13 April 2022, NIICE Commentary 7766
Bishal Bhattarai

In late March, everyone was surprised with news that Sri Lanka had to cancel exams for millions of its students after the country ran out of paper. The shortage was because the Sri Lankan government didn’t have enough money to import papers. That’s when the world knew that Sri Lanka was dealing with its worst financial crisis since it gained independence from British rule back in 1948. Following unrest and violent protests across the country, the Sri Lankan President declared a state of emergency and imposed a nationwide social media blackout. Cabinet ministers resigned from their posts and the surging protests demanded the resignation of President Gotabaya Rajapaksa and Prime Minister Mahinda Rajapaksa. However, leaders have been appealing for patience as they are working to overcome the economic crisis.

Sri Lanka’s economic recovery has been remarkably good since 2009 after nearly three decades of civil war between the army and separatist Tamil Tiger rebels. Today, the island nation of 22 million people is experiencing massive shortage of even essential foods, basic needs, and suffering long power cuts due to fuel shortages. The major sources of foreign revenue in Sri Lanka are Textile, garment export (almost 52 percent of total export), tea export (17 percent), tourism (13 percent) and remittance. There have been a lot of speculations for why Sri Lanka is struggling with the worst economic crisis ever.

Battered Tourism Industry

Sri Lanka’s major foreign revenue source; tourism industry was wrecked with 2019 Easter Sunday suicide bombings killing 42 foreign nationals, which was even crippled by global COVID-19 pandemic in 2020. By 2021, Sri Lanka welcomed just 173,000 travelers, down from 2.3 million in 2018. Russia-Ukraine war further hindered the tourism recovery as these nations have been the top three largest sources of visitors in Sri Lanka.

Drastic Tax Cuts

The economy was already fragile due to multiple bombings and crippled tourism industry. As President Rajapaksa promised tax relief during the Presidential Election 2019, his cabinet decided to cut the value added tax from 15 percent to 8 percent, abolished seven other taxes and also announced that all religious institutions are exempted from taxes. It was done so to revive the country’s ailing economy because drastic tax cuts were expected to increase consumption thus increasing income for the country. But, it was proved counterproductive as the COVID-19 pandemic made the situation even worse. The sweeping tax cuts led to a credit rating downgrade, losing access to the international financial market and Sri Lanka started dipping into its foreign reserves to meet its debt obligations.

Nationwide ban on Import and Use of Chemical Fertilizers

Sri Lanka’s apparel exports of USD 488 million in January were the highest in five years. Despite its positive performance in textile export, the crucial forex earner, tea export plummeted due to the significant slump of tea production across the country. This was due to the ban on import and use of chemical fertilizers by the Sri Lankan government in April 2021. President Rajapaksa claimed this sudden move as a shift towards organic farming but critics argue it as a reason to stop imports to prevent draining the country’s foreign reserves. Rice production fell by 50 percent forcing the country to import rice for the first time in years. By March 2022, Inflation rate climbed to 18.8 percent and food prices soared by 30 percent.

Falling Remittance

Due to COVID-19 pandemic, tourism revenue fell further, major exports declined due to lower demands, and remittances, another booster to the foreign exchange reserves, also fell as Lankans across the globe lost jobs. Remittance dropped to a 10-year low from USD 7.1 billion in 2020 to USD 5.49 billion in 2021. It has dropped by 61.6 percent in January 2022 compared to the same month of 2021. Due to all these reasons, Sri Lanka’s foreign currency reserves dried up.

Debt Trap

Sri Lanka imports more than it exports, creating a huge trade deficit. Until this January, Sri Lanka’s export was worth USD 1.1 billion and it imported goods worth USD 2.24 billion which is double the export. Sri Lanka is now struggling with huge debts. Its current debt-to-GDP ratio has skyrocketed in recent years, increasing from 42 percent in 2019 to 104 percent in 2021. Sri Lanka’s foreign reserve stood at USD 1.93 billion at the end of March, with foreign debt payments of about USD 4 billion due this year, including a USD 1 billion international sovereign bond maturing in July. Seeing it impossible to service its debt, Sri Lanka has decided to suspend its foreign debt payments temporarily.

Analysts also say that Sri Lanka has succumbed to China’s debt trap diplomacy. China is accused of making ‘Sri Lanka’ another ‘Laos’. China built a railway line (USD 6 billion project) in its neighboring nation, Laos known as the China-Laos railway network. Laos had to borrow a USD 480 million loan with a Chinese bank to fund its small part of the equity. The project has cost Laos so much that its debt to China equals 45 percent. Facing bankruptcy due to debt, Laos had to sell a portion of its electrical system to China to seek debt relief from Chinese creditors. Similar case is seen in Sri Lanka too. Sri Lanka’s external debt totals USD 51 billions of which China owns about USD 8 billion which amounts to 16 percent of its foreign debt. This debt burden was a result of China’s huge Belt and Road Initiative projects like Hambantota International Port and Colombo Port City for which Chinese agencies lent large amounts to Sri Lanka under stiff terms of repayment. Since Sri Lanka was unable to service its debt; its strategic Hambantota Port was handed over to Chinese control and is already leased out to China for 99 years. Critics argue that these massive infrastructure projects are nothing but Chinese outposts.

President Rajapaksa has appointed an advisory panel that will engage with financial institutions like the International Monetary Fund to negotiate another bailout, and both India and China have offered to provide Sri Lanka with funds to help cover its debt. But this alone is not enough to escape from this serious crisis. Russia-Ukraine war, the rising cost of fuel, the economic fallout during the pandemic will be the parallel challenges to deal with. In the short term, IMF loans can help hurdle the balance of payment crisis but cannot end this problem in the long run. Sri Lanka needs to implement reform programs. Its debt needs to be restructured. Taxes need to go up. Government’s expenditures need to be rationalized and budget deficits need to be cut. Uncontrolled money printing should stop. To reach long term economic sustainability, domestic production needs to be maximized to avoid economic dependence. Sri Lankan financial institutions should go through structural reforms. Central Bank’s independence should be maintained and depoliticized by enacting the promised Central Bank Act that has been drafted in the parliament earlier. Government should focus on strengthening governance and reducing corruption vulnerabilities, which is of crucial importance to gain inclusive economic growth. It should also ensure that poor people, people with disabilities are provided with social safety nets so that these reforms can go through.

Bishal Bhattarai is an international relations enthusiast with a core interest in diplomacy, regional politics, peace building, and conflict management.