Sri Lanka is currently facing its worst economic crisis in decades in the form of a combined balance of payment and sovereign debt crisis. The Mahinda Rajapaksa government is finding it difficult to pay for essential imports after a 70% drop in foreign exchange reserves over two years which triggered a currency devaluation. Prices of food and essential goods have increased tremendously, fuel is in short supply and protests have broken out. With a population of 2.19 crore, Sri Lanka has announced its decision to default on its foreign debt of $51 billion as of April 12. As per the data, Sri Lanka's primary creditors include China and the Asian Development Bank (ADB). 36.4% of Sri Lanka's debt is in international sovereign bonds, with ADB accounting for 14.6%, Japan 10.9% and China 10.8%. India has already extended a $1 billion line of credit to help Sri Lanka buy fuel, food and medicine but some analysts warned that this assistance might prolong the crisis rather than solve it. Sri Lanka is now seeking financial help from the IMF and Sri Lanka finance minister Basil Rajapaksa will also meet with World Bank officials next month to seek support from the United States-headquartered agency.

What really happened to the Sri Lankan economy? 

The crisis in Sri Lanka is broadly seen as a result of mismanagement of government finances and ill-timed tax cuts, in addition to the impact of the COVID-19 pandemic. Post-independence in 1948, Sri Lanka's agriculture was dominated by export-oriented crops such as tea, coffee, rubber and spices. But a decline in exports put foreign exchange reserves under strain. Therefore, from 1965 onwards, Sri Lanka obtained 16 loans from the IMF. To make matters worse in April 2021, the government banned the import of fertilizer which affected the production of tea and rubber. Though in November 2021 the ban was lifted, the earnings from agriculture had declined significantly. 

A gloomy situation turned worse with two economic shocks in 2019. First, there was a series of bomb blasts in churches and hotels in Colombo in April 2019. This led to an 80% decline in tourist arrivals. At the same time, the world was struck by an unprecedented pandemic. Being a tourism dependent country, its situation got worse due to the pandemic. According to the IMF recent report, COVID-19 has severely hit the Sri Lankan economy. The annual GDP growth rate of 2.3% in 2019 declined to -3.6% in 2020.  

Second, the Rajapaksa government introduced populist tax cuts prior to the pandemic, limiting the government’s revenue options from corporate tax revenue. Value added tax rates were cut from 15% to 8%, whereas the government reduced the corporate tax rates from 28% to 24%. Foreign remittances from Sri Lankan workers abroad were drying up already. With a weak revenue base, the adverse impact of COVID-19 and the announced relief spending measures led to higher government expenditure which made fiscal deficits to be larger than 10% of GDP in 2020 and 2021, while the economy witnessed a rapid expansion in public debt to 119% of GDP in 2021, i.e., it has borrowed more money than it can produce via goods and services. 

In 2020, Sri Lanka lost its access to international capital markets, leading to a decline of international reserves to critically low levels and large-scale direct lending to the government by the Central Bank of Sri Lanka (CBSL). A widening current account deficit and huge external debt repayments led to foreign exchange (FX) shortages, while the official exchange rate remained de facto fixed since April 2021. All these impacted imports of fuel and other essential goods which sent prices soaring. The war in Ukraine hasn't helped either; the cost of fuel surged by 40% within a week.

Lives of people in Sri Lanka

For Sri Lankans, the crisis has turned their daily lives into an endless cycle of waiting in queues for essential goods, many of which are being rationed. Soldiers are stationed at gas stations to calm customers, who line up for hours in the searing heat to fill their tanks. Life of Sri Lankans is made more difficult by frequent power cuts that plunge Colombo into darkness, sometimes for more than 10 hours at a time. Shops have been forced to shut just because they can't run fridges, air conditioners, or fans. Hospitals have refused to do any surgeries because of shortage of medical supplies. People have to wait for hours for propane gas to cook food for their families. The situation in Sri Lanka is so bad that people have now started to flee out of the country. According to experts, bad macroeconomic policy management further accentuated the economic crisis making the common citizenry suffer. Public frustration and anger erupted on April 1, when thousands of people came out on the streets to protest the crippling power cuts and shortages of essential commodities caused by the country’s economic meltdown. Consequently, Sri Lanka’s President Gotabaya Rajapaksa declared an Emergency on April 1.

What should Sri Lanka do now ?

According to some experts, Sri Lanka should establish a three-year repayment structure. They believe that doing so would reduce the burden on citizens of Sri Lanka. As per the Verité Research Executive Director and Economist Dr Nishan de Mel, "Sri Lanka is unreasonably committed to repaying its debt. It is more important to press pause on debt repayment and take care of critical economic needs”. The Lankan economy would need a robust path towards revenue based fiscal consolidation. Reforms must focus on strengthening value added taxes, income and corporate taxes, through gradual rate increases and base broadening measures. In order to reduce fiscal risks from loss-making public enterprises, fiscal adjustment would need to be accompanied by energy pricing reforms.  Short-term monetary contractionary policy is needed to reduce the inflation. As the IMF report suggests institution building reforms, such as revamping the fiscal rule, would also help ensure the credibility of the strategy.  

Other longer-term reforms include establishing a flexible exchange rate policy and a medium-to-long-term debt reduction strategy, while ensuring that most of government spending is in targeted social areas for developmental objectives such as in areas of healthcare, education and social security goals.