1 April 2022, NIICE Commentary 7726
Sunil Kumar Chaudhary
Sri Lanka is facing its worst economic crisis since its independence in 1948. The country is running short of foreign exchange reserves. Because of this, they are unable to import essential commodities like food, fuel, and medicines. Shortage in fuel has led to long hours of power disruptions across the country. A serious shortage of diesel has shut multiple thermal power plants causing rolling power cuts across the nation. The economic problems that brought Sri Lanka to its knees has now directly impacted ordinary Sri Lankans in the form of skyrocketing prices of essential goods: rice, pulses, milk powder as well as cooking gas and fuel. Even those who have the money can’t actually purchase them as they spend hours in long queues. The sudden rise in prices of key commodities has left many people at the mercy of subsidies as all essential items are in short supply due to import restrictions forced by the forex crisis. Faced with power cuts lasting half a day or more, and a lack of fuel and essential food and medicines, public anger has reached a new high in the island nation of 22 million.
With several essential food items in high demand, Sri Lanka’s food prices increased by a record 21.1 percent last month on a year-on-year basis. The inflation rate is 18.7 percent which is the highest inflation rate since 2008. Currently, 295 Sri Lankan Rupee is equal to 1 US dollar, which means the Sri Lankan rupee has depreciated, so the imports for Sri Lanka have become more expensive. This has a trickle-down effect on the Sri Lanka domestic market. Since Sri Lanka is an import-dependent country the balance of trade further worsens. The country’s usable funds of currency reserves have plunged below one billion dollars limiting its ability to repay loans. The mismanagement by the Sri Lankan government of failure to admit that it was having problems as well as corruption has aggravated the situation. As the crisis deepens, there have been street protests and special new rules preventing people from gathering in public places that failed to silence people’s voices; and protests despite the curfew to express their anger and frustration against the current government.
What turns Sri Lanka into an Unprecedented Economic Crisis?
First, Sri Lanka is heavily dependent on its tourism. The Easter Sunday terrorist attack in 2019 led to a decline in tourist arrivals. In 2019, tourist arrivals decreased by 20 percent compared to the previous year. Its tourism sector, a foreign exchange earner was battered by the Easter attack of 2019 and the COVID-19 pandemic.
Second, the COVID-19 led lockdown crippled whatever was left of tourism and the economy. The global pandemic reduced tourist arrivals by 70 percent. In 2020 due to the pandemic followed by lockdown the tourism industry of Sri Lanka which accounts for about 10 percent of the GDP of the country got badly hit. Sri Lanka earned nearly USD 4 billion from tourism in 2019 – and that has dropped by around 90 percent due to the pandemic. That led to a huge foreign exchange crisis. The years 2019, 2020, and 2021 became a curse for the Sri Lankan tourism industry.
Third, workers’ remittances have been a key pillar of Sri Lanka’s foreign currency earnings providing a substantial cushion against the widening trade deficit and thereby enhancing the external sector resilience of the country. Being a major source of foreign exchange earnings, workers’ remittances have covered around 80 percent of the annual trade deficit, on average, over the past two decades. But workers’ remittances, a major source of foreign exchange in Sri Lanka, dropped to a 10-year low in 2021.
Fourth, common causes of the Sri Lankan crisis are widespread flaws in government policies and programs, which have been implemented one after another. Unprecedented and unnecessary tax cuts in 2019 December was announced to provide great relief to the people. They reduced the Value Added Tax rate to 8 percent from 15 percent leading to Sri Lanka’s revenue decline even further. Tax cuts led to a sharp decline in public income, which pushed the budget deficit, which averaged 5 percent of GDP in 2019, to 10 percent in 2021. There was no alternative but to take a public loan to cover the budget deficit. The burden of public debt has been increasing due to the tendency of the political leadership to make development projects in the interest of the short-term vision and to take public loans indiscriminately to complete them.
Fifth, a similar eccentric decision was made in the agricultural sector. The Sri Lankan government decided to make the country’s agricultural system fully organic. In 2021, the Sri Lankan government banned all kinds of agricultural chemicals and fertilizers. But this hasty decision led to a massive decline in agricultural production and increased the likelihood of a famine in the country. In fact, that decision turn out to be a disaster and up to 70 percent of the harvest was lost and leading to high prices of food items. The inflation hit a new high and the situation got even worse.
