What is happening in Sri Lanka and how did the economic crisis start?

The island nation of Sri Lanka is in the midst of one of the worst economic crises it has ever seen. It has just defaulted on its external debts for the first time since independence, and the country’s 22 million people face crippling 12-hour power cuts and dire shortages of food, fuel and electricity. other essential items such as medicines.

Inflation is at an all-time high of 17.5%, with prices for food items such as a kilogram of rice reaching 500 Sri Lankan rupees (A$2.10) when it would normally cost around 80 rupees (0 .34 $A). Amid the shortages, a 400g pack of powdered milk would cost more than 250 rupees (Australian $1.05), when it usually costs around 60 rupees (Australian $0.25).

On April 1, President Gotabaya Rajpaksha declared a state of emergency. In less than a week, he withdrew it following massive protests by citizens angry at the government’s handling of the crisis.

The country depends on the import of many essential items, including gasoline, food and medicine. Most countries will keep foreign currency on hand in order to exchange these items, but a shortage of foreign currency in Sri Lanka is responsible for the exorbitant prices.

Read more: Sri Lanka is reeling economically, from pandemic-fueled financial crisis and fallout from war in Ukraine

Why do some people blame China?

Many believe that Sri Lanka’s economic relations with China are one of the main drivers of the crisis. The United States has called this phenomenon “debt trap diplomacy”. This is where a creditor country or institution grants debt to a borrowing country to increase the lender’s political clout – if the borrower stretches out and cannot repay the money, they are at the mercy of the creditor.

However, China’s loans accounted for only around 10% of Sri Lanka’s total external debt in 2020. Most of it – around 30% – can be attributed to international sovereign bonds. Japan actually accounts for a higher proportion of their external debt, at 11%.

Defaults on Chinese infrastructure-related loans to Sri Lanka, particularly funding for the Port of Hambantota, are cited as factors contributing to the crisis.

Protests erupted against the government’s handling of the economic crisis.

But these facts do not add up. The construction of the Port of Hambantota was financed by the Chinese Exim Bank. The port was making losses, so Sri Lanka leased the port for 99 years to the Chinese Merchant’s Group, which paid Sri Lanka US$1.12 billion.

So the Port of Hambantota fiasco didn’t lead to a balance of payments crisis (where more money or exports go out than come in), it actually bolstered foreign exchange reserves. Sri Lanka of $1.12 billion.

So what are the real reasons for the crisis?

After independence from the British in 1948, agriculture in Sri Lanka was dominated by export crops such as tea, coffee, rubber and spices. Much of its gross domestic product came from foreign currency earned from the export of these crops. This money was used to import essential foodstuffs.

Over the years, the country also started exporting clothes and earning foreign exchange through tourism and remittances (money sent to Sri Lanka from abroad, perhaps by family members). Any drop in exports would be an economic shock and put a strain on foreign exchange reserves.

For this reason, Sri Lanka has frequently encountered balance of payments crises. From 1965, she obtained 16 loans from the International Monetary Fund (IMF). Each of these loans came with conditions, including that once Sri Lanka received the loan, they had to reduce their budget deficit, maintain tight monetary policy, reduce government subsidies for feeding the people of Sri Lanka and depreciate the currency (exports would thus become more viable).

But generally, during an economic downturn, good fiscal policy dictates that governments spend more to stimulate the economy. This becomes impossible under IMF conditions. Despite this situation, IMF loans continued to flow and a beleaguered economy fell deeper and deeper into debt.

The last IMF loan to Sri Lanka was in 2016. The country received $1.5 billion over three years, from 2016 to 2019. Terms were familiar and the health of the economy plummeted during that period. Growth, investment, savings and income have fallen, while the debt burden has increased.

A bad situation worsened with two economic shocks in 2019. First, there was a series of bombings in churches and luxury hotels in Colombo in April 2019. The explosions led to a sharp drop in tourist arrivals – with some reports indicating as much as an 80% drop – and depletion of foreign exchange reserves. Second, the new government led by President Gotabaya Rajapaksa cut taxes irrationally.

A drop in tourist numbers and tax cuts have led to further economic hardship.
AAP/Eranga Jayawardena

Value added tax rates (similar to goods and services taxes in some countries) have been reduced from 15% to 8%. Other indirect taxes such as national construction tax, pay-as-you-go tax and economic service charges were abolished. Corporate tax rates have been reduced from 28% to 24%. About 2% of gross domestic product was lost in revenue because of these tax cuts.

In March 2020, the COVID-19 pandemic hit. In April 2021, the Rajapaksa government made another fatal mistake. To avoid the depletion of foreign exchange reserves, all fertilizer imports were completely banned. Sri Lanka has been declared a 100% organic nation. This policy, which was withdrawn in November 2021, led to a drastic drop in agricultural production and more imports became necessary.

But foreign exchange reserves remained under pressure. A decline in tea and rubber productivity due to the fertilizer ban also led to a decline in export earnings. Due to declining export earnings, there was less money available to import food and food shortages arose.

Because there is less food and other items to buy, but no drop in demand, the prices of these goods rise. In February 2022, inflation rose to 17.5%.

What will happen now?

In all likelihood, Sri Lanka will now get a 17th loan from the IMF to overcome the current crisis, which will come with new conditions.

A deflationary fiscal policy will be followed, which will further limit the prospects for economic recovery and exacerbate the suffering of the Sri Lankan people.

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