Sri Lanka is in the midst of its worst economic crisis since gaining independence in 1948. People took to the streets protesting, even with violence, against the political dispensation in the face of shortages of essential commodities. On April 1, 2022, President Gotabaya Rajapaksa declared a state of emergency but had to withdraw it within a week as angry citizens defied the emergency to continue their protests over the government’s handling of the crisis. The people are facing an extreme scarcity of food, fuel, and other essential commodities. Inflation is at an all-time high of 17.5 per cent. The country relies on the import of many essential items including petrol, food items, and medicines, but the acute shortage of foreign exchange has pushed up the prices of basic necessities exorbitantly.
A Crisis in the Making
Experts are of the opinion that the crisis has developed gradually over the years, mainly due to government mismanagement. According to a former Deputy Governor of the Central Bank of Sri Lanka, W.A. Wijewardena, the country was already into an economic crisis in 2015 but the government did not adequately address the economic warnings and emerging dangers. A 2019 Asian Development Bank working paper referred to Sri Lanka as a classic twin deficits economy, i.e., an economy suffering from a budget shortfall alongside a current account deficit; a situation in which a country’s national expenditure exceeds its national income and the production of tradable goods and services is inadequate.
Election-related economic decisions such as excessive distribution of freebies further exacerbated the problem. The Institute of Policy Studies of Sri Lanka’s 2014 State of the Economy Report highlighted hot money, worrying borrowing practices, temporary and superficial quick-fixes, and monopoly of FDI flow into one sector– hospitality. The political turmoil in 2018 worsened the economic outlook. At that time, government could successfully control inflation by undertaking several reforms under an IMF supported programme towards fiscal monetary consolidation. However, the new government that came to power after the 2019 elections reversed many of the reforms.
Causes of Economic Crisis
Over the past decade, the Sri Lankan government borrowed vast sums of money from foreign lenders to fund public services. A major creditor of Sri Lanka is China. This has led to enormous public debt. During this time, the country also faced natural disasters, such as heavy monsoons, the pandemic, and catastrophes born of wrong policy decisions, such as a government ban on chemical fertilizers, which led to distress for farmers, and mismanagement as in the Easter Sunday bombings of 2019. Sri Lanka built up unsustainable commercial debt and an acute balance of payments shortfall as foreign exchange earnings fell.
The various factors behind the crisis can be enumerated as follows:
Covid19 pandemic Sri Lanka is highly dependent on its tourism sector to bring in the foreign exchange required to import essential items such as food and fuel. The tourism sector contributes to about 10 per cent of Sri Lanka’s gross domestic product. But the country’s tourism sector has been hit hard by the pandemic which, in turn, has affected the inflow of US dollars into the Sri Lankan economy. As a result of the drop in tourism, forex reserves of the country plummeted to $2.3 billion in February 2022 from over $7.5 billion in 2019. As a consequence, it became quite difficult for the Sri Lankan government to repay its foreign debt obligations (in dollars).
Tax cuts lowering credit rating In the wake of the massive deficit, President Gotabaya Rajapaksa reduced taxes in a futile attempt to stimulate the economy. Corporate tax rates were reduced from 28 per cent to 24 per cent. The move proved disastrous for government revenue: about 2 per cent of the gross domestic product was lost in revenues because of these tax cuts. This led rating agencies to downgrade Sri Lanka to near default levels, meaning the country lost access to overseas markets.
Sri Lanka was forced to fall back on its foreign exchange reserves to pay off government debt, shrinking its reserves from $6.9 billion in 2018 to $2.2 billion in 2022. This impacted imports of fuel and other essentials, which sent prices soaring.
Fixing of exchange rate The way Sri Lanka tried to fix the exchange rate of the Sri Lankan rupee against the US dollar in order to prop up the value of the rupee may also be a factor in the foreign debt crisis. As foreign exchange inflows became scarce during the pandemic and the Sri Lankan rupee came under increasing pressure, the country’s central bank at a certain point banned the payment of more than 200 Sri Lankan rupees for one US dollar. This rate was much below the actual market price of the dollar. This caused trade to be pushed into the black market and also caused a drop in the supply of U.S. dollars in the forex market.
Floating the Sri Lankan rupee In March 2022, the government floated the Sri Lankan rupee (meaning its price was to be determined based on the demand and supply of foreign exchange markets) with the apparent aim of devaluing the currency. This was done to qualify for a loan from the International Monetary Fund (IMF) and to encourage remittances. However, the fall of the rupee against the US dollar made the matter worse.
