Economic Crisis in Sri Lanka

In Context

• Sri Lanka is in the middle of one of the worst economic crises in its history since independence.
• With the economy defaulting on foreign debt, the situation in the nation is grim. Inflation is at an all-time high and the public is facing great unease in getting the essentials. 
• The Sri Lankan PM resigned recently in the wake of fierce public protests.

Factors behind the crisis

• Long-run historical imbalance:

• Sri Lanka for long has been a high fiscal deficit economy. It was an inward-looking closed economy from the 1950s to the late 70s with low levels of growth.
• Thereafter ethnic conflict between the majority Sinhalese and the minority Tamils, which spanned over a period of nearly three decades further widened the fiscal deficit.
• In the post-war phase, the government for its lust for world-class infrastructure ended up taking huge loans from China and various other multilateral institutions without giving a second thought to debt servicing.

• Short-run imbalances in economy: 

• In the run-up to the 2019 elections, Mahendra Rajapaksa announced deep tax cuts in his manifesto which led to a steep fall in revenues. 
• This severely impacted Sri Lanka’s capacity to service the import bills which ultimately led to plummeting of forex reserves by 70 percent.

• Huge infrastructural debt: 

• Sri Lanka tried emulating the China-led model of growth and development by rapidly developing the infrastructure.
• In order to achieve the development goals, it took huge long gestation loans without analysing the financial, and ecological viability of the projects. 
• This led to a vicious cycle of debt and its interest payments.

• Dwindling tourism sector: 

• Sri Lanka primarily is a tourism led economy. 
• The Easter bombing in 2019 led to a sharp downfall in tourists’ arrival which got further aggravated due to the Covid-19 crisis thus leading to huge unemployment and revenue loss.

• Misguided policies of the authoritative regime:

• In 2021, the Sri Lankan government declared that it would be opting for 100 percent organic farming thus wiping out conventional farming, deploying chemical fertilizers and High Yielding Variety (HYV) seeds at once.
• The move led to a sharp decline in grain production which compelled the government to import food items thus further aggravating the debt and balance of payment problem.

• Impact of Covid-19:

• Covid further exacerbated the already fragile economic condition in Sri Lanka. 
• Exports of tea, and rubber further took a sharp dip and the tourism sector with various backward and forward linkages came to halt.
• Sri Lankan laborers were left stranded amidst war and many lost their jobs. They had to return home jobless.
• Thus, remittances also dropped significantly. Government expenditure rose while revenue took a hit.
• This has led to a drop in sovereignty rating which means Sri Lanka will face problems while seeking loans from multilateral institutions 
• It would also hinder the inflow of foreign investment in the near future resulting in a downward spiral in the economy.

• Narrow production basket:

• Island economy production basket comprises rubber and tea mostly. 
• Other vital contributors to the economy are tourism and remittances. 
• All these contributors are highly elastic whose prices fluctuate to a great variation.

• Aging demography: 

• Sri Lankan society is an aging one whose demographic dividend epoch has already passed. 
• The increase in economic productivity has not been able to offset the aging population thus keeping the production base small.

• Impact of Russia Ukraine war: 

• The war has accentuated the price level of commodities across the world.

 Impact on the economy due to the crisis

• Macroeconomic instability: Because of the crisis, the economy is running low on forex reserves, and high external debt and thus is not able to pay for essential import bills such as fuel, food items and other essential goods.
• High inflation rate: Economic crisis has led to inflation nearing 17.5 percent with food inflation at 25 percent. This has led to public unrest on the streets and high food and fuel shortages.
• Food and fuel shortage: There is a serious shortage of food grains, fuel and other essential imports as the island nation’s production basket is too narrow to self-sustain its domestic demand.
• Health care in shambles: Nation relies on imports for 85 percent of its medicinal needs.  The nation is short of medical drugs, anesthetic drugs, implants, and suture materials.  Doctors’ consortium has warned that healthcare services can collapse if immediate relief is not provided.
• Plummeting employment level: Unemployment has become a common phenomenon in almost every household. The government has identified that a large chunk of households has severe financial distress and the number of poor has gone up.
• Foreign Investment suffering: Because of bad macro indicators, the sovereign rating has come down because of which fresh foreign investment has stalled thus negatively impacting the income and employment levels.
• Looming political crisis: There is great angst amongst the citizenry against the incumbent government. Huge protests have been organized by civil society to oust the Government. The Prime Minister has finally resigned which will lead to the fall of the government, However the protestors are adamant on President’s resignation as well.

India’s Role So Far

• Extending credit: 

• Relief from India so far has been USD 1.4 billion – a USD 400 currency swap, a USD 500 loan deferment and a USD 500 Line of Credit for essentials. 
• India has also extended an additional USD 1 billion short-term concessional loans to the island nation to help the country as it faces an unprecedented economic crisis.

• Essential supplies: India has also sent food and grains shipments to Sri Lanka so as to tide over the tough times.
• Currency Swap: India has inked SAARC currency swap deal with Sri Lanka. This will help in saving up precious forex reserves for Sri Lanka.

Way Forward for Sri Lanka

• Short-Run steps 

• Immediate policy prescription: Urgency in policy intervention is needed to address the unmanageable levels of debt and debt service, reducing the fiscal deficit, restoring external stability and doing away with the adverse impacts on the vulnerable citizenry.
• Arresting inflation: The Central Bank should arrest the high inflation rate of nearly 18 percent and more so in the case of food inflation which has shot past 25 percent.
• Reviving agriculture: The agrochemical imports ban should be done away with at once and organic farming across the island should be implemented in a graded fashion so as to avoid the supply shocks.
• Import ban: it should stop the import of non-essentials in the short run thus saving up precious forex reserves which in turn can be used to finance essential imports.
• Seeking bail out: from multilateral institutions  but should be cautiously used so as to incentivize the export sector which can increase the export earnings and fill up the forex coffers in addition to bridging the trade deficit which as of now is $8.1 billion.
• High powered interim administration: As the PM has already given the resignation and protestors are demanding the resignation of the President too. SL will see the cabinet resignation soon. The President should immediately appoint an interim administrative unit with domain experts who can guide the country through tough times.

• Long run steps

• Controlling fiscal deficit: Fiscal deficit is estimated to have remained at 11.1 percent of GDP in 2021 which should be dragged down to 5 percent in the medium run and 3.5 percent in the long run. This will increase the sovereign rating and attract fresh foreign investments.
• Robust macro tools: It should be more proactive in using macroeconomic tools to mitigate any shocks to the growth and stability of the economy and not in a reactionary way.
• Assessing viability of the projects: it should institutionalize a robust mechanism to assess the economic, and environmental viability of the heavy infrastructure projects using the overseas credits.

Expanding export basket: Sri Lanka should expand its exports baskets and not just rely on handful products that are susceptible to global price shocks.