Sri Lanka: Financing the post-war economy

In recent years, the Sri Lankan economy has been increasingly looking towards the East. This policy trend first became evident during the height of the war in 2007 as the 'international community' called upon the government of Sri Lanka to show restraint and be sensitive to the predicament of civilians. At the time, Sri Lankan officials raised the question of exactly who constitutes this 'international community'. Indeed, in 2005 itself, President Mahinda Rajapakse, in his election manifesto before his first term, had signalled very clearly his turn Eastward, away from the strong economic and geopolitical ties of previous governments with Western powers. Following on this, over the last five years there has been considerable economic engagement with the Eastern powers, particularly China, India and Iran. Beijing is now Sri Lanka's largest donor. 
For the moment, President Rajapakse has managed to neutralise the Western powers with the economic strength of the emerging Eastern powers. Furthermore, over the last five years he has also sought to balance the export sector of the economy with an emphasis on agriculture and the rural economy. Both steps were seen as a shift away from the foreign and economic policies of the previous regimes. 
Over the year and a half that has passed since the end of the war, however, there has been another major shift in what seems to be a contradictory direction. Sri Lanka is quickly being integrated within the structures of global capital, as financial liberalisation moves along at a much quicker pace with the post-war economic boom. In other words, Sri Lanka's external sector of the economy was moving beyond the foreign direct investment of Western and Eastern powers alike, towards international financiers seeking returns in the emerging markets. Sri Lanka's financial press is abuzz with news of the booming stock market; and the Securities and Exchange Commission (SEC) is now attempting to transform Sri Lanka's economy. Indeed, the main thrust of President Rajapakse's 2011 budget speech was about tax reform and financial liberalisation, reducing both the income taxes of the wealthy as well as facilitating the flow of capital into the country. 
There are four main areas where the Rajapakse government is relying on investment to expand the economy: reconstruction efforts in the north and east after the war; investment in infrastructure, particularly roads, ports and power plants; business investment in the stock market and corporate debt as companies seek to expand amidst rapid economic growth; and increasing investment in real estate. The last two are gaining far more importance with the liberalisation of the financial sector and the integration into the global capital markets. In early January, the SEC chairperson, Udayasri Kariyawasam, made a statement that the Commission wants to substantially expand the value of capital markets, now equivalent to 40 percent of Sri Lanka's gross domestic product of SLR 5.5 trillion (USD 49.6 billion). Plans are to increase market capitalisation of the Colombo Stock Exchange from current levels of SLR 2 trillion to SLR 3 trillion in 2011. Two Chinese investors have also unveiled plans to purchase prime real estate in Colombo worth USD 250 million. 
Neoliberal embrace
The rapid pace of financial change is likely to significantly impact upon the structure of Sri Lanka's economy, making it increasingly susceptible to ebbs and flows of global capital markets. A year and a half ago, the country was facing a major balance-of-payments problem, leading to a USD-2.6 billion standby facility from the International Monetary Fund. This boosted the confidence of international financiers, and official foreign reserves reached USD 6.6 billion by the end of 2010. Furthermore, Sri Lanka, in the last year and a half, has floated USD 1.5 billion worth of sovereign bonds. Now, there are moves afoot to list many more companies on the stock exchange, and to encourage a larger corporate-debt market. 
Historically, foreign aid and debt played an important role in sustaining the Sri Lankan economy. However, now the liberalised capital markets are set to counterbalance the impact of any single bilateral or multilateral donor. Consequently, the impact of the external sector, dominated by global finance and capital markets and the attendant changes to the class structure of society, are likely to transform the country's political economy. Sections of the Colombo elite, well connected to the financial and real-estate sectors, are likely to gain from such liberalisation, whereas the marginalised and regional actors might find themselves further excluded from the new economic growth.
While the year ahead looks rosy for the Sri Lankan economy, in the medium term there are significant risks. The free inflow of finance capital is such that it can as easily flow out, leading to severe economic crisis. As seen from the recent experiences of emerging markets, the East Asian economic crisis of the late 1990s and the global economic crisis of the last three years, the combination of expansion of capital markets and excessive emphasis on real estate can lead to an economic bubble that portends serious consequences. 
Income inequality within Sri Lanka, which has been increasing since the open economy reforms of 1977,  is likely to further diverge as the benefits of economic growth are limited to a smaller wealthier class. Indeed, the cost of living has been on the rise over the last five years, and the government now does not have the excuse of the war to call for a tightening of belts. The massive flooding in January has displaced close to a million people, and agriculture has suffered major losses, which will lead to further rise in the cost of living and economic woes.
The underlying economic changes impacting post-war Sri Lanka might simultaneously benefit and create major challenges for the Rajapakse government. In fact, these changes could prove far more significant in shaping the country's future than the weak political opposition or, for that matter, the dwindling interest of the international community. And the support of the Eastern powers, so crucial for the military efforts that came with the war, might not be able to bail the country out of a crisis. If one takes a cue from the short-term attitude towards foreign relations, the Rajapakse government seems to be ill-prepared to address the challenges that could result from the economic changes it has unleashed in post-war Sri Lanka.
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Himal Southasian