The Sri Lanka Economic Crisis

    • By,
      Lohith Kumar Reddy – Research Assistant, Kautilya

Sri Lanka’s economic collapse is really very tragic. For a long time, the country was projected to be the next Asian tiger, but it is currently struggling to keep its balance sheet in order. Several factors have driven the economic situation to the point where it is currently, including the government trajectory.

The Sri Lankan government declared an economic emergency in late August last year, citing rising inflation, a weakening currency, and rapidly depleting foreign exchange reserves. However, none of the policies that the country has employed have been able to improve the situation. And now, the government of Gotabaya Rajapaksa has been shaken by a wave of spontaneous protests that have swept the country, threatening its survival.

While the epidemic has played a role in the economic downturn, the difficulties are mostly the result of its own actions. In 2019, populist tax cuts supported by money printing triggered a balance of payments problem. Despite repeated warnings from independent analysts, the government has stuck to its domestic policy of import substitution to save money.

Let us attempt to shed some light on the various aspects of Sri Lanka’s economic position that have resulted in the country’s current dilemma.

The Forex problem

Sri Lanka’s foreign exchange reserves are critically low, with only enough dollars to cover imports for less than two months. At the end of July, Sri Lanka had only $2.36 billion in foreign currency, compared to $6.93 billion in August 2020. The Sri Lankan rupee had lost 7.5% against the US dollar by the end of 2021.

In a bid to protect the local currency, Sri Lanka’s Central Bank hiked interest rates late last year, making it the first central bank in Asia to do so since the outbreak. Sri Lanka has typically borrowed to fuel its expansion, but throughout most of its history, it has benefited from low-interest concessionary loans.

Sri Lanka, however, had to rely on new finance sources once it reached middle-income status. According to a February 2021 article in The Diplomat, commercial borrowings accounted for 56 per cent of Sri Lanka’s foreign loans by the end of 2021, largely in the form of International Sovereign Bonds.

The impact of the balance of payments crisis has resulted in higher prices for items such as sugar, rice, onions, and potatoes, as well as long lineups outside stores, due to shortages of milk powder, kerosene oil, and cooking gas.

In addition to this, there are several more aspects to consider: The local economy has also been harmed by a drop in tourism, which accounts for nearly 10% of Sri Lanka’s GDP. The third-largest source of foreign exchange was tourism. Surprisingly, the tourism slump occurred before COVID-19: in 2019, tourist footfalls fell by 18%, the first drop in nearly a decade of constant increase.

The government appeared to believe that its troubles were mainly due to the virus, and that things would rapidly return to normal once tourism increased, however, this has also not been the case.

Economic policy: a factor in worsening situation in Sri Lanka

Gotabaya issued massive tax cuts shortly after taking office. In 2020, revenue is expected to drop by roughly 30%. After that, the government went on a money-printing binge. Between December 2019 and August 2021, the amount of money poured into the economy increased by 42%.

Even while people were grappling with rising prices and scarcity, Gotabaya struck again. His government outlawed the use of chemical fertilizers completely in May, 2021. Farmers were unable to sow at the start of the monsoon season due to the rain.

Food output fell and prices climbed as a result of this erroneous attempt to preserve foreign exchange by restricting the import of things like chemical fertilizers. At the same time, to service international debt, available foreign reserves were drained anyway. To put it into perspective, one should note that the agriculture sector employs two-thirds of Sri Lanka’s population.

The continuing problem

Over the past year, public discontent has grown as a result of increased costs and shortages of commodities such as cooking gas, food, and medicines. In January, fuel grew scarce, and power outages became increasingly common. As the country entered its hot season, queues for basic commodities and services stretched for miles, forcing consumers to spend hours in the sweltering heat.

In the first week of March, the currency plummeted and public outrage erupted as power outages were extended to up to 10 hours every day. For several weeks, a wave of spontaneous nonviolent public protests swept the country, expressing a compelling demand for change, but the government, strangely, did not respond or even acknowledge the problem.

*The Kautilya School of Public Policy (KSPP) takes no institutional positions. The views and opinions expressed in this article are solely those of the author(s) and do not reflect the views or positions of KSPP.