Sri Lanka on the verge of bankruptcy after the worst economic crisis in its history

The city of Colombo is famous for its pristine beaches, clean streets, heritage buildings, delicious cuisine and enthusiastic locals. Leaving behind bitter memories of the decades-long civil war that ended in 2009 and the 2019 Easter bombings, the Sri Lankan capital and the rest of the country are gradually returning to normal. Yet all the progress the country has made on this journey seems to be going up in smoke as it faces a severe economic crisis, leaving it on the brink of bankruptcy.

After taking office as president, Gotabaya imposed import controls and implemented a misguided tax cut that devastated the already fragile economy.

Sri Lanka is devastated by the collapse of its tourism industry, which contributes almost 10% of GDP and is a major source of foreign exchange.

The Gotabaya government still does not know how to resolve the crisis. He could not agree on a roadmap for recovery even after two cabinet meetings on the subject.

Things have gotten worse since January, with food and fuel prices spiraling out of control, and now crippling shortages. With its foreign exchange reserves nearly depleted, the island nation of 2.2 million people is unable to import even basic necessities like rice, milk and kerosene.

President Gotabaya Rajapaksa, hailed as a “Terminator” by his supporters for ending the civil war, said his country would work with the International Monetary Fund (IMF) to tackle the crisis. He blamed the slowdown on previous governments. “When those who contributed to the crisis criticize the government, I try to solve it and relieve the people,” Gotabaya said.

But the president’s explanation was not well received by the people. Anger, frustration and desperation to grab available food and fuel are rampant on the streets of Colombo. Armed forces have been deployed to oversee the distribution of fuel in many places.

The incumbent government led by Gotabaya and his older brother, Prime Minister Mahinda Rajapaksa, made a series of policy mistakes that deepened the crisis, which had been brewing for some time. “The origins of the crisis can be traced back to trade liberalization in 1977,” said K. Don Vimanga, a policy analyst at the Advocata Institute, a think tank in Colombo. “The major problem is macroeconomic instability, tax cuts and large budget deficits financed by printing more money. Subsequent debt downgrades forced Sri Lanka out of capital markets. The country could not refinance maturing debts or finance the rapidly growing current account deficit due to fiscal expansion. They then tried to fix the exchange rate and control imports, which led to the shortages.”

After taking office as president, Gotabaya imposed import controls and implemented a misguided tax cut that devastated the already fragile economy. He banned the import of luxury vehicles, chemical fertilizers and spices like turmeric to prevent the outflow of foreign currency. The motor vehicle import ban came into force in March 2020. Prior to the ban, Sri Lanka spent around $400 million a year on fertilizer imports. Vehicle imports were worth $1.5 billion.

The government believed the ban would protect foreign exchange reserves, encourage domestic production and even boost exports. But the ban did not achieve these goals and only led to a further depletion of foreign exchange reserves. The situation became so serious in mid-January that Sri Lanka had to sell its gold reserves and use its currency swap agreements with India and China to redeem an international sovereign bond (ISB) of 500 million dollars that needed to be settled.

For a country like Sri Lanka, which has traditionally relied on large-scale imports for most essential supplies, the sudden policy reversal has brought unprecedented problems. It has crippled the manufacturing industries sector, especially clothing. The Sri Lankan clothing industry even imports buttons. “When imports are stopped, how can we ensure the quality of exports? Sri Lanka depends on imports of raw materials,” said Kopalapillai Amirthalingam, professor of economics at the University of Colombo.

Sri Lanka had already lost much of its crucial tourism revenue to the pandemic, and the import ban and tax cuts have further hurt revenue flow. Since 2020, inflation has increased, foreign exchange reserves have fallen by 70% and the outright ban on chemical fertilizers has crippled the agricultural industry. The short-sighted monetary policy of the Central Bank of Sri Lanka and the capping of interest rates on bonds aggravated the crisis.

Experts also point to a lack of discipline in the handling of imports. In 2021, Sri Lanka spent $6 billion importing non-essential items like cheese, butter, vegetables, fruits, ice cream, chocolates and sauces. Mobile phone imports cost $386 million. “The main challenge facing the country is the dollar crisis. When we earn $100, we have to pay off $115 in debt,” Environment Minister Mahinda Amaraweera told a news conference. “Our dollar receipts are not even enough to pay off our debts.”

