What was the root cause of Sri Lanka’s economic crisis?

This article has been written By – VIKASH KUMAR, BA.LLB, Final Year, RNB GLOBAL UNIVERSITY, BIKANER.

Abstract: –

The Sri Lanka Economic crisis has put the alarm bells on alert especially for developing south Asian nations which rely heavily on Debt procurements for their demands and the political compulsions to win elections leads to announcing freebies which hamper the revenue collections and ultimately cost the development and losses to the state treasury. Development should be based on a sustainable model which provides growth along with managing the financial aspects of the nation.

How did the crisis begin?

The crisis started in 2019 when Gotabaya Rajapaksa won the presidential election by defeating Maithripala Sirisena. After assuming office as President of Sri Lanka, Gotabaya announced a large number of benefits, including massive tax cuts, a ban on fertilizer imports, and the promotion of only organic farming, which resulted in a lower yield of food grains and made the country heavily dependent on food imports. citizens’ demand for food, which, together with a drop in tourism revenue due to the lockdowns and restrictions brought about by the Covid pandemic, has led to a massive dollar crisis and foreign exchange reserves are now in ruins.

Successive Sri Lankan governments continued to borrow huge amounts of loans and aid in the form of lines of credit and currency swap agreements to keep the nation’s economy afloat, but were not serious about mounting debt burdens and interest obligations. Not bringing structural and financial changes to reform the country’s tax structure, which ultimately led to the country’s current situation where it is facing the worst economic crisis since Sri Lanka’s independence in 1948.

Freebies and other financial concessions given by the Gotabaya Rajapaksa government have hampered issues like tax revenue, fertilizer import revenue and other government institutions. the collections slowly dried up due to these political decisions and the government. there was nothing left but to borrow more money to maintain the treasury, which had accumulated already skyrocketing debts to countries such as China, India, the USA and institutions such as the World Bank, the Asian Development Bank, the New Development Bank.

Sri Lanka has not learned from its past mistakes of borrowing huge amount of money from China for development of ports, highways, airports and other infrastructural purposes, but later failed to pay back and was compromised to give the strategically important port of Hambantota on Lease. China for 99 years in lieu of the time concession provided by China to pay interest instalments. The loan was not a debt-for-asset exchange and Sri Lanka still needs to repay the debt. Sri Lanka used the $1.1 billion lease to repay debts to other creditors and increase foreign exchange reserves.

The main causes of the crisis:-

Tax Cuts and Money Creation –

The Sri Lankan government under President Gotabaya Rajapaksa implemented large-scale tax cuts that affected government revenue and fiscal policy, causing budget deficits to increase. These cuts included an increase in tax-free thresholds which led to a 33.5% drop in the number of registered payers, a reduction in VAT to 8%, a reduction in corporation tax from 28% to 24%, the abolition of Pay As You Earn (PAYE) tax and a 2% “ nation-building tax’, which financed infrastructure development. The massive loss of tax revenue resulted in rating agencies downgrading the state, making it more difficult to take on more debt.

In 2021, P. B. Jayasundera stated that President Rajapaksa was aware of the loss of revenue but considered it an “investment” and had no plans to raise taxes for the next 5 years. To cover government spending, the central bank began printing money in record amounts, ignoring the International Monetary Fund’s (IMF) recommendation to stop printing money and instead raise interest rates and taxes while cutting spending. The IMF warned that continuing to print money would lead to economic implosion. Former Finance Minister Mangala Samaraweera also opposed the tax cuts, noting that since the Sri Lankan government already had much lower tax revenues compared to most countries, combined with high debt, tax cuts would be dangerous. Samaraweera predicted that “If these proposals are implemented like this, not only will the whole country go bankrupt, but the whole country will become another Venezuela or another Greece.” On 6 April 2022, CBSL reportedly printed 119.08 billion rupees, the highest ever. reported amount printed in one CBSL day for 2022. Total money added to financial markets for 2022 rose to Rs. 432.76 billion.

Foreign Debt –

Sri Lanka’s foreign debt has increased substantially from USD 11.3 billion in 2005 to $56.3 billion in 2020. While external debt was about 42% of GDP in 2019, it rose to 119% of its GDP in 2021. By the end of 2022, the country is due to pay US$4 billion to borrowers, while government reserves stood at US$2.3 billion in April 2022. Various economists blame the previous presidential administration of Mahinda Rajapaksa for the debt crisis when he led Sri Lanka into the Chinese “debt trap”. Much of this was borrowed for large-scale infrastructure projects that proved unprofitable and were seen as white elephants, such as the Hambantota port.

