaling Indian aid?

With India becoming one of the world’s fastest growing major economies, it has gradually shifted from aid recipient to aid donor since the early 2000s. Concessional lines of credit (i.e. concessional loans or guarantees) forms the bulk of Indian aid while grant aid is small. The available data suggest that India’s concessional lines of credit presently amount to $30.5 billion with half of it going to poor Asian countries. Meanwhile, according to the allocation in 2021-2022 Indian budget, grants could amount to $2.4 billion.

India was the first responder to Sri Lanka’s desperate request for bridging finance and foreign aid. India has been motivated by the unfolding humanitarian crisis affecting the Sri Lankan people and political pressure from South Indian states to provide aid. In the first six months of 2022, Indian aid worth $3.8 billion has flowed in through credit lines, deferred loans and grants making it India’s largest bilateral aid programme in recent times.

Back of the envelope calculations suggest that Sri Lanka would require financing of between $20-25 billion over the next three years to provide essential imports and to help to stabilise the economy. India alone may not be able to mobilise such a large aid envelope in the short run. Nonetheless, India has a unique opportunity to cement its reputation as an emerging donor by leading an aid consortium for Sri Lanka, working closely with other friendly countries (e.g. Japan, the US, and the EU) and the IMF and World Bank.

Supporting Sri Lanka could be in India’s best interest. Stabilising Sri Lanka’s economy could be a major win for Prime Minister Modi’s neighbourhood-first policy and enable India to steal a march over China as an emerging donor. Moreover, once the economy stabilises, India can deepen its trade and investment linkages with Sri Lanka, transcending from the current humanitarian aid relationship. This could spur regional integration and prosperity. Furthermore, it could help advance India’s long held ambition of securing a seat on the UN Security Council. Meanwhile, an unstable Sri Lankan economy could pose security risks to India and lead to a flood of refugees across the Palk Strait.

Guideline for aid effectiveness

Some question why Indian taxpayers should bail out Sri Lanka when there is a perception that Sri Lanka’s debt default is largely of its own making, the result of mismanagement and corruption.

International experience suggests four important guidelines on how to make Indian aid more effective. One is aid should be divided into smaller projects directed to the poor and be distributed countrywide rather than just to the Western Province. Another is where possible the private sector and grassroots non-governmental organisations should complement nationwide aid delivery by state institutions. Another is it would be prudent to have appropriate controls in place to ensure that leakages and dead weight losses are minimised to acceptable levels.

Finally, the impact of aid from India and elsewhere can be maximised only if Sri Lanka adopts comprehensive economic and political reforms. There are five important items in the in tray of the new administration of President Ranil Wickremesinghe.

It has to show it is serious about stabilising the economy by concluding talks on an IMF programme that will increase taxes and utility prices to raise revenue and increase interest rates to control inflation while preserving social welfare expenditures to protect the poor. It has to implement structural reforms to make the economy more open to trade and investment and allow market forces to determine resource allocation. This means reducing barriers to trade and investment and cutting red tape hampering business. It has to build a national consensus on implementing the IMF programme and reforms by explaining to the public that this is the only solution to the crisis. It has to restore the rule of law and enforce strong anti-corruption policies (including asset declarations for all parliamentarians and a strong anti-corruption office supported by the United Nations). Later, the executive presidency should be abolished and a return made to a Westminster style of parliamentary system. It has to reset foreign policy towards a more neutral direction and away from the pro-China stance of Mahinda and Gotabaya Rajapaksa.

The Wickremesinghe administration faces the difficult job of turning around the economy particularly in a situation of political uncertainty and a looming global recession. A strategically location in the centre of the Indian Ocean gives Sri Lanka a sporting chance of achieving some economic normalcy in the next two to three years if it can harness the political will to implement good policies. By emphasising more aid effectiveness and leading an aid consortium for Sri Lanka, India can cement its growing reputation as an emerging aid donor. The alternative is the bleak prospect of a lost development decade for Sri Lanka.

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