Crossword……………………………………………...……..…………………….41

PRAJJWAL SINGH

SCMS, Noida

Sri Lanka’s Economic Crisis: A Lesson For

Policy Makers

Context

On 1st September 2020, the Sri Lankan government declared a state of economic emergency, empowering the administration to seize food inventories and fix their prices, in order to contain the spiralling inflation. As the economy battles out a food shortage, long queues were seen outside shops in Colombo selling essential items such as rice, sugar, potato, kerosene and onions. Apart from food shortage, many reasons have contributed to this crisis.

Sri Lanka’s economy

Sri Lanka is a frontier economy i.e., an economy that is more developed than the least developed economies but too risky or small to be deemed as a developing economy. The principal characteristic of this type of economies is that they depend on a few sectors for their GDP, and in Sri Lanka’s case these areas are tea & agricultural products, textiles and tourism. Domestically, services (tourism, banking and finance) and manufacturing (mainly apparel & textile and tea) contribute to almost 74% of its GDP. In case of merchandise exports, Sri Lanka earns majority of its foreign exchange from textile and tea exports, accounting for 52% and 12% of its exports respectively. When talking about service exports, Sri Lanka earns almost 1/3rd of its foreign exchange from the tourism sector, which in addition contributes to 10% of its GDP. It also heavily relies on foreign aid from other countries for infrastructure development projects. Countries like these do not have the financial strength or resources like those of bigger economies like India or China to endure economic shocks without any foreign assistance because of their small size.

The intertwined factors leading to a crisis

Inflation in August rose to 6% from 5.7% in July this year. The main driver for this was the rapidly depreciating Sri Lankan Rupee. The exchange rate has dropped by 9% this year till date. The drop in the exchange rate has been a result of the fast-depleting foreign exchange reserves. Banks having run out of foreign currencies, are unable to finance imports of essential items (food and medicine) causing their shortage. US Dollars have dried up wreaking a havoc as USA is Sri Lanka’s biggest trading partner and paying import bills in Dollars has got extremely costly. In August, a Dollar was being sold in black markets for 230 Sri Lankan Rupees.

Tourism sector, the third largest foreign exchange contributor, took a hit due to the pandemic and hurt the local economy causing drops in employment rate. Tourism attributable revenues fell from $455.5 million to under $3 million a month between December 2019 and July 2021.

The foreign exchange reserve upheaval was aggravated by the government’s policy push to go ‘100% organic’. Subsequently in April, they banned imports of all types of chemical fertilizers; a bold step towards going environment friendly taken at a wrong time. The tea industry (a driving force for its economy) heavily depends on chemical fertilizers and the market for organic tea produce is very small and it is not cost effective to switch to an all-organic produce due to a lower crop yield. This gave another blow to the already troubled economy with predictions that it it could lead to a widespread crop failure, inevitably pushing crop prices even further.

Additionally, owing to the increasing borrowings of billions of Dollars during the past years especially from China, its debt to GDP ratio increased to a concerning all time high of 101% in 2020. After repayment of a $1 billion bond in July this year, Sri Lanka’s foreign exchange reserves fell further to $2.8 billion, leaving them with just enough reserves to cover 1.8 months’ worth of imports.

Lastly, Covid-impelled pent-up demand has put up a lot of stress on the already damaged supply chains, which is causing a delay in import of commodities. Sri Lanka being a net importer of food, has not been able to substitute its import demand for essential commodities, fuelling the economic crisis. Hoarding of essential food items also gained traction as traders looked for quick gains, contributing to the goods shortage.

The government’s course of action

The Central Bank of Sri Lanka (CBSL) has raised its deposit and lending rates by 50 basis points to 5% and 6% respectively, in a bid to ease inflationary pressures. In order to control foreign currency shortage, the government has banned the imports of cars, industrial raw materials and machinery, oils and spices and also plans to introduce fuel rationing later this year. Moreover, in an attempt to restrict foreign currency moving out of the country, it imposed capital controls in July for six months. Government officials have also been raiding food hoarders in a bid to relieve stressed supply. Furthermore, to address the outcry of farmers, the government reversed the fertilizer import ban in August – a much needed relief brought in too late. Lastly, it recently ended price controls on essential foods to curb black market trading.

Outlook for its economy

In August, Sri Lanka received $787 million from IMF’s special drawing rights (SDR) allocation and a $150 million currency swap agreement from Bangladesh. It had earlier received a $500 million loan from South Korea, and a $1.5 billion currency swap agreement from China. While this has given a temporary relief to the government, it has heavy debt obligations to look out for till next few years. required by Sri Lanka annually between 2021 and 2025 to meet its foreign debt obligations. This is too large of a debt burden for Sri Lanka to pay because it runs not only a massive budget deficit but also a vast balance of payments deficit as it has been expending its foreign currency at a greater pace than it is earning. The deteriorating reserves position induced rating agencies to downgrade Sri Lanka’s sovereign rating, indicating that it could soon default on its debt obligations, amounting to $1.5 billion next year. Due to the ratings cut, the cost of borrowing money will increase for Sri Lanka and will likely lead to a cautious approach while borrowing more. Nonetheless, its debt to GDP ratio is forecasted to hit 108% by next year. It also cannot print more currency in exchange for Dollars (an argument of the Modern Monetary Theory) because it would only lead to a further fall in Sri Lanka’s Rupee value. It would really take a ‘miracle’ to get out of this situation.

That being said, unless it receives help from its creditor countries (especially from China, its biggest lender) in forms of loan moratoriums, funding lines or currency swap agreements, the best solution would be to seek help of IMF, albeit with strict loan utilization conditions.

Conclusion

Being an import dependent country, Sri Lanka instead of banning imports, should focus on increasing its export revenues and developing tourism industry to cater to high volume tourism, as it would bring in much needed foreign earnings. It must also establish control over its debt obligations and work on its budget deficit. These measures would ensure a better position while handling any future economic shocks.