Inherited problems that led to Sri Lanka’s economic crisis

The Sri Lankan crisis has been intensified by the pandemic and the war in Ukraine. However, the government’s attention is focussed on its foreign exchange crunch. If the international community does not roll over loans and hike assistance, a sovereign default is likely.

A container vessel being offloaded at the East Container Terminal of the Colombo port on June 2, 2021. In 2021, the Gotabaya Rajapaksa government cancelled a tripartite agreement that the Maithripala Sirisena government signed with India and Japan in 2019 for the development of this container terminal and handed the contract to the Chinese government’s China Harbour Engineering Company.

Sri Lanka’s economy is sliding into chaos, afflicted with multiple crises: a steep fall in foreign exchange revenues because of the COVID pandemic, a difficult-to-manage external debt servicing burden, a collapse in the volume of foreign exchange reserves and, finally, the ripple effects of the war in Ukraine. Between January 2020 and mid March 2022, foreign exchange reserves fell by as much as 70 per cent to around $2.4 billion. A collateral trend that compounds the crisis has been a sharp depreciation of the Sri Lankan rupee. The Central Bank of Sri Lanka (CBSL) had been avoiding a devaluation by keeping the official exchange rate at 200 rupees to the dollar for months, but at the end of the first week of March, it gave in and devalued the currency by 15 per cent. Even that level was unsustainable, and the rupee was soon allowed to float, setting off a fall to the 300 rupees to the dollar mark by end March.

Underlying the crisis was a set of accumulated weaknesses that were intensified by the pandemic, which adversely affected tourism earnings and revenues from exports. As compared with earnings from tourism of $4.4 billion in 2018 and $3.6 billion in 2019, receipts fell to just $682 million in 2020 and $534 million in 2021, according to figures from the CBSL. Export revenues fell from $11.9 billion in 2019 to $10 billion in 2021 and rose to just $12.5 billion in 2021.

The resulting foreign exchange earnings crunch has hit Sri Lanka particularly hard because of its large external debt of around $35 billion. Much of this is a historical legacy. Under the previous Mahinda Rajapaksa government, between 2004 and 2015, Sri Lanka borrowed externally to the tune of $14.06 billion. Its debt service payments in 2022 are estimated at $6.9 billion.

Combined with the fall in foreign exchange earnings, these large outflows on account of interest and amortisation payments on accumulated foreign debt have eaten into foreign reserves, which fell to $2.8 billion at the end of July 2021. That figure was shored up for a short while with receipts of $780 million from the International Monetary Fund’s (IMF) special SDR (special drawing rights) allocation, first disbursals from a currency swap arrangement between the Sri Lankan and Bangladeshi central banks, and rounds of support from China and India. It did not help that the final tranche of a standby line of credit under the IMF’s Extended Fund Facility negotiated in June 2016 was held back because of reported delays in completion of a review of performance. Because of these factors, Sri Lanka has been severely short of foreign exchange and its rupee has been depreciating significantly. It began 2022 with just $1.6 billion in the kitty.

In response, for some time now, the government, not wanting to be seen as defaulting on external debt payments, has been curtailing imports. It announced a wide-ranging import clampdown in 2020 to reduce foreign exchange outflow, affecting goods ranging from motor cars to fertilizers, sugar and turmeric. Particularly contentious was the Gotabaya Rajapaksa government’s decision to ban imports of chemical fertilizers and pesticides, justified as reflecting a commitment to organic farming but really influenced by the foreign exchange shortage. Although subsequently rescinded, the import ban is expected to reduce domestic production of paddy and tea in the coming months.

For a country dependent on imports for a range of manufactured capital and consumption goods, the clampdown resulted in limited supplies of imported fuel and long queues of harried motorists at gas stations; power outages; hospitals running out of stocks of critical drugs; shortages of milk, food and cooking gas; suspension of examinations at educational institutions because of non-availability of paper to print question papers; and newspapers dropping print editions because of lack of newsprint. The fall in agricultural production following the ban on chemical fertilizer and pesticide imports has only increased dependence on imported supplies. Shortages have hit the poor and middle classes badly, and political observers argue that the country could experience food riots.

