Economic Crisis in Sri Lanka – Explained, Pointwise

Introduction

The economic crisis in Sri Lanka has been unprecedented for the island nation. The crisis has been characterized by high inflation and severe shortage of fuel and electricity. High foreign debt, fall in foreign currency reserves, devaluation of currency and series of lockdowns have adversely impacted the economic growth. The crisis has been caused by mismanaged government finances and ill-timed tax cuts, besides the impact of the COVID-19 pandemic. Countries like India, China and Bangladesh have stepped in to help Sri Lanka weather this crisis. Sri Lanka might approach the International Monetary Fund (IMF) to seek financial assistance to effectively combat the economic crisis.

What is the status of the economy of Sri Lanka?

The growth of Sri Lanka’s economy slowed down to 1.8% in the fourth quarter of the FY2021-22, with annual growth of 3.7%. This is much lower than projected growth of 5% by the Sri Lanka’s Central Bank.

Source: The Times of India

Sri Lanka is left with foreign reserves of only around US$ 2.31 billion as of February 2022. It faces debt payments of about US$ 4 billion through the rest of the year, indicating rising susceptibility of defaulting on debt. The US$ 4 billion debt includes a US$ 1 billion international sovereign bond that matures in July 2022.

What are the reasons behind the economic crisis?

Poor Economic Policy Decisions: The present Government had come to power in 2019 promising rapid economic growth. The government reduced value-added tax by nearly half and abolished some other taxes as a way to boost consumption and growth. The tax cuts led to a loss of billions of rupees in tax revenues, putting further pressure on the public finances of the already heavily indebted economy. 

The Government wanted to become first country to fully adopt organic farming. So the use of chemical fertilizers was banned in April 2021. However, 90% of Sri Lanka’s farmers used chemical fertilizers for cultivation. The move led to drastic reduction in food production, resulting in high prices.

COVID-19: The pandemic dealt a huge blow to the tourism sector, which accounts for over 12% of the Sri Lanka’s total economic output. Similarly, remittances from Sri Lankans working overseas also declined sharply. Sri Lanka’s public debt is estimated to have risen from 94% in 2019 to 119% of GDP in 2021 during the pandemic period.

Depleting Forex: The country’s foreign exchange reserves have fallen 70% in the past two years, from US$ 8 billion in 2020 to about US$ 2.31 billion. This has made it difficult to pay for essential imports, including food and fuel. A critical shortfall in foreign currency has enhanced hardships for traders in order to finance their imports.

Global Uncertainties: The crisis got compounded by the Russia-Ukraine conflict that has led to a steep hike in oil prices. The rising prices and depleting forex has led to severe shortage of fuel. 

What impact is being created by the crisis?

Unemployment and Poverty: Job losses have become a common phenomenon in almost every household. Besides, fall in earning has led to rise in poverty rates. According to World Bank data, the share of the poor based on a daily income of US$ 3.20 was estimated to have grown to 11.7% in 2020 from 9.2% a year before. 

Rising Inflation: Retail inflation in February 2022 reached 15.1% while food inflation hit 25.7% – the highest in a decade. This has created a severe shortage of food. A cup of tea now costs Rs 100, up from Rs 25 as of October 2021.

Source: The Times of India

Shortage of Fuel: Fuel shortages have led to long lines at petrol stations. A serious shortage of diesel has shut multiple thermal power plants causing rolling power cuts across the nation. There are long power outages with only 4 hours of power a day in most areas.

The electricity crisis has been exacerbated by low water level in reservoirs. Hydro-electricity contributes 40% to Sri Lanka’s electricity generation. 

Health concerns: Doctor’s visit, medicines have also become increasingly expensive. Most people have resorted to self-medication. The WHO has said that this can lead to higher morbidity.

Discontent among the masses: Sri Lanka has witnessed massive protests over shortages and steep prices, with thousands gathering on the main Galle Road in Colombo earlier this month. Some of the protestors are demanding the resignation of the current President.

Forced Migration: The deteriorating situation would induce the native Sri Lankans to migrate to other countries like India, Maldives etc. for better opportunities and a stable environment.

What are the concerns for India?

India’s Trade: India relies considerably on Colombo port for global trade given it is a transhipment hub. 60% of India’s trans-shipment cargo is handled by the port. Further more than one-fifth of Sri Lanka’s total imports come from India but poor economic conditions may reduce income of Indian exporters’. 

India’s Investment: India is also one of the largest contributors to Foreign Direct Investment in Sri Lanka. FDI from India amounted to about US$ 1.7 billion from 2005 to 2019. A number of leading companies from India have invested and established their presence in Sri Lanka. These include Indian Oil, Airtel, Taj Hotels, Dabur, Ashok Leyland, Tata Communications, Asian Paints, SBI and ICICI Bank.

Refugee Influx: Refugees, mostly Sri Lankan Tamils, have started arriving in India via the sea-route. The influx is going to rise in future if the crisis does not abate.

Geopolitical Considerations: Sri Lanka is a neighboring country of India whose stability is a sine qua non for ensuring a peaceful and vibrant South Asia and the Indian Ocean region. Further, India needs to counter the growing Chinese influence on Srilankan economy.

What steps have been taken to combat the economic crisis?

Domestic Measures: The Sri Lankan government has restricted imports of several items which have been declared “non-essential. It postponed school exams indefinitely due to a paper shortage. 

Sri Lanka deployed troops at petrol stations last week as sporadic protests erupted among thousands of people who had queued up for fuel. The central bank of the country raised interest rates to reduce growing inflationary pressures.

Sri Lanka’s central bank has devalued the rupee by up to 15%. It has set an exchange rate limit of 230 rupees per dollar compared to a limit of 200-203 that had prevailed since October 2021.

In December, the Central Bank announced a host of measures including giving an additional 10 rupees per dollar as an incentive.This had limited impact with remittances dropping 61.6% in January to $259 million from $675 million a year earlier.

International Measures: Sri Lanka has asked China to restructure its debt repayments to help navigate the financial crisis. The country is also in talks with China for a further US$ 2.5 billion in credit support.

Sri Lanka has sought an additional credit line of US$ 1 billion from India to import essential items, after the Sri Lankan Finance Minister signed a US$ 1 billion credit line with New Delhi earlier this month.

In addition to the credit lines, India extended a US$ 400-million currency swap and a US$ 500-million credit line for fuel purchases to Sri Lanka earlier this year.

What lies ahead?

First, Sri Lanka has shown keen interest to negotiate with the IMF in order to prevent the looming Balance of Payment crisis. This deal should be brokered swiftly in order to provide sufficient cushion to the island nation.

Second, the country should try to revive its key driving sectors like Tourism. Proactive measures should be undertaken to make sure tourists are safe and secure in the nation. Tourism was brutally hit even before the pandemic when the 2019 Easter Sunday suicide bombings took place and killed more than 250 people.

Third, while the work on building a transshipment hub in Kerala has begun, it is still in India’s interest to help Sri Lanka come out of the economic crisis. Therefore it must extend more aid and resources to help the island nation.

Conclusion

Economic crisis in Sri Lanka is a reminder to other countries to constantly introspect their economic policies at regular intervals. It provides a lesson to every nation regarding the adverse consequences that can arise due to ill-timed and irrational policy decisions.

India should further enhance its support to Sri Lanka, if required. A peaceful and stable Sri Lanka is in India’s long term geopolitical interests.

Source: Indian Express, Indian Express, The Times of India, Business Standard