How Sri Lanka reached this economic precipice

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The Sri Lankan economy has been facing a crisis for a while now, and the situation worsened in last few days. To contain widespread protest and unrest, and to prevent the situation from further deteriorating, Sri Lankan President Gotabaya Rajapaksa declared emergency on April 1.

How did Sri Lanka reach this economic precipice?

Sri Lanka was under a civil war from 1983-2009 where the economy barely made any progress. In the period from 1970 to 2020, the share of agriculture declined from 28 percent of GDP to 7.7 percent, the share of industry has remained stagnant at 17-19 percent, and the share of services has risen from 54 percent to 73 percent. Within services, share of trade, hotels and transport has comprised 30-35 percent of GDP.

The economy is highly-dependent on imports for essential items such as food, and oil. The economy finances these imports mainly via agricultural exports (tea, rubber, and coconut), industrial products (textiles), and remittances from abroad. The revenues from exports, and remittances have not covered the cost of imports, and Sri Lanka has always been in a current account deficit (CAD). The average CAD in 2010-19 was around 1.2 percent of GDP.

The CAD has been met mainly by the government borrowing from abroad. As the government borrowing from abroad has been larger than the CAD, the balance has been pegged to the foreign exchange reserves. What can one make of an economy where the forex reserves consist of mainly borrowings from abroad!

Apart from a large CAD, the government also ran large fiscal deficits. The average fiscal deficit in 2011-20 has been ~6.2 percent of GDP. The government was financing fiscal deficits through both domestic and foreign sources. As foreign sources dried up, it resorted to borrowing domestically by issuing bonds and taking advances from The Central Bank of Sri Lanka. The government also lowered tax rates to check high tax evasion.

The twin deficit Sri Lankan economy was under enormous pressure in the 2010-19 period, but somehow managed to run the show. The conditions were ripe for an economic wildfire, and all that was needed was a spark.

In 2020, COVID-19 was more than a spark, and completely sucked out the air from the Sri Lankan economy. The pandemic led to a global recession curtailing global demand. Sri Lanka’s exports dipped and imports (mainly goods for survival) went up, and adding to this Sri Lanka’s tourism sector came to a grinding halt. The GDP declined by 3.5 percent, the CAD touched 7.9 percent of GDP, and the fiscal deficit climbed to 11.1 percent.

Before the economy could stabilise, in April 2021 the government decided to stop the use of chemical fertilisers and go 100 percent organic. While the intentions cannot be questions, it’s the timing that matters. At ~2 percent of the import bill, fertilisers is a marginal expense. This shift in an important sector such as agriculture pushed inflation from 5.7 percent in July 2021 to 15 percent in February 2022.

The Sri Lanka official reserves as of end January 2022 was provisionally estimated at $2.4 billion, equivalent to 1.3 months of imports. The country is struggling to import oil, and is facing power cuts for more than 10 hours per day. The central bank is firefighting the crisis by raising policy rates, and has also asked the government to take measures to improve its finances. The Russia-Ukraine war only added to woes as tourists from Russia and Europe could not travel to Sri Lanka.

Sri Lanka’s economic crisis reminds one of India in 1991. The seeds of India’s 1991 economic crisis were sown in the 1980s when we saw a rise in both fiscal deficits and current account deficits. Unlike Sri Lanka today, India followed a highly-restrictive trade policy where forex reserves were scarce due to policy design. By 1989-90, on the eve of the crisis, India’s forex reserves had declined, and were equivalent to just 1.9 months of imports. The economy was precariously placed, and the West Asian oil crisis acted as a shock for the economy.

Thirty-one years later, Sri Lanka is in a similar economic situation. However, there is one key difference: While New Delhi had leaders such as (late) PV Narasimha Rao and Manmohan Singh to rely on, there are none visible so far in Colombo. Public anger is largely towards the Rajapaksas (and rightly so, because seven family members are part of the government, including President, Prime Minister and Finance Minister). In this regard, Sri Lanka’s economic crisis is a lot like the Arab Spring during the beginning of the last decade, where people protested against leaders in the backdrop of an economic crisis.

Sri Lanka’s economic crisis, yet again, draws attention to politics in South Asia. Questions are being raised about Sri Lanka heavily relying on China, and Beijing’s ‘debt trap’ politics (the effects of which are now also being discussed in many African countries). Pakistan, another of India’s neighbours and China’s ‘all-weather friend’, is undergoing a political and economic turmoil.

Amidst all these developments, India stands out as a ray of hope for keeping its economic buoyancy stable despite testing times.

Amol Agrawal is faculty at Ahmedabad University.

Views are personal and do not represent the stand of this publication.