*Paromita Das
The Sri Lankan economy has been in crisis for some time, and the situation has deteriorated in recent days. To quell widespread protests and unrest and prevent the situation from deteriorating further, Sri Lankan President Gotabaya Rajapaksa declared a state of emergency on April 1.
How did Sri Lanka get to this economic abyss?
From 1983 to 2009, Sri Lanka was engulfed in a civil war, during which the economy made little progress. From 1970 to 2020, agriculture’s share of GDP fell from 28% to 7.7%; industry’s share remained stable at 17-19%, and services’ share increased from 54 % to 73%.
Within services, trade, hotels, and transportation have contributed 30-35 % of GDP.
The economy is heavily reliant on imports for necessities such as food and oil. These imports are primarily funded by agricultural exports (tea, rubber, and coconut); industrial products (textiles), and remittances from abroad. Export and remittance revenues have never covered the cost of imports, and Sri Lanka has always run a current account deficit (CAD). In 2010-19, the average CAD was around 1.2 % of GDP.
The CAD has primarily been met by government borrowing from abroad. Because the government’s borrowing from abroad has exceeded the CAD, the balance has been tied to foreign exchange reserves. What is one to make of an economy whose forex reserves are primarily made up of foreign borrowings?
In addition to a large CAD, the government ran large fiscal deficits. In 2011-20, the average fiscal deficit was 6.2% of GDP. The government financed fiscal deficits with both domestic and foreign funds. As foreign sources dried up, it turned to domestic borrowing, issuing bonds and obtaining advances from The Central Bank of Sri Lanka. In order to combat high tax evasion, the government also reduced tax rates.
The dual deficit The Sri Lankan economy was under enormous pressure from 2010 to 2019, but it managed to keep the show running. The conditions were ideal for an economic conflagration, and all that was required was a spark.
COVID-19 was more than a spark in 2020, sucking the air out of the Sri Lankan economy. The pandemic caused a global recession, which reduced global demand. Sri Lanka’s exports fell while imports (primarily necessities for survival) increased, and to make matters worse, the country’s tourism industry came to a halt. GDP fell by 3.5 %; the CAD reached 7.9% of GDP, and the fiscal deficit increased to 11.1% of GDP.
Before the economy could stabilize, the government decided in April 2021 to phase out chemical fertilisers in favor of 100 % organic fertilisers. While intentions cannot be questioned, timing is critical. Fertilisers are a marginal expense at 2% of the import bill. Inflation rose from 5.7ly % 2021 to 15% in February 2022 as a result of this shift in an important sector such as agriculture.
Sri Lanka’s official reserves were estimated to be $2.4 billion at the end of January 2022, equivalent to 1.3 months of imports. The country is struggling to import oil and is experiencing power outages lasting more than ten hours per day.
The central bank is fighting the crisis by raising policy rates, and it has also requested that the government take steps to improve its finances. The Russia-Ukraine conflict exacerbated the situation, as tourists from Russia and Europe were unable to visit Sri Lanka.
The economic crisis in Sri Lanka is reminiscent of India’s in 1991. The seeds of India’s 1991 economic crisis were sown in the 1980s, when both fiscal and current account deficits increased. Unlike Sri Lanka today, India followed a highly restrictive trade policy that resulted in a scarcity of forex reserves as a result of policy design. By 1989-90, on the eve of the crisis, India’s forex reserves had plummeted to just 1.9 months of imports.
The economy was in a precarious position, and the West Asian oil crisis acted as a shock to the system.
Thirty-one years later, Sri Lanka finds itself in a comparable economic situation. However, there is one significant difference: whereas New Delhi had leaders such as (late) PV Narasimha Rao and Manmohan Singh to rely on; Colombo has none. The Rajapaksas are the target of widespread public rage (and rightly so, because seven family members are part of the government, including President, Prime Minister and Finance Minister). In this regard, Sri Lanka’s economic crisis resembles the Arab Spring of the early 2000s, when people protested against leaders against the backdrop of an economic crisis.
Sri Lanka’s economic crisis has once again focused attention on South Asian politics. Concerns have been raised about Sri Lanka’s reliance on China, as well as Beijing’s ‘debt trap’ policies (the effects of which are now also being discussed in many African countries). Pakistan, another of India’s neighbors and China’s “all-weather friend,” is in a state of political and economic upheaval.
Among all of these developments, India stands out as a beacon of hope for maintaining its economic buoyancy in the face of adversity.
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