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The story of Sri Lanka’s economic nosedive is a really tragic one. For a long time, the country was touted as the probable next Asian tiger, and now it is struggling to even maintain its balance sheet properly. Multiple factors have impacted the economic situation to the state that it has reached now, be it the government policies both domestic as well as foreign policy.

In late August, the government of Sri Lanka declared an economic emergency, citing soaring food costs, a weakening currency, and rapidly depleted foreign exchange reserves. President Gotabaya Rajapaksa has called in the army to help manage the issue by rationing critical products.

While it can help mitigate the exacerbation of the crisis in the short term as it could increase the efficience by circumventing most of the government mechanisms, this is not a long term solution.

In the following write-up, let us try to shed some light on the different facets of Sri Lankan economic situation that have culminated into the crisis that the country is facing right now.

The Forex problem

Sri Lanka’s foreign exchange reserves are severely depleted, with only enough dollars to fund fewer than two months’ worth of imports. Sri Lanka had only $2.36 billion in foreign currency at the end of July, compared to $6.93 billion in August 2020. This year, the Sri Lankan rupee has lost 7.5 per cent against the US dollar.

Sri Lanka food and forex crisis: Here's all you need to know | World  News,The Indian Express
Labourers load food items into a delivery lorry near a main market in Colombo, Sri Lanka June 8,2018. (Reuters)

Sri Lanka’s Central Bank recently raised interest rates in an effort to support the local currency, making it the first central bank in Asia to do so since the outbreak. While Sri Lanka has traditionally borrowed to fund growth, it has benefited from low-interest concessionary loans for the majority of its history.

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

Lanka's Central Bank gets USD 400 mn swap from RBI - The Hindu BusinessLine
Srilanka’s Central Bank. Credits – Business line

Due to shortages of milk powder, kerosene oil, and cooking gas, the impact of the balance of payments crisis has resulted in higher pricing for goods such as sugar, rice, onions, and potatoes, as well as long lines outside stores. While enforcing anti-hoarding laws, the administration has claimed that there are no food shortages. Importers owe loans to state banks, and the broad policy aims to recoup that debt.

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.

Sri Lanka declares economic emergency to contain food prices amid forex  crisis | Deccan Herald
People stand in a queue to buy kerosene oil used in cooking stoves in Colombo on August 31, 2021 following Sri Lanka’s declaration of state of emergency over food shortages as private banks ran out of foreign exchange to finance imports. Credit: AFP

While there were some attempts to gain tourism as the cases were greeting under control, however, the news of the Omicron (B.1.1.529) variant has brought back the scare of countries closing themselves, painting a dark picture for the Sri Lankan economy.

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%.

The choice was ill-advised, especially considering the economy’s net growth during this time period was only approximately 1%. W. A. Wijewardena, a former central bank deputy governor, has warned that inflation could reach 40% in the next several years.

Even while people were grappling with rising prices and scarcity, Gotabaya struck again. His government outlawed the use of chemical fertilizers completely in May of this year. Organic fertilizer from China was discovered to be harmful. Farmers were unable to sow at the start of the monsoon season due to the rain.

According to agricultural expert Jeevika Weerahewa, the chemical fertilizer prohibition is likely to cut paddy yield by 43 per cent and cash crops like rubber, coconut, and tea exports by 40 per cent.

The fertilizer prohibition will have a negative influence on Sri Lanka’s food security and exports, as well as the livelihood in the agriculture sector. Agriculture employs two-thirds of Sri Lanka’s population.

The currency problem

In October alone, the Central Bank of Sri Lanka printed almost 130 billion rupees ($640 million), yet it is merely the tip of the iceberg. Sri Lanka’s money supply increased by 2.8 trillion rupees, or 42 per cent, from December 2019 to August 2021.

Much of the money was used to pay the wages of 1.2 million state employees and to fund pension costs, which totalled one trillion rupees each year. Unlike the commercial sector, which saw salary cuts during the COVID-19 pandemic, state personnel were paid in full despite the fact that the government’s coffers were empty. In order to keep interest rates low, money was also printed.

Though it has been referred to as “printing money,” the majority of the rise in the overall money stock since the end of 2019 has been made up of government borrowings from the central bank and commercial banks. Central Bank Governor Ajith Nivard Cabraal defended the decision to print money at a press conference earlier this month, claiming that it was necessary to maintain stability.