Agriculture crisis In order to prevent the drain of foreign exchange reserves, the Government of Sri Lanka, in April 2021, banned all chemical fertilisers and declared the country a 100 per cent organic farming nation. The decision to switch overnight to organic farming resulted in a drastic fall in agricultural production; production of the critical rice crop also declined. So, more imports became necessary, further stressing the foreign exchange reserves. A fall in the productivity of tea and rubber, also due to the ban on fertiliser, led to lower export incomes and availability of less money to import food. All this led to food shortages, and the prices of food and other essential items rose.
The decision on fertilisers was reversed in November 2021, but by then the damage had already been done to crop yields.
Overall economic policy direction Political analysts have opined that the Rajapaksa government’s ‘Sinhala nationalist’ approach also directed its economic policies. The government moved away from the pro-market, liberalisation policies of previous dispensations to adopt policies in favour of investment in infrastructure and welfare, mostly funded by bilateral and commercial market loans. It is to be noted that the country had to move towards commercial debt partly because it had progressed into the middle-income bracket, thus no longer being eligible for concessional multilateral aid. Moreover, the Rajapaksa’s nationalistic view did not favour the conditionalities attached to multilateral aid.
Role of China’s Debt Trap
Many are of the view that Sri Lanka’s economic relations with China is the root cause of the crisis in Sri Lanka. Defaults over China’s infrastructure-related loans, especially relating to the Hambantota port, are being considered as the drivers of the crisis.
This phenomenon has been termed as debt-trap diplomacy by the USA. Under debt trap diplomacy, a creditor country or institution extends cheap loans to a borrowing country to increase the lender’s political leverage besides economic gain. If the borrower extends itself and fails to keep up the repayment, it puts itself at the creditor’s mercy. The creditor then has the chance to get concessions or some extra advantages in exchange of debt relief.
Two countries in India’s close neighbourhood, Pakistan and Sri Lanka, signed up for massive Chinese debt-funded infrastructure projects, fell into economic crisis, and are now undergoing political turmoil. In Myanmar, the Chinese are pushing projects for an economic corridor. Analysts point out that among the countries in the region, the ones in turmoil are those with the greatest exposure to Chinese debt. However, the entire blame cannot be put on China. In the case of both Pakistan and Sri Lanka, long-term economic mismanagement has been a major issue, which made them more vulnerable to the repercussions of the COVID- 19 pandemic and the Ukraine war. Loans from China accounted for only about 10 per cent of Sri Lanka’s total foreign debt in 2020. The largest portion of the country’s foreign debt, i.e., some 30 per cent, can be attributed to international sovereign bonds.
Without associated reforms, even good projects become financial burdens. Due to this reason, privately-funded infrastructure projects are often a bad idea, and foreign-funded projects with costly loans are the worse. It is very unsound to undertake such projects in the first place. So, ultimately, the onus is on the borrower, not the opportunistic lender.
China’s main role lies in having acted like a shrewd moneylender, selecting its targets carefully. Projects and loans went to resource-rich or strategically-placed countries, a majority of which did not have a good credit rating or any rating at all and, thus, had few alternative sources of external finance. China protected its own interests by holding project assets as collateral, taking over quite a few. Lending has therefore been followed by asset-grab. Co-option of political leaders (like Sri Lanka’s Rajapaksa family) was a necessary component of the strategy. So, China exacerbated but did not quite cause the problem.
Fallouts of Crisis
People affected by shortages The crisis has made the daily lives of Sri Lankans quite miserable. People are compelled to wait in long queues for basic goods, many of which are being rationed. Soldiers have been called in to manage the customers at gas stations, soldiers are stationed to manage customers, who stand in line for hours to fill their tanks. Severe power shortage has led to massive power cuts throughout the country.
The healthcare sector of the country is also experiencing immense difficulties. Hospitals are said to be running out of medicines and essential supplies as the country’s economic crisis worsens.
Political aspects On the political front, the government’s cabinet was effectively dissolved on April 3, 2021 as there were mass resignations of top ministers of the government. The governor of the central bank also resigned.
On April 10, talks for the formation of an interim government failed. A new cabinet comprising 17 ministers was formed on April 18.
Foreign debt As of February 2022, Sri Lanka was facing debt repayments of around $4 billion in 2022, including a $1 billion international sovereign bond (ISB) maturing in July and was in possession of only $2.31 billion in its reserves. The largest share of Sri Lanka’s foreign debt at $12.55 billion was in the form of ISBs, the major lenders being the Asian Development Bank, Japan, and China.
As per an IMF review of the country’s economy released on March 2022, public debt had reached ‘unsustainable levels’, and foreign exchange reserves were not sufficient for near-term debt payments.
