• Khushi Parikh

Econ 101: The Sri Lankan Crisis Explained

The Sri Lankan government declared an economic crisis in April 2021, leading to violent protests, crippling blackouts and abundant hunger. Now, not only is the country’s inflation sky-high, but the economy is also on the verge of a default, with debt exceeding 120% of the GDP.

What is the problem?

Sri Lanka has a twin deficit: both the current account and fiscal account are in red.

This means:

1) national expenditure exceeds national income and

2) production of tradable goods and services is inadequate.


What Caused the Fiscal Deficit?

President Gotabaya Rajapaksa, cut the 15% value-added tax (VAT) by almost half and abolished some other taxes, despite warnings from experts, as promised during his election campaign in 2019. This reduction in tax revenue was contrasted by pandemic-fueled high expenditures, resulting in a large fiscal deficit with public and publicly guaranteed debt to be valued at an estimated 109.7% of GDP. The central bank monetized this deficit by 38.7%, but fiscal accounts continued to deteriorate.


Triggering the Current Account Deficit

Sri Lanka has extremely high foreign debt. It has been steadily increasing since 2014, in part due to the large infracural projects initiated by the previous government. Sri Lanka’s forex reserves dropped from over $7.5 billion in 2019 to around $2.8 billion in July 2021.


This was partly due to the repayment of a billion dollar bond in foriegn currency debt and partly due to the pandemic, which adversely impacted various sectors like agriculture, industry, construction, and service. Most importantly however, the tourism industry, which accounts for more than 10% of the country’s GDP and is a major contributor of foriegn exchange currencies, saw its revenue plummet from $450 million a month to $2 million over the past two years. Also, the war in Ukraine further threatens the tourism industry as Russians and Ukrainans made up the biggest share of Sri lankan tourists.


As a result, the value of Sri Lankan Rupee depreciated more than 20 percent against the United States Dollar since 2019, which significantly impacts the Sri lankan economy as the US makes up about 25% of Sri Lanka's exports.


What was the government’s response?

The Rajapaksa government implemented capital controls and import restrictions to limit outgoing foreign currency, whereas the Central Bank of Sri Lanka increased its interest rates in order to strengthen the local currency. Moreover, the Central Bank banned forward contracts (a contract between two parties to buy or sell an asset at an agreed price at a future date) and spot trading (purchase or sale of a foreign currency or commodity for instant delivery) of rupees at above 200R/$ to restrict speculative practices of traders.


Food Crisis

Inflationary pressures made imports expensive. Since Sri Lanka is reliant on imports for essential goods like food and energy, it led to a massive food crisis: food inflation estimated to be 11.5% by the World Bank in 2021. This was exacerbated by the ban on chemical fertilizers in a bid to make agriculture 100% organic.


Expecting further inflation, the general public began hoarding food supplies, which led to a massive shortage. Moreover, the government’s restrictions on imports, including food items and cooking gas, worsened the crisis. The Central Bank’s restrictions on forward contracts and spot trading meant traders could not hedge their risks anymore, decreasing trading and increasing the food shortage.


Current Energy Crisis

Sri Lanka, already short on foreign exchange, cannot afford to buy oil due to an accompanied rise in international prices due to the war in Ukraine. While petrol is scarce, Sri Lanka ran out of diesel and petrol was scarce, leading to long power cuts, and extensive lines outside petrol filling stations.


Political Scene

Piling crises sparked one of the biggest protests in recent years, with calls for the government to step down. Troops were sent to quell the protests and a curfew was imposed in Colombo.


International Aid

India has already offered 2.4 billion, including a $500 million credit line for diesel shipment, while Indian ports have begun loading 40,000 tonnes of rice to ship to its Southern neighbour. The Indian government is considering offering an additional $2 billion in swaps and support.

China provided a $1.5 billion swap and $1.3 billion syndicated loan, and is in talks with the Sri Lankan government about additional aid $2.5 billion in the form of a credit facility worth $1.5 billion and $1 billion.

Negotiations for an aid package with the International Monetary Fund and World Bank are ongoing - a move Rajapaksa’s government resisted taking previously.

Conclusion

This economic crisis is as much the fault of Sri Lanka’s historic woes of high foreign debt and slow economic growth, as it is the consequence of political mismanagement. The Sri Lankan government failed to manage its borrowing and forex reserves, worsening inflation and credit ratings which will undoubtedly further deteriorate the situation. With two bonds worth $1 Billion and $1.25 billion still due in 2022 and 2023 respectively, whether there is any light at the end of this tunnel is yet to be seen.

 

~ Khushi Parikh