Colombo eased price controls on key food goods, including domestic gas, in mid-October. In the space of a week, the price of a 12.5-kilogram cylinder of cooking gas jumped from 1,400 to 2,675 rupees. A 400-gram pack of milk powder, an essential in practically every Sri Lankan household, went up from 380 rupees to 480 rupees, while wheat flour went up by 10 rupees per kilo, generating a domino effect in bread and other flour-based products.

As reported by Nikkei Asia, W. A. Wijewardena, a former central bank deputy governor warned that a 42% increase in money supply will pump severe inflation, possibly to over 40% in the next few years. “Normally a central bank can allow this money stock to increase without causing inflation if the increase is equivalent to the real growth of the economy,” Wijewardena told Nikkei Asia.

Since growth in 2020 was -3.6% and is expected to be around 4.5% in 2021, real net growth for the two years will be “about 1%,” he said. It was Wijewardena who used the economic time bomb analogy: “It is now ticking and can go off at any time,” he told Nikkei.

Subsequent protests

Thousands of supporters of Sri Lanka’s biggest opposition party demonstrated in the city, Colombo, to protest the country’s economic woes, marking the first significant campaign against President Gotabaya Rajapaksa’s administration since it came to office last August.

Sri Lanka Opposition Rallies Thousands to Protest Economic Woes - Bloomberg
Demonstrators protest in Colombo, Sri Lanka, on Nov. 16. Photographer: Eranga Jayawardena/AP Photo

Supporters of the Samagi Jana Balawegaya, led by party leader Sajith Premadasa and other leaders, marched to the president’s office in Colombo on Tuesday, carrying placards and shouting slogans against spiralling prices and shortages exacerbated by a foreign exchange crisis that has led to import controls, despite heavy sporadic rains, tightened Covid-19 guidelines, and court orders. Police pushed back those travelling to the capital from neighbouring provinces.

The continuing problem

The current problem is not the result of “the domestic economy-based economic growth strategy adopted by Mahinda Rajapaksa administration” between 2005 and 2015, as W. A. Wijewardena claims. As Prof. Lalithasiri Gunaruwan has demonstrated, the so-called export orientation did not succeed, and Sri Lanka experienced a negative trade balance during the duration of the strategy’s implementation.

During this 43-year period, we relied increasingly on imports of commodities, and as a result, Sri Lanka’s import bill increased to 25% of GDP in 2019. As also mentioned in a report on Ceylon Today, the export-oriented development plan was eventually transformed into a consumption and production strategy centred on imports.

In the early years, foreign assistance and soft loans were used to fund the import-based consumption and manufacturing strategy, which was later replaced by foreign debt. As a result, Sri Lanka went from being a foreign-aid recipient to a foreign-debtor.

As mentioned earlier, Tourism has been a big contributor to the Sri Lankan economy, which accounts for around 5% of its GDP. However, the contribution has fallen since the country had to ban passenger flights and ships movement. In 2020, tourism revenue was less than a third of what it was in 2019 and with the new variant forcing countries to stop travels again, the numbers of 2021 and 2022 can turn out to be much worse.

In the background of these grim situations, Sri Lankan Central Bank is still hopeful for a fast recovery next year. Following a resurgence in the tourism sector, which boosted foreign exchange inflows to the country, Central Bank Governor Ajith Nivard Cabraal predicted that the GDP will increase by roughly 6% next year.

Cabraal said last week at a media briefing on the monetary policy stance that if debt restructuring is done properly, there is no need to seek rescue from the IMF. The past regime chose a scheme with the international lender because the value of International Sovereign Bonds (ISBs) increased from roughly US$ 6.9 billion in 2010 to around US$ 18 billion by the end of 2019, according to Cabraal.

If we seek IMF assistance, we will have to weaken the currency, reduce the number of public officials, cut pensions, sell state lands, and cut subsidies, he said. Apart from effective taxation, Sri Lanka’s economy requires more export-oriented growth to recover from its current financial issue, but the virus has weakened global purchasing power. Sri Lanka’s external sector weaknesses, such as a foreign currency deficit, will necessitate outside assistance, whether from China, India, the United States, or international organizations.

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