Sri Lanka: Can the peace dividend continue?

Sri Lanka recently brought an end to its long running civil war and is enjoying a honeymoon of rapid economic growth, political unity and increasingly warm relations with China. However, the country’s political and economic situation remains fragile and there is the danger of a return to widespread inter-ethnic violence, which plagued the country for over 25 years, along with the risk of a deteriorating economic situation and a further manifestation of a growing authoritarian streak in the government. Below I summarize the country’s geo-political, economic and trade issues, as well as outline three potential scenarios the country could face.

When I visited Sri Lanka in 2009 the civil war was just coming to its dramatic conclusion and the Asian Development Bank and World Bank officials I spoke to were cautiously optimistic that the violence would end for good and the country would benefit from a significant peace dividend. No longer having to fight against the Tamil Tigers meant the armed forces budget could be cut considerably , leaving more funds for infrastructure and social spending, while civilians and soldiers involved in the war are able to put their energies into something more productive; “swords into ploughshares”.

The end of the conflict provided a big boost to business confidence, as companies rode the wave of optimism and took the opportunity to invest and expand. On a personal level, Cinnamon Gardens, the charming Hikkaduwa based guest house we stayed in was planning an expansion of rooms in anticipation of rising visitor numbers. Since then a Chinese funded motorway has improved links between Colombo airport and the main tourist hotspots in the south of the country and tourist numbers hit 1 million in 2012, bringing USD 1 billion in revenue, both new records.

These factors have already translated into an 8 per cent GDP growth rate in 2011, up from an average of 5 per cent during the last few years of the war. The island has always enjoyed spectacular scenery, but the end of the war has seen tourists returning to enjoy the views, providing important foreign currency earnings. Most of the tourists I met were western who lived for months at stretch on the island during the winter or honeymooners, but new groups are emerging, middle class Russians and Ukrainians looking for a warm place to spend the winter and invest money, but the biggest potential is from China, which has a growing taste for foreign travel, and whose numbers are rising rapidly, albeit from a small base.

The country has recently turned away from the IMF to international capital markets to finance its increasing fiscal deficit; this represents a vote of confidence in the island’s economy, but also raises new risks, that of an unsustainable debt problem, particularly as Sri Lanka entered 2013 with a deficit of 7.8% of GDP in 2013. A sharp downturn in the economy could quickly raise the spectre of a sovereign debt problem and a run on the Rupee, leading Sri Lanka straight back to the door of the IMF.

Sri Lanka is also poised to benefit from two external forces; firstly the potential for South Asian trade to increase, particularly with India, but also Myanmar, Pakistan and Bangladesh. Currently the region has the biggest barriers to inter regional trade in the world; only 5 per cent of South Asia’s trade is inter-regional, compared to 25 per cent for the ASEAN region or 67 per cent for the EU. Sri Lanka has a bi-lateral trade agreement with Pakistan and India, but nonetheless tariffs and barriers remain high. If the countries manage to overcome the political barriers (such as border disputes) that exist between them, and reduce tariffs and other trade restrictions, then all the countries involved would see significant economic benefits, and Sri Lanka would be no exception.

Secondly: Sri Lanka is also in a position to benefit from China’s growing investment and trade ties with the region. The foremost example of this trend is the construction and development of the Port of Hambatota, which was largely financed and constructed by Chinese firms such as Sinohydro and China EXIM bank. Hambantota lies just a few miles from the vital shipping lane, which runs from the Straits of Malacca to the Suez Canal. The Port will provide berths for repairs, refuelling and maintenance for ships on this route, which represents a large proportion of the world’s shipping traffic. Next to the port will be Sri Lanka’s biggest export processing zone as well as a new international airport.

The construction of this port has deepened and strengthened relations with China, as that country sinks physical and financial assets into the island. Increased trade and investment from China will act as a counterweight to India’s influence, preventing overdependence on its northern neighbour.

