The Sri Lanka Economic Crisis 2022: What Went Wrong With The Country’s Economy?

by | 27 Jun 2022 | News & Media

Sri Lanka is currently experiencing its greatest financial crisis in over 70 years. In March 2022 alone, food prices in the island nation increased by a record 30 per cent.

For many, the cost of living in this tourism-dependent country has become untenable. Thousands of people have taken to the streets around the country in recent weeks to seek the president’s resignation.

Sri Lanka’s political unrest and economic problems have resulted in severe food scarcity, with the country’s 21 million citizens now having to spend three times as much for staples such as rice, sugar, lentils, and milk powder.

In March, Sri Lanka’s food inflation was 30.2 per cent, meaning that the average price of food was 30 per cent more than a year before, a new high. In March of this year, food inflation was -1.4 per cent.

The price of milk powder has risen by about 1,000 Sri Lankan rupees, or around INR 236 in just a few days, according to the Indian Express.

Rice now costs around 500 Sri Lankan rupees per kilogramme.

Essentials, especially those produced locally, have grown out of reach for many. Since 2019, the price of white rice, a major Sri Lankan staple, has risen by 93 per cent. Since 2019, the prices of chicken and lentils have increased by at least 55 per cent and 117 per cent, respectively.

The state-owned Ceylon Petroleum Corporation hiked the price of a litre of fuel from 137 rupees in 2021, to 254 rupees in March 2022($0.45 to $0.85; or $2.04 to $3.86 per gallon in 2021). Diesel prices also rose from 104 rupees per litre the previous year, to 176 rupees this year ($0.34 to $0.58; approximately $1.54 to $2.63 per gallon in 2021).

A 12.5kg cylinder of cooking gas for a typical home increased in price from 1,493 rupees ($4.9) in 2021 to 2,750 rupees ($9) in 2022. Cooking gas has become prohibitively expensive for many Sri Lankans, therefore many are turning to firewood and kerosene as alternatives.

Multiple compounding reasons including tax cuts, money creation, a statewide programme to convert to organic or biological farming, as well as events like the Easter bombings in 2019 and the impact of the COVID-19 epidemic, have contributed to the issue.

Understanding Sri Lanka’s economic downturn: How did the country get here?

According to critics, the foundation of the crisis, which is the worst in decades, is economic mismanagement by successive governments, which established and maintained a dual deficit – a budget deficit as well as a current account deficit.

“Sri Lanka is a classic twin deficit economy,” according to a working paper published by the Asian Development Bank in 2019. “The country’s national expenditure exceeds its national revenue, indicating that its production of tradable products and services is insufficient.”

Further, massive tax cuts promised by Rajapaksa during his 2019 election campaign and implemented months before the COVID-19 pandemic, which wiped out swathes of Sri Lanka’s economy, have worsened the current catastrophe.

With the pandemic decimating the country’s vital tourism industry and foreign workers’ contributions, credit rating agencies downgraded Sri Lanka, virtually shutting it out of international capital markets.

As a result, Sri Lanka’s debt management programme, which relied on access to those markets, fell apart, and the country’s foreign exchange reserves plunged by about 70% in just two years.

The debt trap

Sri Lanka has roughly USD 2 billion in foreign-currency reserves, while the entire debt repayment objective for 2022 is USD 7 billion. Further, a total of USD 1 billion in bonds is due to mature in July 2022.

Since 2005, Sri Lanka’s external debt has been steadily increasing: from USD 11.3 billion in 2005 to USD 21.7 billion in 2010, USD 43.9 billion in 2015, and USD 56.3 billion in 2020. As of April 2021, China had accounted for 10% of all its loans, while India accounted for 2%.

The Currency game

The country’s troubles don’t end here. Sri Lanka’s external debt grew at a faster rate than its GDP. The external debt-to-GDP ratio increased from 31.6 per cent in 2010 to 32.4 per cent in 2015, and is expected to rise to another 40.4 percent by 2020.

The rise in overall debt, as well as their interest rates, caused the central bank to raise policy rates in order to keep inflation under control. The currency, however, fell in value against the dollar, and the central bank had to draw down foreign reserves to keep the exchange rate stable. These variables had the opposite effect than what was desired, and pushed the Sri Lankan economy into a vicious cycle.

The Sri Lankan Rupee, on the other hand, has lost over 50% of its value against the US dollar, just this year. As a result, a dollar now costs almost Rs. 310 in Sri Lanka, up from Rs. 200 in January 2021.

According to the Central Bank of Sri Lanka, between January 1 and March 31, 2021, the Sri Lankan Rupee lost 31.6 percent of its value against the Indian Rupee, 31.5 percent against the Euro, 31.1 percent against the pound sterling, and 28.7 percent versus the Japanese Yen.

What does Sri Lanka’s future look like? How will the dire economic crisis end?

Ever seen military troops at gas stations and petrol pumps? This seems to indicate the height of a crisis, and Sri Lanka, amidst the ongoing economic downturn, has reached this height. People are waiting for hours in queues to fill their tanks, as the country is facing extreme fuel shortages and inflation.

And this is only one of the country’s many problems. Sri Lanka is experiencing a full-fledged economic collapse.

The scenario has become increasingly bleak as a result of rising costs and the country’s debt dilemma. What comes next is the question.

Will the dire economic crisis in Sri Lanka ever end?

To put these crises to an end, a few options have been suggested by Indian exporters, including temporary permission for Lankans to make payments in their local currency. Another option from India is to either increase the current line of credit in the dollar, or extend a fresh line of credit in the rupee. Both these options are quite difficult for India as well. However, Sri Lanka might just go for another loan from China, but this is not a smart move as the country is already flattened by huge foreign debt — about $51 billion in total.

To understand the endgame of Sri Lanka’s economic crisis, we first have to check the sources of revenue in the country.

Tourism, tea export, apparel, textile, rice production, and other agricultural items are the country’s key revenue drivers. While the tourism sector accounts for 12% of Sri Lanka’s GDP and is the country’s fifth-largest source of foreign revenue, the tea industry accounts for 1.2 percent of GDP and is also important, particularly in terms of foreign exchange earnings, because Sri Lanka primarily exports to the United States, the United Kingdom, and Germany.

Sri Lanka has had a particularly rough time in recent years. The tourism-related effects of the COVID-19 pandemic, as well as the consequences of the Easter Sunday bombing in 2019, have shattered foreign investor and tourists’ confidence in the country. The country’s government also recently decided to go 100% organic, by banning the use of all chemical fertilisers across the board, and resulting in a drastic drop of yield for tea and other agricultural products. The country’s dependency on tourism and tea exports are a few of the key reasons that led to this downturn.

Sri Lanka’s economy needs diversification. For more than two decades, it has produced a limited but consistent basket of primary exports, but these exports are now stagnating or declining.

They have limited resources, yet they must focus on certain products and industries, such as clothes and textiles, which have a constantly changing market. To protect the country’s economy from potential dangers, the country needs to alter its investment rules in order to engage and attract new investors.

 

What are the lessons that India and other countries can learn from the Sri Lanka Crisis?

The Sri Lankan problem does not happen overnight, which is something that any business or country must understand. Sri Lanka has a number of structural difficulties that have been ignored for a long time. India, too, has structural issues, particularly with its public sector’s size and inefficiency.

The country’s dalliance with big-ticket projects that didn’t give enough value to the economy, as well as the necessity for more export diversification, were two other factors that contributed to Sri Lanka’s economic catastrophe. India, too, has to diversify its exports, and the most straightforward method to do so is to broaden the list of in-line items and strengthen the country’s manufacturing skills.

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