SriLanka’s Economic Crisis
What is an economic crisis
An economic crisis is a time where a country's economy experiences a significant and sustained downturn. This can manifest as a sharp decline in economic output, rising unemployment, and financial instability, often triggered by a financial crisis.
How does an economic crisis start?
Economic crises, including recessions and financial crises, often begin with imbalances in the economy that lead to a loss of confidence and a subsequent contraction in economic activity. These imbalances can manifest in various forms, such as asset bubbles, excessive credit expansion, or sharp changes in prices of key inputs. When these imbalances become unsustainable, they can trigger a cascade of negative events, including bank runs, stock market crashes, and reduced consumer and business spending.
SriLanka’s economic crisis
Why?
Why did the crisis in SriLanka begin?
The crisis is said to have begun due to multiple compounding factors like tax cuts, money creation, a nationwide policy to shift to organic or biological farming, the 2019 Sri Lanka Easter bombings, and the impact of the COVID-19 pandemic in Sri Lanka.Soaring prices, shortages of essential goods and crippling international debts sparked nationwide protests in 2021 which caused the president to flee the country.
The government blamed the Covid pandemic, which badly affected Sri Lanka's tourist trade - one of its biggest foreign currency earners.
It also said tourists were frightened off by a series of deadly bomb attacks in 2019.
However, many experts blame Mr Rajapaksa's economic policies.
At the end of its civil war in 2009, Sri Lanka chose to focus on providing goods to its domestic market, instead of trying to boost foreign trade.
This meant its income from exports to other countries remained low, while the bill for imports kept growing.
When Sri Lanka's foreign currency shortages became a serious problem in early 2021, its government tried to tackle the issue by banning imports of chemical fertilisers.
It told farmers to use locally sourced organic fertilisers, instead.
This led to widespread crop failures. Sri Lanka had to supplement its food stocks from abroad, which made its foreign currency shortage even worse.
What?
What were the factors that led to the crisis?
In early 2022, Sri Lankans started experiencing power cuts and shortages of basics such as fuel. The rate of inflation rose to 50% a year.
As a result, protests broke out in the capital Colombo in April that year and spread across the country.
The supply shrunk alot, due to miss calculations and wrong policies. But the demand remained the same, inevitably leading up to 70% increase in inflation (17.5% in 2022).
As per certain economists, is that SriLanka tried monetization of debt, meaning the country started using newly created money and buying back government securities from public instead of raising taxes or issuing new debt. This is an example of modern monetary theory advocated by economists.
The country ran short of fuel for essential services such as buses, trains and medical vehicles because it did not have enough reserves of foreign currency to import any more.
The fuel shortage caused petrol and diesel prices to rise dramatically.
In June last year, the government banned the sale of petrol and diesel for non-essential vehicles for two weeks. Sales of fuel remain severely restricted.
Schools had to close, and people were asked to work from home to help conserve supplies.
Plan to tackle the crisis
In the face of massive protests, President Gotabaya Rajapaksa resigned in June last year. Prime Minister Ranil Wickremesinghe became acting president and declared a nationwide state of emergency across the country.
Mr Wickremesinghe has been prime minister six times, without seeing out a full term in office.
The mass protests have subsided, but the new president is trying to deal with a huge financial crisis.
Sri Lanka owes about $7bn (£5.7bn) to China and around $1bn to India.
Sometime ago, both these countries agreed to restructure their loans, giving Sri Lanka more time to repay them.
Thanks to this, the International Monetary Fund (IMF) has agreed to lend Sri Lanka $3bn. That is on top of a $600m loan that the World Bank made last year.
Sri Lanka's government says it will raise funds to repay its debts by restructuring state-owned enterprises and privatising the national airline.
In early 2023 the country introduced income taxes for higher earners, ranging from 12.5% to more than 36%.
It also raised other taxes to pay for critical purchases, including fuel and food.
All the above contributed greatly to currency crisis that saw unfavourable balance of payments.
Managing the India-China Equation
During the 2022 economic crisis, India provided Sri Lanka with economic and humanitarian assistance of over US$4.5 billion (S$6 billion) and supported Sri Lanka’s debt restructuring efforts.These developments indicate the growing India-Sri Lanka economic relations and financial connectivity between the two countries, with the authorisation of the Indian Rupee as a designated currency in 2023.
Meanwhile, China is still Sri Lanka’s largest bilateral creditor and it reached an agreement with the Sri Lankan government’s approval to build a US$4.5 billion (S$6 billion) refinery in the southern port of Hambantota in November 2023. The project is the largest investment received by Sri Lanka since 2022. The project has strategic importance as the state’s sole refinery, has been struggling to meet the demand of the population and relying on imported fuel. Previous Chinese loans have been utilised to finance a number of large infrastructure projects, including highways, an airport and a port. Moreover, as mentioned earlier, China is crucial to Sri Lanka’s attempts to restructure its foreign debt.
