Sri Lankan President, Gotobhaya Rajapaksha had called on its expatriates to increase remittances to the island nation, on the occasion of the country’s 74th Independence Day on February 4th. The country has been staring at a looming economic crisis since the beginning of the pandemic. The fast-declining Forex reserves which touched as low as $ 1.6 billion as of end-November 2021 is the root cause of the trouble. Foreign worker remittances and Tourism had been the two main foreign currency earners for the country. Income from both these sources has been critically affected by the pandemic. Sri Lanka has to service debt payments exceeding $7 billion in 2022, equivalent to nearly 430% of official foreign reserves as of November 2021.
Fitch has downgraded Sri Lanka’s rating from “CC” to “CCC” in December saying there is an increased possibility of default in the coming months. S&P too followed suit in January citing greater sovereign default risk.
Remittances, the main foreign exchange earner to the country, was down to 325.2 million USD in December 2021, a 60% drop from the previous year. Year-on-year remittances have declined by 22.7 percent in 2021 to 5491.5 million USD. The Central Bank of Sri Lanka (CBSL) has already announced an additional incentive of Rs.10 per US dollar received by way of remittance. The Central Bank will also bear the transaction costs incurred by Sri Lankan nationals while remitting their money through exchange houses or banks (official channels).
CBSL has resorted to a variety of interventional methods to preserve the foreign exchange. It has attempted to maintain an artificially low peg on the USDLKR (Unites States Dollar – Sri Lankan Rupee) exchange rate to accumulate foreign currency. This move has shifted huge volumes of remittances to parallel channels. Remittances through formal channels fell to $271m in November 2021, the lowest recorded since 2010.
Strong-arm measures like repatriation of export earnings within 180 days of shipment and mandatory surrender of a portion of forex receipts to the Central Bank are implemented to desperately shore up the leaking foreign reserves
Central Bank data shows that the foreign reserves were on a steady decline from the start of the pandemic. In June 2020, Sri Lanka introduced a broad import ban to ease pressure on the exchange rate and Balance of Payments. This resulted in supply-side shortages which pushed up the prices of commodities. Exports too were hit, deprived of crucial imported raw materials, further putting strain on foreign reserves.
Sri Lanka faces a dilemma between paying its external debt obligations and importing essentials such as food, fuel, and medicines. So far, it has saved itself from huge reputational damage by not defaulting payments even as people struggle for necessities at home.
In November 2019, Sri Lanka announced massive tax cuts to promote growth. It so happened that the timing of this policy went awfully wrong because the pandemic struck within 3 months after the announcement. The tax reductions and the pandemic put a huge downside on revenue generation. To counteract the money shortage, the Central Bank resorted to excessive money printing to meet the deficit, which further fed into the inflationary pressure.
Almost simultaneously, the government prematurely pulled out of a USD 1.5 billion lending arrangement with the IMF (International Monetary Fund) to get rid of the attached conditionality’s and loosen its fiscal policy.
All these measures would have made sense if they led to a spurt in growth and income generation. Nonetheless, the GDP of the country shrank by 1.5% in the quarter from July to September 2021, a double whammy to the government. The country’s persistently low growth rates over the past years had direct consequences on debt sustainability.
Over the past months, Sri Lanka finalized currency swaps with China and India to prevent a sovereign default. In December, Sri Lanka raised its official Forex reserves to USD 3.1 billion supported by a USD 1.5 billion currency swap with the People’s Bank of China. It had also settled a USD 400 million currency swap with the Reserve Bank of India during the last year.
Behind the Forex crisis lies the serious predicament of debt serviceability. The government does not favour an IMF-supported debt restructuring option due to the conditionality’s attached. The President, at the same time, reached out to China for the restructuring of its loans and access to preferential credit for the import of essential goods.
The pandemic-induced restrictions have indeed dried up sizeable sources of income. The unsustainability of debts has also brought the quality of government expenditure into question. Investments in mega infrastructural projects like Hambantota port have turned out to be uneconomical and wasteful. Sri Lanka needs long-term strategies to bring back the external debt to sustainable levels. For that to happen, it is imperative that revenue sources are diversified and capital expenditure utilized judiciously. Till then, the support from the expatriates could help the country buy some time.