There is speculation that the Chinese navy wants to set up a military base in Sri Lanka, similar claims have been made for Gwadar in Pakistan and for ports in Myanmar, the “String of Pearls” theory which suggests that China wants to surround India with naval bases to contain it. However, for now there is no hard evidence of the Chinese constructing a permanent naval base.

While Chinese investment is currently making the headlines, India remains the country’s biggest trade partner apart from the EU. India naturally dominates Sri Lanka in a geographical sense, with a land area and population that vastly outweighs its Southern neighbour and its powerful influence remains undeniable. Perhaps Sri Lanka’s most overlooked international relationship is with the Gulf Council States, which supply 90 per cent of the country’s oil and gas, and in addition is a major destination for the island’s migrant workers, that help to alleviate the island’s unemployment problems and are a rich source of remittances, as workers send wages home to their families.

Although relations with the West have cooled somewhat, thanks to on-going concern and criticism of the human rights situation in the country (the Rajapraksa Government most recently ignoring the UN Human Rights Council’s recommendations to carry out investigations into allegations of war crimes, as well as moves by the executive to seize more power, such as controversially firing a supreme court judge) as well as Rajapraska’s government inclination towards Asian partners. The US, Japan and EU will of course continue to be significant external influences on Sri Lanka, as the major aid providers to the country, as well as exerting influence via western institutions such as the World Bank and Asian Development Bank.

Below I outline three scenarios for Sri Lanka, encompassing geo-politics, economics and business developments. Naturally these scenarios will play out in a more complex interlinked way than described, but provides a number of pathways the country’s future may play out.

Positive Scenario

•             Sri Lanka’s economy continues to power on, buoyed by increased infrastructure spending, stable government, increasing tourist revenues, and the appearance of foreign investors all contribute to a high steady positive growth rate. The country develops as a trade regional hub, taking advantage of the deep water port of Hambantota and its position close to the Malacca – Suez shipping route, the port’s export processing zone provides a boost for the country’s industrial sector, which begins to expand, providing high quality jobs and a sustainable economic future.

•             Good economic news helps to mollify ethnic tensions, despite its tendency towards the authoritarian, the Government retains its legitimacy and the country’s democracy remains intact. Crucially ethnic and religious violence, in particular Muslim Vs Buddhism and Tamil Vs Sinhala conflicts are kept to a minimum.

•             Sri Lanka develops closer relations with China, but not going so far as too offer the Chinese navy hosting rights, which keeps New Delhi “onside” as well as developing closer links with Bangladesh, Pakistan and Myanmar.

Some good, some bad Scenario

•             GDP growth will continue, but not at the high levels previously enjoyed by the country, as the peace dividend fades and the Government fails to fully capitalise on the country’s potential for development.

•             The government’s failure to address the issues of war crimes during the civil war and lack of action on other grievances lead to outbreaks of ethnic and religious inspired violence, hampering progress towards political unity and damaging confidence in the investment climate and discouraging tourism.

•             South Asian trade integration improves, but political obstacles prevent the levels of integration seen in the ASEAN region, Chinese investment and trade continues to increase and Sri Lanka is able to find a balance between Chinese, Indian and Western influences.

Negative Scenario

•             The peace dividend is quickly exhausted, and the government fails to take advantage of this period to build a sustainable economy, by failing to invest in infrastructure, by allowing corruption to flourish, and through taking a protectionist stance against foreign investment and trade not helped by the failure of the SAARC countries to develop inter-regional trade. In addition Sri Lanka fails to follow the World Bank supported Mahinda Chintana economic plan to take the country forward. Hambantota’s role as a regional and international trade hub fails to materialise and growth in trade is generally disappointing. Although Chinese investment continues to rise thanks to intervention of Beijing, other foreign investors are scared away.

•             The government’s failure to build an inclusive democracy comes back to haunt it as poor economic conditions worsen the country’s inequalities, which exacerbate ethnic tensions, which in turn take the country down the road of violence once again.

•             The country’s lack of economic success, coupled with its lack of natural resources mean that regional powers such as India and China turn their eyes and cash to other parts of the Indian Ocean and Sri Lanka is forced to use the IMF and the World Bank as its main economic partners.