These outcomes feed into each other and aggravate the situation. A falling rupee has increased the costs of imports and worsened inflation. The depreciating currency has also worsened the foreign reserves position because exporters are holding back on repatriating proceeds and Sri Lankan workers abroad are avoiding official channels for remitting funds back home to benefit from the much better “black market” conversion rates they get when using informal circuits. Thus far, the government has privileged repaying foreign lenders over diverting foreign exchange to finance imports that would alleviate shortages. In January 2022, when the CBSL announced that it was allocating $500 billion for a debt repayment instalment, some of the country’s leading economists urged the bank to default and divert that foreign exchange to access crucial imports.

With agriculture production falling and cultivation turning non-viable, industrial units operating at less than full capacity because of lack of demand and/or restricted access to crucial inputs, and tourist arrivals being low for two years now, the economic crisis is deep. In addition, the imported inflation resulting from rising fuel prices and a steeply depreciating currency are pushing up input costs that cannot be matched with increases in the prices of goods and services produced with those inputs. Finally, to the extent that firms have foreign exchange liabilities to service, the local currency costs of that commitment would be soaring. These trends can trigger a wave of bankruptcies. All these troubles had already afflicted Sri Lanka before the Ukraine invasion, which has made matters much worse, especially because Russia and Ukraine are important trade partners and sources of tourist arrivals. Meanwhile the government muddles through, keeping the economy afloat with aid and credit from neighbours, especially China and India, and is now wooing the IMF, which it had shunned because of the conditions it imposes on borrowers.

Between two neighbours

Sri Lanka has been successful in the past playing the two neighbours against each other to maximise the bilateral support it receives. However, until recently Sri Lanka had leaned more on China than India, benefiting from projects under the Belt and Road Initiative and obtaining large bilateral foreign exchange swap arrangements with the Chinese central bank. In return, Sri Lanka had favoured China, with the Rajapaksa government cancelling in 2021 a tripartite agreement that the Maithripala Sirisena government signed with India and Japan in 2019 for the development of Colombo port’s East Container Terminal and handing the contract to the Chinese government’s China Harbour Engineering Company. This and other acts of the Sri Lanka government have upset India in the past, and the gesture of providing India’s Adani a second port terminal near the original one has not smoothed ruffled feathers. Sri Lanka has also not shown much enthusiasm regarding a host of projects India was to initiate in the country on the basis of a memorandum of understanding former Prime Minister Ranil Wickremesinghe signed with the previous Narendra Modi government in 2017 during a visit to New Delhi.

But matters seem to have changed recently, with signs of some tension between Beijing and Colombo. One factor that played a role was the Sri Lankan government’s decision to cancel an order for organic fertilizers placed on China’s Qingdao Seawin Biotech Co. Ltd after a consignment of 20,000 tonnes had reached Sri Lanka. Alleging that the consignment was carrying the Erwinia bacteria that can destroy crops, Sri Lanka refused to permit offloading of the consignment and make payments against the order. Sensing an opportunity, India stepped in and provided emergency supplies of nano nitrogen to partially meet the demands of Sri Lankan farmers.

Sri Lanka has also decided to suspend the development of hybrid energy systems in three northern islands by Sino Solar Hybrid Technology because of security objections raised by India regarding Chinese involvement in projects that are extremely close to its coastline. China has made it clear that the projects were dropped because of third-party intervention. India is now supporting substitute projects.

It is not clear, however, how much further support China and India would between them provide to reduce domestic shortages and dampen inflation and shore up Sri Lanka’s foreign exchange reserves until dollar earnings revive. If that support is inadequate, the only other option is the IMF. The Rajapaksa government was wary of being subject to the IMF’s conditionalities again but is now open to a discussion. If a deal is struck, the IMF is likely to demand strong measures that will intensify the pain.

The problem is that the Sri Lankan government is not able to mitigate the effects of the crisis because its own fiscal position is strained. Even while burdened with legacy and newly accumulated public debt, the current Rajapaksa government decided in December 2019 to slash the value added tax (VAT) rate to 8 per cent from 15 per cent as well as offer other tax concessions such as abolition of the 2 per cent nation building tax on domestic goods and services, the withholding tax and the capital gains tax on stock market gains. This tax bonanza is estimated to result in a loss of revenue equivalent to 4 per cent of the gross domestic product annually. This has aggravated the post-COVID collapse in revenues, and efforts to correct the error with a surcharge on the super-rich and a couple of other adjustments in the Budget for 2022 were too little too late.

However, the foreign exchange crunch is the focus of the Sri Lankan government’s attention. If competing neighbours, China and India, and the rest of the international community do not roll over loans and hike assistance, a sovereign default is likely.