Despite facing grave risks, the Sri Lankan government and the Central Bank of Sri Lanka (CBSL) resisted calls by experts and opposition leaders to seek help from the IMF, but after oil prices soared in the wake of Russia’s invasion of Ukraine in late February 2022, the government came out with a plan to approach the IMF in April.
On April 15, 2022, the country defaulted on its foreign debt amounting to $51 billion for the first time since its independence.
The act of defaulting on foreign debt may make international lenders unwilling to lend any more money to the Sri Lankan government unless such lending is part of a restructuring agreement. This will also impact the ratings that international ratings agencies give to debt issued by the Sri Lankan government. The cost of fresh borrowing is likely to be high for the Sri Lankan government because lenders face greater risk in lending to a government that has not been able to repay its earlier debt.
India’s Help to Sri Lanka
India has extended assistance of about $2.5 billion to Sri Lanka, including credit facilities for fuel and food. Since mid-March, over 270,000 metric tonnes of diesel and petrol have been delivered to Sri Lanka. In addition, around 40,000 tonnes of rice were supplied under the recently extended $1 billion credit facility to support the contracting economy.
In April 2022, India sent vegetables and daily ration items to Sri Lanka. Items like sugar, rice, and wheat—of which India has a surplus—were part of the consignment.
India also sent a shipment of 11,000 MT of rice in the wake of the Sinhala and Tamil new year. In February 2022, India gave a short-term loan of $500 billion to Sri Lanka to help it purchase petroleum products.
In November 2021, India had given 100 tonnes of nano nitrogen liquid fertilisers to Sri Lanka as their government stopped the import of chemical fertilizers.
Under the Asian Clearance Union, the Reserve Bank of India (RBI) extended a currency swap of $400 million and deferred payments owed by the CBSL worth several hundred million dollars.
Other Countries Facing Similar Crisis
With the growing crisis in its economy, Sri Lanka has joined the league of countries that have encountered similar situation. These countries are:
Afghanistan According to the United Nations, at least 55 per cent of the population of Afghanistan is expected to be in crisis or emergency levels of food insecurity through March 2022. Ever since the Taliban took control of the country in August 2021, Afghanistan’s economic and humanitarian crisis has worsened. Acute malnutrition has been ruling over the country causing food shortage and threatening food security.
Venezuela The economic crisis in Venezuela has been ongoing for decades. According to the World Food Programme (WFP), one out of every three Venezuelans is food-insecure and in need of urgent food supplies. The COVID-19 pandemic has further deepened the country’s humanitarian and economic crisis. There is a continuous shortage of fuel, electricity, and clean water, which has led to several riots over years.
Middle East Several countries in the Middle East face economic crisis, which has deteriorated in the last two years. Syria, Iraq, Libya, and Yemen are worst hit and are on the brink of a humanitarian catastrophe. There is acute poverty and an economic breakdown that can push the region into an even more severe chaos.
Russia Moscow’s war on Ukraine and the consequent financial backlash it has created are not only wreaking havoc in Russia, but are also threatening the global economy. Russia is the main supplier of oil, natural gas, and metals; higher prices for these commodities are bound to have economic implications around the world. Europe is dependent on Russia for nearly 40 per cent of its natural gas and 25 per cent of its oil. Russia’s war has considerably increased the possibility of runaway inflation and an economic setback for the European continent.
Sudan In March 2022, Sudan announced it will float the country’s currency as its economic conditions deteriorated further. It is likely to cause a rapid increase in prices of commodities and services in response to a fall in the value of the pound.
Way Forward for Sri Lanka
The way forward for Sri Lanka is not going to be easy, even with IMF support. Economists believe that the situation will take a turn for worse before getting better. The outcome will depend on the conditions set by the IMF and the way Sri Lanka responds to them.
A bailout by the IMF implies that the Sri Lankan government will have to agree to implement structural reforms as a pre-condition for such aid. The IMF may ask the Sri Lankan government to revert its stance on 100 per cent organic farming that has affected food supplies and caused food prices to rise. There could also be recommendation to do away with price controls on food and other essential goods as price controls on any commodity affect the incentive that producers have to bring fresh supplies into the market. Similarly, controls imposed on the exchange rate of the rupee may also need to end so as to attract US investment once again.
Abolishing price controls and reverting from full-scale organic farming could help the domestic economy to move towards normality. A sense of normality can help the tourism sector of the country as in the present scenario of uncertainty and turmoil in the country, tourists may be unwilling to visit Sri Lanka.
The IMF is also likely to recommend reforms such as increasing taxation and reducing state spending. The impact of such measures on common people already suffering under the crisis remains to be seen. It would be a stupendous task for the Rajapaksa government to take tough policy stance in view of its diminishing political capital.
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