Elucidating the Sri Lankan Economic Crisis

Asia has turned out to be a hotspot for the pandemic to regroup. Unfortunately, the frontier economies have faced the repercussions of disruption: a tad bit more than their emerging counterparts. In recent months, the badly battered economy of Sri Lanka has emerged as a prime example of how the pandemic has crippled the economic mechanism to the extent of paralysis. And while endemic inflation and external imbalances are a commonality in the developing economies today, Sri Lanka is facing a fatal blend of fiscal mismanagement, economic incompetency alongside excruciating debt obligations; all that is leading the country on the precipice of bankruptcy.

The South Asian island nation is currently under an extended lockdown due to mounting hospitalizations and deaths related to the recent outbreak of the delta variant. Amid a health crisis, Sri Lanka is beleaguered by the economic downturn which is tightening the noose around the country’s fragile monetary mechanism. Sri Lanka’s forex reserves have dwindled significantly in the past few months. As of July, the foreign exchange reserves have dropped down from the highs of around $7.5 billion (back in 2019) to a dismal level of $2.8 billion. The drying reserves could be fundamentally attributed to the debt repayment schedule. Colombo recently registered an outflow of $1 billion on account of the international debt payment. The remaining reserves barely provide an import cover of 1.8 months: massively falling short of the minimum desired three-month mark. Thus, Sri Lanka’s credit default premium has climbed through the roof as the country wades through a blinding shortage of foreign currency to meet even basic requirements.

“The economic turmoil has been further compounded by the colossal drop in revenue and remittances,” said Finance Minister Basil Rajapaksa. The issue at the forefront is the worsening health crisis and the subsequent restrictions that have all but wrecked the key industries of Sri Lanka: Travel and Tourism. Tourism contributes roughly 12% of the Sri Lankan GDP and congregates an approximate share of 5% of the $81 billion economy. The sector stands as the most lucrative industry in Sri Lanka. However, the tide has been harsh against recovery. Over the past few months, the revenue from tourism has fallen, from more than $450 million a month two years ago, down to $2 million a month, according to the data from Trading Economics. Such a steep downfall has resulted in further deterioration of the forex reserves that are already at their lowest level since 2009.

Despite receiving concessionary funds from both the World Bank and the Asian Development Bank, the Sri Lankan economy seems to be spiraling towards an impending downfall. The apparent reason is the extreme inflationary pressure which is weighing heavily: especially on food essentials. According to data acquired from leading economists, the Colombo Consumer Price Inflation has bloated at 5.7% year-on-year. As a result, the Sri Lankan rupee has increasingly depreciated by more than 8% this year. A combination of high inflation and massive devaluation has all but punctured the balance of payment. As Sri Lanka imports the majority of its food supplies, it is only straightforward to connect the dots: the more the inflation prevails, the faster the rupee would depreciate, and thus, the more expensive the food items would turn out to be.

To make matters worse, the Sri Lankan government has facilitated a food crisis by barring the use of chemical fertilizers to achieve 100% organic agricultural production. With expensive imports and throttling domestic regulations, the Rajapaksa regime has created a deliberate shortage of even the most basic food items like sugar. Instead of acknowledging the faulty policy, the Sri Lankan government has ventured through to declare an economic emergency: passing the baton to the army to ensure adequate supply at a fair price. Moreover, price caps have further pushed against the supply chain since traders are engaging in black markets instead of selling at a loss. The Rajapaksa regime has been befuddled by the fissures in the economy and has since started playing the Blame game.

While refusing to end its aggressive policy of organic farming, the government has blamed speculators and hoarders for the surging food inflation. Naturally, the supposed corrective policies did nothing to resolve the underlying problem. The Central Bank of Sri Lanka (CBSL) recently implemented restrictions in the forex market to disarm the alleged speculators from further plunging the rupee. The CBSL limited spot trading of rupee to a maximum of 200 rupees to a US dollar. Furthermore, CBSL also banned traders from entering forward contracts in the currency market to control the volatility of the rupee. However, the strategy has so far backfired. The inability of traders to get more US dollars has resulted in a fall of imports of even the basic food essentials and necessities. Moreover, the ban on forward contracts in the forex market has made it difficult for traders to mitigate the risk of currency volatility. As a result, foreign trade has ceased to exist in some industries while a growing demand is all but exacerbating inflationary pressure in the domestic economy.

To dampen the demand pressure, Sri Lanka adopted a hawkish shift in a desperate attempt to reach equilibrium and harness inflation. Recently, Sri Lanka became the first Asian country to raise its policy rates since the pandemic. The CBSL hiked the interest rates by 50 basis points while also increasing the Statutory Reserve Ratio by 200 basis points. The CBSL officials claimed that the rate hike was scheduled to “mitigate pressure on the currency and preempt the buildup of excessive inflationary pressures.” However, the reasoning was based on a faulty groundwork assuming that the dwindling forex reserves are due to excessive borrowing and import of exotic goods: which is simply ludicrous. As already discussed, high imports are basically comprised of food essentials which are turning more and more expensive due to excessively devalued rupee along with extreme food inflation in the domestic market. The real causes of depletion are the crippling debt obligations, mounting inflationary pressures, massive devaluation of the rupee, and inane agricultural policies. Therefore, the hike in interest rates is only making it harder for domestic traders to meet their margins while the shortage is only expanding with time as the supply struggles to keep up.

Sri Lanka stands at a high risk of bankruptcy, especially since the S&P Global Ratings has recently slashed the country’s credit outlook to negative. The change in ratings along with significantly low forex reserves and a nosediving rupee, all have jointly contributed to the doubts prevailing regarding Sri Lanka’s ability to service its $1.5 billion debt that matures in 2022. To make matters worse, the CBSL Governor Weligamage Don Lakshman recently announced his abrupt resignation from the office. Amid such uncertainty and economic disparity, the Rajapaksa regime is still dabbling in options instead of resolving the problems head-on. The president himself asserted that the country’s policy is to “borrow without any conditions harming the country’s independence and sovereignty.” However, ironically his aspirations are at a dead end as Sri Lanka is rapidly falling short of survival. In the end, the only option left would be to turn to the IMF for aid: where the regime would be forced to choose between survival or independence – reforms or bankruptcy in simpler terms.

Syed Zain Abbas Rizvi
Syed Zain Abbas Rizvi
The author is a political and economic analyst. He focuses on geopolitical policymaking and international affairs. Syed has written extensively on fintech economy, foreign policy, and economic decision making of the Indo-Pacific and Asian region.