Sixth, the Russian-Ukraine crisis has disrupted the fuel supply leading to rising fuel prices which further aggravated the Sri Lankan economic crisis.
Overall, internal factors are more responsible for the Sri Lankan crisis than external ones. The Easter bombings, COVID-19 pandemic, Russia-Ukraine conflict may not have been in Government’s control but what happened after that was because of the government’s policy errors. Domestic factors such as political decisions taken for cheap popularity and wrong economic policies have pushed the country into a whirlpool of crisis.
Debt Crisis
During the presidency of Mahinda Rajapaksa from 2005 to 2015, Sri Lanka took on huge amounts of expensive debt, meant to help turn the country into another Singapore by building ambitious infrastructure projects, including ports. But, so far, many of those projects have stalled, failing to attract the private investment that the government had hoped for. Since 2010, there is a sharp rise in Sri Lanka’s external debt. All these external debts include money borrowed from countries like China, Japan, India, and international financial institutions like the World Bank and Asian Development Bank in the name of infrastructure projects.
Sri Lanka’s sovereign debt has been rising since it entered the BRI is not entirely true, as investments in BRI projects account for only 10 percent of Sri Lankan public debt. Sri Lanka’s foreign debt is mainly borrowed from the international capital market, which accounts for 47 percent of the total debt. Borrowings from multilateral donors, such as the Asian Development Bank and the World Bank, account for 22 percent of total public debt. The Sri Lankan economy has been based on debt for decades. Public debt, which averaged 60 percent of GDP two decades ago, has risen from 88 percent in 2019 to more than 109.3 percent in 2021.
How Sri Lanka will Come out of the Crisis?
The path to resolving the Sri Lankan crisis is undoubtedly long and painful. The two major dimensions of the Sri Lanka crisis need to be addressed as a first priority. First, to avert a potential food crisis, and second, to increase foreign exchange reserves. Failure to address these two issues as soon as possible will only deepen the crisis. Emphasis should be placed on revenue collection. Raising tax rates internally is not a good thing as it will push up rising inflation which is like jumping out of a hot pan. To boost investor sentiment, it is likely that Sri Lanka will start repaying some domestic and foreign loans.
It is in its best interest to reduce interest rates, increase domestic investment and promote foreign investment as much as possible, as this will prevent further depreciation of the Sri Lankan currency. But there will also be some negative effects of this effort, with the rise in total money supply creating some pressure on the price level.
With the current declining export trade and declining remittances, the main challenge for Sri Lanka is to get the foreign sector back on track. The country has to push back the loan repayment deadlines. Now going just to the IMF is not going to resolve the problem because the country is unable to pay the debt. Debt needs to be restructured, taxes need to go up, expenditures need to be rationalized, and the budget deficit needs to be cut. There is a need for the exchange rate to be managed so that people will be able to purchase imported goods. Sri Lanka can request major lenders like China to restructure its debt. Similarly, request the International Monetary Fund and the World Bank for concessional loans. IMF has suggested raising income tax and value-added tax to make the situation better. India recently gave Sri Lanka a USD 1 billion line of credit to tide over a fuel crisis, and China is considering a USD 2.5 billion assistance package, including USD 1.5 billion credit line and USD 1 billion loan. In addition, India has also approved 400 million dollars of credit swap arrangement with Sri Lanka.
Lessons to Nepal
The crisis in neighboring Sri Lanka has sent an important message to developing countries like Nepal, which have unstable politics and weak external sectors. Like Sri Lanka, Nepal is also dependent on tourism, remittances, external debt, grants and imports. Thus, the policy makers should learn from the Sri Lankan experience and implement the economic policies cautiously. The Sri Lankan experience shows the world what happens when politicians make the wrong choices. Sri Lanka is also a good example of how the commitments made by the big political parties in the last election for cheap popularity have put the overall economy in jeopardy and how it could turn into a nightmare for the next election. Hence, Nepal should also avoid such cheap popularity in the upcoming local and provincial election that can aggravate the economic crisis. Second, policymakers need to understand that macroeconomic indicators become negative as budget deficits become higher when tax rates are reduced unexpectedly. Thirdly, there is another picture of how the situation is getting worse as export trade and remittances are declining along with the policy of immediate decline in agricultural production. Third, Nepal should also refrain from acquiring huge loan for unproductive sector and get caught into the debt trap that can challenge the Nepalese economy.
Sunil Kumar Chaudhary is Research Associate at NIICE.
