- GS-3: India and its neighbourhood
Sri Lanka’s economic crisis
Context: The Sri Lankan economy has been facing a crisis owing to a serious balance of payments (BoP) problem.
- Its foreign exchange reserves are depleting rapidly and is becoming increasingly difficult to import essential consumption goods.
- The country is also unable to repay past debts.
What are the causes of the current crisis?
- Historical imbalances in the economic structure
- Even in the 21st century, Sri Lanka’s economic fortunes continued to be tied to the export of primary commodities such as tea and rubber, and garments.
- It mobilised foreign exchange reserves through primary commodity exports, tourism and remittances, and used it to import essential consumption items including food.
- Slowdown much before the Pandemic
- Possibly because of pent-up demand, Sri Lanka’s post-war GDP growth was reasonably high at 8-9% per annum between 2009 and 2012.
- However, the economy was on a downward spiral after 2013 as global commodity prices fell, exports slowed down and imports rose.
- The average GDP growth rate almost halved after 2013.
- Continuing drain of foreign exchange reserves
- During the period of the war, budget deficits were high. The 2008 global financial crisis of 2008 had led to flight of capital further draining Sri Lanka’s foreign exchange reserves.
- It was in this context that the government obtained $2.6 billion loan from IMF loan in 2009 with the conditionality that budget deficits would be reduced to 5% of the GDP by 2011.
- This commitment tied the hands of the government to go for counter-cyclical fiscal policy when economy slowed down after 2013.
- IMF’s loan-related conditionalities
- With no pick-up in growth or exports, and the continuing drain of foreign exchange reserves, the government approached the IMF in 2016 for another US$1.5 billion loan for a three-year period between 2016 and 2019.
- The IMF’s conditionality was that the fiscal deficit must be reduced to 3.5% by 2020. Other conditionalities included
- a reform of the tax policy and tax administration;
- control of expenditures;
- commercialisation of public enterprises;
- flexibility in exchange rates;
- a free environment for foreign investment.
- The IMF package led to a deterioration of Sri Lanka’s economic health.
- GDP growth rates shrank from 5% in 2015 to 2.9% in 2019.
- Investment rate fell from 31.2% in 2015 to 26.8% in 2019.
- Gross government debt rose from 78.5% of the GDP in 2015 to 86.8% of the GDP in 2019.
- New Shocks to the Economy
- First, the Easter bomb blasts of April 2019 in churches in Colombo led to the death of 253 people. Consequently, the number of tourists fell sharply leading to a decline in foreign exchange reserves.
- The new government which came to power in Nov 2019 went for lower taxes as was promised in their election campaign. VAT rates were reduced from 15% to 8%. The nation building tax, the PAYE tax and the economic service charges were abolished.
- As a result of this policy, close to 2% of the GDP was lost in taxes thus foregone. GST/VAT revenues were halved between 2019 and 2020.
- The COVID-19 pandemic in 2020 made the bad situation worse. Exports of tea, rubber, spices and garments suffered. Tourism arrivals and revenues fell further.
- The pandemic also necessitated a rise in government expenditures: the fiscal deficit exceeded 10% in 2020 and 2021, and the ratio of public debt to GDP rose from 94% in 2019 to 119% in 2021.
- Misguided policies: Chemical Fertilizer ban
- Sri Lanka annually spent about $260 million (or about 0.3% of its GDP) on fertiliser subsidies. Most of the fertilisers are imported.
- To prevent the drain of foreign exchange reserves, the government came up with a bizarre solution in 2021 to ban all fertiliser imports from May 2021, and declared that Sri Lanka would overnight become a 100% organic farming nation.
- This policy, which was withdrawn in November 2021 after protests by farmers, literally pushed Sri Lanka to the brink of a disaster.
- However, this policy adversely impacted the agricultural yields leading to fall in agricultural production necessitating the import of foods.
- But increasing imports was difficult in the face of foreign exchange shortages. Thus, inflation rose to 17.5% in February 2022.
- Also, a fall in the productivity of tea and rubber led to lower export incomes. And thus, the organic farming policy, which aimed to soften the pressure on reserves, ended up straining them even further.
- The government might approach the IMF once again for a new loan with fresh conditionalities. With the global outlook appearing dim, a renewed push to such a deflationary policy would not just limit the prospects of economic revival, but also exacerbate the sufferings of the Sri Lankan people.
Connecting the dots:
- India’s 1991 BOP Crisis
- 2008 Global Financial Crisis