In September 2021, the government declared an “economic emergency” as the situation was further aggravated by the falling exchange rate of the national currency, rising inflation due to high food prices, and pandemic restrictions on tourism, which further reduced the country’s revenue. This brought Sri Lanka to the brink of bankruptcy due to a drop in foreign exchange reserves to US$1.9 billion in March 2022, insufficient to pay US$4 billion in foreign debt obligations and US$1 billion International Sovereign Bond (ISB) payments for 2022. On 12 April 2022, Sri Lanka announced that it would default on its $51 billion foreign debt.

Tourism –

The country’s tourism sector accounted for more than one-tenth of Sri Lanka’s GDP. The sector was negatively affected by the Easter bombings in 2019 and the COVID-19 pandemic prevented recovery. Tourism earned Sri Lanka $4.4 billion and contributed 5.6% to GDP in 2018, but this will drop to just 0.8% in 2020. According to the World Bank in April 2021: the lives of its people, the economy will recover in 2021, although problems remain.”

Agricultural failure –

Sri Lanka has been self-sufficient in rice production with imports limited to specialty rice such as Basmati. In April 2021, President Gotabaya Rajapaksa announced that Sri Lanka would only allow organic farming and ban inorganic and agrochemical fertilizers. The decline in tea production due to the fertilizer ban alone led to economic losses of approximately $425 million and caused a 20% drop in rice production in the first six months alone, reversing previously achieved self-sufficiency in rice production and forcing the country to import $450 million worth of rice . The situation in the tea industry was described as critical, with farming under the organic scheme described as ten times more expensive and producing half the yield of farmers. The ban on the trade in chemical fertilizers and pesticides caused a severe economic crisis for the population. The ban on the trade in chemical fertilizers and pesticides has caused a severe economic crisis as the population expects to be left without income and without food. In November 2021, Sri Lanka abandoned its plan to become the world’s first organic farming country after rising food prices and weeks of protests against the plan. The government has lifted some measures, but the import of urea remains prohibited. Sri Lanka is seeking to introduce a peacetime rationing system of essential commodities.

On 29 May 2022, the government declared that the Yala growing season would fail with a forecast of 50% of the maximum harvest, and that the government could not provide fertilizer to save the season, while the country’s rice stocks would only last until September.

Russia-Ukraine War –

The effects of the ongoing tension between Ukraine and Russia due to the Putin-Zelensky war are being felt in Sri Lanka’s already stagnant economic conditions. Russia’s invasion of Ukraine on 24 February 2022 further exacerbated the country’s economic woes, as Russia is Sri Lanka’s second largest market for tea exports and Sri Lanka’s tourism sector is heavily dependent on these two countries for the majority of tourists arriving. from Russia and Ukraine. As a result, the Ukraine crisis halted Sri Lanka’s economic recovery and hit the tea and tourism industries hard.

IMPACT: –

Sri Lanka’s then new Prime Minister & current President Ranil Wickremesinghe has admitted that their economy has completely collapsed and the country does not have enough dollars to buy oil, food, life-saving drugs and other basic commodities from foreign countries.

Major Reasons –

1. Emigration – a record number of Sri Lankans applied for passports in 2022 until now and many are said to be waiting to create a passport to move abroad to avoid the worsening economic crisis. In-fact, ousted president Gotabaya himself was a dual citizen holding US Green Card along with Sri Lankan citizenship and he fled the country during protests and got settled in US along with his wife.
2. Inflation – For months Sri Lanka lacked foreign currency to buy everything it needed from abroad. Food and fuel shortages caused prices to soar. Inflation is now skyrocketing to 30%. The year-on-year increase in food inflation was 24.7%, while non-food items saw an increase of 11%. The government has given Friday holiday to encourage her. workers to grow crops on Friday and take care to avert an impending food crisis.
3. Shortages of electricity and fuel – Govt. asked people to refrain from non-essential travel and imposed restrictions on electricity supplies. On June 20, 2022, the government banned offline courses and entered the government. employees can work from home with the exception of healthcare only to save fuel used by students and employees traveling to their destination. government. announced that it would implement a fuel rationing system from July as fuel stocks continued to decline and the dollar crisis prevented them from buying more oil.  Education – Final examinations in schools, colleges and universities have been postponed indefinitely due to severe shortage of paper and the country is currently unable to import paper due to negligible foreign exchange reserves.

