Updated: Jun 23, 2022
The Sri Lankan economy is in a state of dire stress. There is a severe shortage of fuel and food. The forex reserves have depleted by 70%, the inflation has touched an all-time high of 19%, and external debt has skyrocketed. With protests raging across the country, the crisis has taken an ugly turn wherein the newly appointed Prime Minister Ranil Wickremesinghe has said, “We need about $6 billion to keep the country afloat for the next six months.” But how did a country that usually performed exceedingly well on various social indicators suddenly find itself in such a deep crisis?
A Crisis in the Making
The Covid-19 pandemic affected the world economy like no other. Years of growth and development suffered, unemployment skyrocketed, incomes fell, and nations tried their best to prevent an economic fallout. And Sri Lanka was no different. With the pandemic and subsequent lockdowns, Sri Lanka's tourism sector—which contributed 12% to its GDP— plummeted. Yet, one can’t blame the current crisis on the pandemic alone. Even politically, Sri Lanka has been in troubled waters because of plagued fiscal management under President Rajapaksa.
Firstly, after being elected in 2019, he cut the Value Added Tax (VAT) from 15% to 8%. Though tax cuts can boost consumption and renew economic growth, negative externalities can turn the tables around. As a result of the pandemic and the ensuing lockdown, people began saving a large portion of their income to weather the uncertain times. Consequently, the tax reduction, instead of boosting demand and invigorating the economy, deprived the government of much-needed revenue to combat the pandemic.
Secondly, one of the biggest reasons for the present situation was Rajapaksa’s decision to impose a blanket ban on imports of chemical fertilizers and pesticides to promote ‘organic farming’. The argument was that Sri Lanka was spending a vast sum of the foreign exchange on imports of fertilizers, whose market, as he claimed, had turned into an oligopoly. Talking highly of the shift at the UN General assembly, he regarded the move as the twin benefit of promoting domestic fertilizer companies and enhancing the population health as it transitions towards natural farming. However, crop yields of cinnamon, pepper, tea, cloves, and cardamom, all of which Sri Lanka exports, have dropped by 50%, causing severe food inflation of 57.4% in the country.
The Debt Burden
One can ask why not use foreign exchange reserves to import food and ease the situation? Ever since the end of the civil war, Sri Lanka wanted to catch up to its developing neighbours and pave the way for modernization. Due to limited natural resources, the country borrowed large sums of money from China to improve its infrastructure. Unfortunately, due to fiscal mismanagement and poor monetary Sri Lanka was unable to pay back and had to default on many of its loans. So, with mounting debt, the foreign exchange reserves depleted drastically. And when it needed it most, as in the case of the food inflation, Sri Lanka simply had very little forex reserves. To override the economic problem, Sri Lanka resorted to deficit financing by printing excess currency to pay off its loans. The printing flurry, though, devalued the Sri Lankan rupee leading to dizzying heights of inflation in a beleaguered economy that still owes more than $3 billion. Ever since, the scenario has exacerbated, with debt totalling 111% of GDP and currency reserves remaining at a pitiful $1.6 billion.
Geopolitics of China and India
To combat the present crisis, Sri Lanka has sought assistance from its neighbours like India and China and the International Monetary Fund (IMF). Geopolitics comes into the picture here. Since the end of the war, Indo-Sri Lankan ties have eroded considerably. New Delhi is displeased by Sri Lanka's growing reliance on China and the lease out of strategically significant ports such as the Hambantota and Colombo ports. The proximity of these ports raises serious security issues for India. Furthermore, Rajapaksa's veiled jab at the QUAD Agreement is interpreted as Sri Lanka's intention to dismiss New Delhi's reservations and openly embrace Beijing.
Using the present crisis as an opportunity to mend relations, the Indian government tried to intervene and restrict China's rapidly expanding influence in Sri Lanka. One such move was the $400 million currency swap and deferral of loan payment announced in January 2022. Since then, India has extended a $500 million credit line for the purchase of fuel and another credit line worth $1 billion was signed between the countries. The Indian Oil Corporation (IOC) additionally announced the release of 6000 MT of gasoline to assist the island state in alleviating ongoing power outages. Moreover, India constructed a strategically positioned Trincomalee oil tank which provides some traction in Sri Lanka and is a clear stand against growing Chinese investment.
The Road Ahead
As the scene continues to worsen, Sri Lanka faces an unprecedented crisis. As stated by their PM Wickremesinghe, the citizens must brace themselves for the ‘most difficult months’ of their lives. County Lanka must realize that Chinese ventures are a classic example of the infamous debt-trap policy that ought to be handled with caution. Despite the assistance, and perhaps, even an IMF bailout, the scenario seems bleak for the island country.
(Written by Sashank Rajaram and Edited by Prakhar Singhania)