THE SRI LANKAN CRISIS: AN OVERVIEW

Present situation

Sri Lanka, the pearl of the Indian Ocean, is currently experiencing one of the greatest economic crises, with worrying repercussions. The country is facing a severe shortage of foreign currency, making it unable to pay for essential imports, including food, fuel and medicines. It defaulted on its foreign debts for the first time since its independence. The Finance ministry has announced that the country currently has only $25 million in usable foreign reserves. Due to its impending bankruptcy, it has put on hold the repayment of around $7 billion in foreign loans that are due this year out of a total of $25 billion that must be paid back by 2026. The total amount of the nation's debt is $51 billion. The lack of gasoline has caused energy outages that can last up to 13 hours each day. The soaring inflation, which is at an all-time high of 17.5%, is aggravating the agony of 22 million Sri Lankans.

With the economic crisis worsening, a state of emergency was declared by President Gotabaya Rajpaksha. He was forced to withdraw it within a period of one week, as angry citizens rose in rebellion and conducted massive protests. The mishandling of the economic crisis has dismantled the political structure and is leading the island country into a political crisis.

What led to this

The successive governments of Sri Lanka have failed to manage its economy over the years. The sustained policy of maintaining a twin deficit, i.e. a budget shortfall along with a current account deficit, is being considered as the root cause of this crisis.

Some researchers are of the belief that Sri Lanka’s economic relations with China might be behind the crisis. China, according to some, followed a debt-trap diplomacy, wherein a creditor country or institution extends debt to a borrowing nation to increase the lender’s political leverage – if the borrower extends itself and cannot pay the money back, they are at the creditor’s mercy.

However, loans from China accounted for only about 10% of Sri Lanka’s total foreign debt in 2020. Defaults over China’s infrastructure-related loans to Sri Lanka, especially the financing of the Hambantota port, are being cited as factors contributing to the crisis. Facts favour the reasoning that the Hambantota port fiasco did not lead to a balance of payments crisis, rather it bolstered Sri Lanka’s foreign exchange reserves by US$1.12 billion.

Historically speaking, a large share of Sri Lanka’s Gross Domestic Product came from foreign exchange earned by exporting crops such as tea, coffee, rubber and spices. The money raised was used to import essential items. Eventually, it became extremely dependent on exports as a source of income and any decline in exports would come as an economic shock, putting the foreign exchange reserves under strain.

Due to its extended reliance on exports, Sri Lanka frequently experienced balance of payments issues. In the previous 56 years, it received 16 loans from the International Monetary Fund (IMF). Each of these loans had terms stipulating that once the loan was granted, the nation would have to reduce its budget deficit and maintain a strict monetary policy, which included reducing food subsidies and currency depreciation.

However, because of downturns in the economy, the government increased spending to stimulate the economy. This was contradictory to the conditions posed by the IMF, still the loans were granted. The economy’s debt burden rose over the years, with falling growth, investments, savings and revenues.

An unfortunate series of bomb blasts in churches and luxury hotels in Colombo In April 2019, led to a steep decline in tourist arrivals, upto 80% decline. This drained foreign exchange reserves. The situation worsened when the new government under President Gotabaya Rajapaksa irrationally cut taxes. Value-added tax rates were cut from 15% to 8%. Followed by abolishment of some other indirect taxes such as the nation building tax, the pay-as-you-earn tax and economic service charges. Corporate tax rates were reduced from 28% to 24%. About 2% of the gross domestic product was lost in revenues because of these tax cuts.

The outbreak of the COVID-19 pandemic brought some serious misery for the people of Sri Lanka. The government mismanaged the situation, in order to prevent the foreign exchange reserves from draining, all fertiliser imports were completely banned. Sri Lanka was declared a 100% organic farming nation. This policy, which was withdrawn in November 2021, led to a drastic fall in agricultural production and more imports became necessary.

The foreign exchange reserves remained under strain. A fall in the productivity of tea and rubber due to the ban on fertiliser also led to lower export incomes. Due to lower export incomes, there was less money available to import food and food shortages arose. Because there is less food and other items to buy, but no decrease in demand, the prices for these goods rise.

Way forward

Sri Lanka will now obtain a 17th IMF loan to overcome the present crisis. This loan will come with fresh conditions. A deflationary fiscal policy will be followed, which will further limit the prospects of economic revival and accelerate the sufferings of the Sri Lankan citizens. A new relief budget will be introduced to replace the 2022 Development Budget. It is also proposed that the Sri Lankan Airlines, which is incurring extensive losses, will be privatised. The loss for 2020-2021 alone amounts to SLR 45 billion. By 31st March 2021, total loss was at 372 billion.