With a $6 billion trade deficit and massive debt stemming from foreign loans, sovereign bonds and large-scale infrastructure projects, repayment is a major challenge. “We have been spending beyond our means for years,” said Ahilan Kadirgamar, a political economist and senior lecturer at Jaffna University.

The fertilizer ban also turned out to be a fiasco. When Gotabaya announced the decision to transform the country’s agricultural sector into an all-organic sector, he hoped to save import costs and also protect the environment. But agricultural experts and economists had warned of food shortages. “The ban led to a reduction in yield, which fell by 25%,” said Saman Dharmakeerthi, professor of soil fertility and plant nutrition at the University of Peradeniya in Kandy.

Rice cultivation has declined significantly in the northern and eastern provinces. Tea cultivation, which is one of the mainstays of the economy, has also been hit hard. The production of pepper, cinnamon and vegetables fell by 30%. “Organic farming, being low yield, is land intensive. Crops can be resilient, but they cannot support a growing population when cultivable land is shrinking,” Dharmakeerthi said.

When the government realized its folly and lifted the ban, the agricultural industry had lost almost 50% of its production capacity. Thus, the government had to rely even more on foreign countries for rice and other staples. Sri Lanka last year signed an agreement with Myanmar to import one lakh tonnes of white rice and 50,000 tonnes of parboiled rice. It also imports rice from India. China, meanwhile, donated a million tons of rice in January.

Gotabaya’s decision to cut taxes has also severely shaken Sri Lanka’s economic prospects. This decision caused income to fall to an all-time low of 9% of GDP. “The fall is one of the main reasons why the government is unable to come to the aid of the people during this devastating crisis. It is difficult to impose indirect taxes on the public, and indeed even taxes. direct income taxes, at a time when the economy is contracting,” Kadirgamar said.

The tax cuts reduced the number of registered taxpayers in the country by 35%, resulting in credit rating downgrades. “With that, the cost of living has gone up,” he said. “Gotabaya’s tax relief package has derailed our financial situation, leading to debt repayment at enormous social cost,” said Patali Champika Ranawaka, MP and leader of the new political movement, the 43rd Brigade.

Inflation rose to 15.1% in February from 14.2% in December, its highest level in 13 years. The government, meanwhile, was forced to withdraw the Special Goods and Services Tax (GST), which was intended to simplify the existing tax structure after the Supreme Court ordered it to hold a referendum and pass the law by parliament with a two-vote vote. majority of third parties.

Sri Lanka is also devastated by the collapse of its tourism industry, which contributes almost 10% of GDP and is a major source of foreign exchange. The pandemic has caused tourism revenues to plummet from $7.5 billion in 2019 to $2.8 billion last year. As the sector returned to normal, the Russian-Ukrainian war was a major setback. A significant share of foreign tourists visiting Sri Lanka come from Russia, Ukraine and Belarus.

The war in Ukraine also poses other challenges. Sri Lanka imports 45% of its wheat, more than half of its soybeans, sunflower oil, peas and asbestos from Russia and Ukraine. “The war has led to a sharp increase in international oil prices. Additionally, Russia and Ukraine are major importers of Sri Lankan tea,” said Colonel R. Hariharan, a retired military intelligence specialist.

“The currency crisis has become an existential threat. An even bigger problem is borrowing. We borrowed to invest in unproductive ways, such as Port of Hambantota and Ceylon Electricity Company,” Amirthalingam said.

The Gotabaya government, meanwhile, still does not know how to resolve the crisis. He could not agree on a roadmap for recovery even after two cabinet meetings on the subject. Sri Lanka has now approached India and China for help. During Finance Minister Basil Rajapaksa’s visit to Delhi on March 17, India offered a $1 billion line of credit to import food, other essentials and medicine. A few days later, China said it was considering a $1 billion loan and a $1.5 billion line of credit.

Colombo has also approached the IMF for help. Still, there aren’t too many optimists in the island nation right now. Kadirgamar said Sri Lanka was unlikely to emerge from the crisis immediately. “The country needs new policies. In the 1970s, we had a strong public distribution system like in India. We also had the cooperative network and the paddy marketing board. There is an urgent need to revive these institutions.

Vimanga said borrowing more money without addressing basic issues would only make things worse. “Implementing economic reforms is the only way out,” he said. “The kind of reforms needed will be very tough and painful, and it is hard to see how acceptable this will be to politicians. With some stabilization, Sri Lanka may be able to return to where the country was in 2019. Debt restructuring could take 18-20 months, while a return to growth will take even longer.