– Penned By Varnika Gupta
Recently the news about exams being canceled in Sri Lanka was doing the rounds in the newspapers. The reason was there was a shortage of printing paper in the island country. It did bring joy to thousands of students across the nation, however, it also shed a light on the grim economic situation of the country. The country lacked enough funds to even finance the import of paper. The debilitating economic crisis brought on by a shortage of foreign exchange reserves to finance essential imports has seen the country running low on food, fuel, and pharmaceuticals. The situation is worsening day by day, with prices of basic commodities skyrocketing, and most of them being unavailable. In this Macroscan, we will dive deeper into what brought Sri Lanka into this crippling economic position, and what is the way forward.
The dire state of Sri Lanka is the interwoven influence of politics, covid pandemic, and poor decisions which ultimately led to the downfall of Lanka’s economy.
Pandemic hits tourism and remittances
“The pandemic-induced strain on finances has been significant, with government revenues coming under excessive pressure as the important revenue-generating tourism sector has effectively been on pause since early 2020,” said Shahana Mukherjee, an economist at Moody’s. “Migrant worker remittances have also suffered a major setback.”
Moreover, tax cuts introduced during the pandemic to revive the economy led to a significant drop in tax earnings weakening the government’s capital initiatives to support the economy.
This led to a downgrading of Sri Lanka’s sovereign rating, further limiting its access to capital market borrowings.
The government led by brothers, Gotabaya and Mahinda Rajapaksa, as the President and the Prime Minister of the Lankan nation, led to dynastic politics, with more family members occupying top positions in the government. One of the brothers, Basil, was appointed as the finance minister in 2021. According to some estimates, more than 75% of the budget is in control of the Rajapaksa ministers in the government. During 2007, there was high capital market borrowing, the time Mahinda Rajapaksa was the President. That now accounts for 38% of the country’s debt, while loans from China account for 10%. The government was initially financing from India and China and refusing wider international aid.
Moreover, the fiscal policy issued by the government was expansionary in nature with high government spending, tax cuts eroding the revenue, vast debt repayments to China, and foreign exchange reserves at the lowest in a decade.
According to Citi research, “the country’s official reserves fell by $779 million to $2.36 billion in January  compared with $3.1 billion in December .”
Reserves were built by borrowing foreign currency funds, rather than through higher earnings from exports of goods and services. This left Sri Lanka highly exposed to external shocks. Moreover, Al Jazeera reports that “Sri Lanka has borrowed heavily and faces repayments on $15bn in international sovereign bonds.”
Earlier the government introduced a fertilizer ban that led to a dramatic fall in yields of crops like rice and tea.
Since 2007, successive governments have issued sovereign bonds, without giving much thought about how they will be given back. Reserves were built upon borrowing foreign currency funds rather than exports of goods and services. This left Sri Lanka exposed to external shocks.
Currently, the situation in Sri Lanka is similar to the 1970s economic crisis where the country was fighting for survival amid a crippling food crisis. Prices of basic necessities have skyrocketed due to limited supply and rationing being introduced. The situation is so alarming that soldiers have been posted at hundreds of gas-run stations to distribute fuel as shortages forced tens of thousands of people to queue for fuel for hours.
Recently, Sri Lankan finance minister Basil Rajapaksa was present at the signing of the agreement pertaining to the Short-Term Concessional Loan facility of $1 billion extended by India to the Lankan government through the State Bank of India.
Currently, it has just 2.31 billion dollars of reserves, which have dwindled even more in the last week.
In addition, Sri Lanka has imposed import restrictions on 367 items such as milk products, fruits, and fish that have been dubbed “non-essential” as part of the bid to tackle the economic crisis triggered by forex shortages. Regular power cuts have become a norm in the island nation.
In January, Rajapaksa met with Chinese foreign minister Wang Yi to request that China restructure its debt repayments. Last year, the country’s central bank and the People’s Bank of China entered into a bilateral currency swap agreement for a swap facility amounting to $1.5 billion — the move was aimed at reducing the risk of fluctuating exchange rates when there is financial volatility.
Sri Lanka owes more than $5 billion in debt to China. It is paying in installments the additional $1 billion loan it took from Beijing last year to help tide over its acute financial crisis, according to reports. And it’s not only China but there are other markets also in the government and private sectors that Sri Lanka owes money to.
Analysts said the country needs to either restructure the debt or go to the International Monetary Fund for a relief package. Sri Lanka needs to act urgently to prevent a looming humanitarian crisis. Rajapaksa assured that the relief package would not contribute to further inflation and that there won’t be any new taxes.
Meanwhile, the central bank has issued a request for foreign currency, including any loose change that people may have after returning from visits overseas. It had banned dealers from exchanging more than 200 Sri Lankan rupees for a US dollar and from entering into forward currency contracts early this year. Since then, the administration has taken temporary measures to alleviate the situation.
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