4. Exports – Due to the prevailing economic crisis in Sri Lanka, leading textile brands including Zara, Mango and H&M have diverted their attention from Sri Lanka to India to place their orders. Following the deteriorating economic and political conditions in Sri Lanka, India has also witnessed a surge in overseas orders for tea and other products.
5. 5.Sports and Broadcasting – The telecast of IPL 2022 in the island was stopped midway due to the inability of the Sri Lanka Cricket Board to make payments to host broadcaster Star Sports India. The sharp decline in dollar reserves has also limited the livelihood of Sri Lankan athletes and many national sports associations have been unable to send their teams to international sporting events.
6. Overseas Diplomatic Missions – The Sri Lankan High Commission in Nigeria, Consulates in Germany and Cyprus were temporarily closed in January 2022 due to lack of foreign reserves. In March 2022, the Sri Lankan embassy in Iraq, the Sri Lankan embassy in Norway and the consulate in Australia were also closed due to a lack of dollar reserves.

Situations regarding India –

India’s economic situation is also not satisfactory as the debt to GDP ratio has risen to 89.6% (April 2021) and inflation is at record high levels, the Indian rupee has hit a new low against the dollar and the prices of basic commodities and fuel products saw a threefold increase compared to the years before the pandemic. India’s forex reserves are consistently above $500 billion, which is a good indicator of the overall health of the economy and is good for the country’s financial stability. India was projected to grow fastest in F.Y. 22-23 by the World Bank and the IMF and it managed to do so.

Situation of our Neighbours –

1. Pakistan – It is also on the same path as Sri Lanka and is facing a rapid depletion of Forex reserves along with record inflation and rising cost of living in the country at present. Persistent political instability since its inception is the main reason for Pakistan’s fragile economy and declining financial situation today. The current government of Pakistan led by Prime Minister Shehbaz Shareef has taken immediate measures but these are proving futile as the country’s economic crisis is deepening day by day. But as they say “better late than never”, the current coalition government has taken some strict measures since taking power after the Imran Khan-led government. lost a vote of confidence in the National Assembly in mid-April 2022. Shehbaz Govt. in early May, he banned the import of 38 luxury items to preserve a rare forex cat, then hiked petrol and diesel prices by PKR 60/litre within a week to avoid a Sri Lanka-like situation and pump up depleting government revenues. government. he later removed all subsidies on petroleum products and electricity as ordered by the IMF to secure an IMF package to stabilize the country’s ongoing economic crisis. Announcing the decisions, Finance Minister Miftah Ismail said that we are not in a position to make further concessions and continue subsidies because the country will be in financial distress if quick decisions are not taken and “we have to protect Pakistan from becoming the next Sri Lanka”. Strict measures are to be put in place and people are asked to cooperate as the nation is going through some tough economic phase. A Forex amount is left in the country, which allows a maximum of only 3 months of imports. government. According to the federal government, Pakistan depends only on oil revenue, import and export duties, electricity tariffs and agricultural taxes on bulk sales of cereals. it lacks revenue from spirits because the consumption of spirits is haram (forbidden) in Islam and the country is officially a Sunni Islamic Republic.
2. Nepal – The Himalayan nation is also facing a serious economic crisis as its Forex reserves are rapidly drying up, remittances are falling and inflation is skyrocketing along with an unprecedentedly higher cost of living. Because of some of these economic difficulties, many people in Nepal are concerned whether Nepal is heading in the same direction as Sri Lanka, where the symptoms of the pre-economic crisis were as evident as the one prevailing in Nepal today. The country is in dire need of foreign exchange to pay its debt obligations, the current level of foreign exchange reserves which cannot sustain imports for more than almost six months is a matter of serious concern.

CONCLUSION: –

The crisis in Sri Lanka is a living testimony that excessive freedoms, concessions and subsidies are a serious threat to the economic stability of countries. Governments need to work on structural reforms to raise revenue and curb investment spending, as well as stem soaring debt-to-GDP ratios. Unnecessary imports should be minimized as a priority and dependence on fossil fuels should be gradually reduced and political decisions should not be taken hastily and the main emphasis should be on achieving self-sufficiency in food and fuel.

Sources –

Wikipedia’s “2019-present Sri Lanka crisis”, available at https://en.wikipedia.org/wiki/2019%E2%80%93present_Sri_Lan kan_economic_crisis (Last visited on 9^th June, 2024).

Ayeshea Perera “Sri Lanka: Why is the country in an economic crisis?”, BBC web, May 20^th, 2022. Available at https://www.bbc.com/news/world-61028138 (Last visited on 16^th June 2024).

Hari Bansh Jha “Nepal’s economic crisis: Is Nepal the next Sri Lanka?”, ORF web Available at https://www.orfonline.org/expert–speak/nepals-economic-crisis/ (Last Visited on 23^rd June, 2024)

Special Reference – The Indian Express.