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India as an emerging aid donor to debt crisis hit Sri Lanka

Written by Ganeshan Wignaraja

Expert Comment

There is growing international interest in the role of emerging Asian aid donors like India in the changing international aid architecture of the 21st century. India’s timely aid to mitigate Sri Lanka’s economic crisis provides insights on how aid from emerging donors works and how it can be made more effective.

Sri Lanka’s aid quest

Sri Lanka’s worst economic crisis in its post-impendence history is attributed to a mix of external shocks (such as the Covid-19 pandemic and the Russia-Ukraine conflict shock) and poor macroeconomic management by ex-President Gotabaya Rajapaksa’s Government. Following the default on its foreign debt obligations in mid-April 2022 and a dollar shortage to pay for essential imports (e.g. food, fuel and medicines), the Sri Lankan economy could contract by more than -6% in 2022. Inflation has soared to over 50%, raising food and fuel prices which have created food insecurity. About three-quarters of a million additional people may become the ‘new poor’, reversing decades of admirable gains in poverty reduction in Sri Lanka.

Sri Lanka has been negotiating an IMF programme of US$3-4 billion since May 2022. But this process will take some time as Sri Lanka needs to whittle down its external debt of US$51 billion to sustainable levels and get assurances from its creditors before it can reach an IMF agreement. Meanwhile Sri Lanka has been seeking bridging finance to provide dollars for essential imports of food, fuel and medicines from friendly countries. This has proved 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.

India as an emerging aid donor

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 suggests that India’s concessional lines of credit presently amount to US$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 US$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 US$3.8 billion has flowed to Sri Lanka though 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 US$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 Sri Lankan 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.

Making Indian aid more effective

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 three important ways to make Indian aid to Sri Lanka more effective. One is aid should be divided into smaller projects directed to the poor and be distributed throughout Sri Lanka, not just to Colombo. 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, to maximise the impact of aid from India and elsewhere, it is essential for Sri Lanka to implement comprehensive economic and political reforms. There are five important items in the in-tray of the new administration of President Ranil Wickremesinghe, a six times Prime Minister, who took office on 21 July 2022.

  1. It has to show it is serious about stabilising the economy by concluding talks on an IMF programme which 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.
  2. 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.
  3. 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.
  4. 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.
  5. It has to reset foreign policy towards a more neutral direction and away from the pro-China stance of Mahinda and Gotabaya Rajapaksa.

A last word

With political will and good policies, Sri Lanka stands a sporting chance of achieving some economic normalcy in the next two to three years. By emphasising more aid effectiveness and leading an aid consortium for Sri Lanka, India can cement its growing reputation as an emerging Asian aid donor.