While economic relations with India and China continue unabated, Sri Lanka’s political relations with India appear to have taken the front seat since 2022. This is a result of location, that is, India being the largest immediate neighbour to Sri Lanka, and is also a result of historical relations between the two countries. India’s political support or the lack of it in the past has determined to a significant extent the trajectory of internal events, such as the 26-year-long civil war.
Since 2022, Sri Lanka has developed significantly close relations with India and is aligning with India on international issues. For example, in September 2023, when the Canadian Prime Minister alleged that there were credible links between the killing of a leader of the Khalistan movement and government agents of India, Sri Lankan Foreign Minister Ali Sabry came out in support of India and criticised Canadian Prime Minister Justin Trudeau’s claim against India. In his statement, Sabry claimed that Trudeau made “some outrageous allegations without any supporting proof”, and in reference to the Sri Lankan Civil War, said that Canada did “the same thing…against India”.
Relations between India and Sri Lanka also grew stronger following Prime Minister Narendra Modi’s visit to Lakshadweep in January 2024. The prime minister’s attempts to promote Lakshadweep as a tourist destination were criticised by several Maldivian members of parliament, leading to growing tensions between India and the Maldives. Sri Lanka was, thereafter, promoted by many Indians, including high-level officials, as a tourist destination for Indians. Subsequently, the Maldives’ president, Mohamed Muizzu, made his first official visit to China instead of India, breaking with tradition.
Meanwhile, Sri Lanka continues to cultivate its political relations with China, even if to a relatively lesser degree. For example, Sri Lankan Prime Minister Dinesh Gunawardena participated in a six-day official visit to China in March 2024. during which he held talks with Chinese President Xi Jinping and Premier Li Qiang on ways to further deepen bilateral ties. China’s importance to Sri Lanka is not only at the economic level but also as a means of balancing India when relations are not always positive. In the past, for example, Sri Lanka governments have experienced India’s pressure on the issue of Tamil minority rights. Most recently, following Modi’s comments on Sri Lanka’s Kachchatheevu island, which was seen by many as an election tactic to gain more votes in Tamil Nadu, Sri Lanka is constantly reminded of the need to balance its foreign relations than depend too heavily on any one country or bloc.
The Recovery
SriLanka began a four year economic reform program supported by International Monetary Fund (IMF), in 2023. The dead relief provided by external creators reduced the burden, the SriLankan people needed to shoulder. $3B debt from external creditors was forgiven and another $25B was sanctioned for a longer horizon over the next 20 years, with much reduced interest rates. However, SriLankan people are paying an avoidable high price for the past policy mistakes and insufficient preparation for bad luck that struck them. Now, the people are paying high taxes against all the previous subsidies and bearing full cost of fuel and electricity. These reforms towards recovery from its still very vulnerable position.
There are significant gains from the reforms majorly due to people’s cooperation. There are no more short ages in fuel, cooking gas, medicines and food. There are no scheduled power outages too.
Sky rocketing inflation has been at bay. Tax revenues are up by 2/3rds of share of GDP.
The macro economic turnaround is staggering even as the households are yet to get the benefit.
The Future
It is important to arrest this boom-bust cycle and manage the economy so that the recovery can be maintained even in an uncertain global situations and so that all Sri Lankans benefit from it.
The path to stable and inclusive growth and fiscal and debt sustainability remains narrow. There is no room for policy errors. It will be important to continue to deliver revenues needed for essential government services, including by limiting tax exemptions. Scarce public resources need to be protected by restoring cost-recovery pricing for fuel and electricity and ensuring social support is well-targeted towards the most disadvantaged. The poor and vulnerable need to be given the opportunity to adequately participate in the economic turnaround. To unlock Sri Lanka’s long-term potential, capital spending in support of medium-term growth should be executed more predictably.
The task ahead is ambitious but doable. Keeping the reform momentum going will be key for a full recovery, benefitting not only this generation but future ones as well. The IMF will have to continue to support Sri Lanka in securing a strong and durable recovery improving the lives and livelihoods of all citizens.
Conclusion
The moral of this story is, bad economics equals great politics. President Raja Paksa introduced policies that would help him stay in power, which nonetheless turned against him, ultimately forcing him to flee the country. Debt monetisation and seemingly limitless spending only increase inflation and bring a country to economic collapse. Due to the immense sacrifice by the people of SriLanka and the magnanimity of external creditors, the country is now on a path towards recovery. SriLanka now bets on its present for a secure future.
Sources
This is a topic I really like, and my topic for my economics project in school. Thought I'd compile all the information and put it here. I guess sometimes I should go back to the topic my blog was started on 🤪
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