What is happening in Sri Lanka?

Sri Lanka, an island country in the Indian ocean, is currently facing one of the worst economic crises it has ever witnessed. The South Asian nation has defaulted on its foreign debts for the first time since 1948, raising concerns among its people. Its population faces long power cuts; shortages of necessities, such as fuel, medicine and food; and inflation has managed to reach an all-time high 39% (As of May 2022).

As a way of expressing their anger over the country’s economic turmoil and the way the government has been handling it, citizens have been protesting and going on strikes. On the first of April, the country’s president, Gotabaya Rajpaksha, declared a state of emergency, ultimately leading to his resignation in July, as tension in the country kept increasing. Rajpaksha was later replaced by the country’s former prime minister, Ranil Wickremesinghe.

Source: Lawfare

So why Is Sri Lanka in the midst of one of the worst crises it has ever seen?

To understand the reason behind Sri Lanka’s economic turmoil, it is essential to take a glance at its history. After being freed from the hands of European colonisers, Sri Lanka relied heavily on the export of agricultural products, such as tea, spices and rubber. The revenue received from the export of those products accounted for the majority of its foreign exchange and was used to import essential commodities.

As time went on, the country started diversifying its exports by also exporting garments, and remittances (Money sent back to families by Sri Lankans working abroad) and tourism started becoming more important sources of foreign exchange. However, its over-reliance on foreign supply contributed to the susceptibility of the Sri Lankan economy to external shocks.

Because of this, the country has had to deal with a number of balance-of-payments difficulties in the past. Since 1985, it has received 16 loans from the international monetary fund (IMF), all coming with conditions that target greater fiscal discipline, such as reducing food subsidies, maintaining tight monetary policy, and depreciating the Sri Lankan rupee to increase the competitiveness of exports. These conditions made it difficult for the Sri Lankan government to deal with economic downturns, since injecting money into the Sri Lankan economy was not feasible under the IMF’s watch. Consequently, to reverse the effects of recessions, the government resorted (had to continue) to borrowing, which meant more accumulated debt.

The last loan received by Sri Lanka from the IMF was a $1.5 billion sum obtained in 2016, planned to be used over the course of three years (from 2016 to 2019). Ever since then, its economy has been on a continuous decline. In 2019, matters took a turn for the worse when the country recorded a series of bombings in churches and hotels. The incidents led to a reduction in the number of tourists visiting the country, ultimately drying up its foreign exchange reserves.

To prevent any further reduction in the country’s foreign exchange reserves, in April 2021, the Rajapaksa administration made a controversial move, banning the import of fertilisers. The policy had a negative impact on agricultural production in the country. After its implementation, the productivity of tea and rubber started dropping, which culminated into lower export revenue. Because export revenue was falling, importing food became more difficult, eventually leading to the food shortages observable today. Even if the supply of food has been declining, demand has remained more or less unchanged. Since supply is unable to match demand, the food shortages have led to higher food prices. Rising food prices has been a driving factor behind inflation in the country.

Source: World Economic Forum

What’s next for Sri Lanka?

Sri Lanka is now set to receive its 17th loan from the IMF to help reverse the effects of the crisis. The loan, however, will come with certain conditions, and one of those conditions involves implementing a deflationary fiscal policy (the use of government spending and taxation to reduce aggregate demand). Such policy has the potential to push the country into a recession, as aggregate economic activity reduces. Once again, Sri Lankans are at risk of having to pay the price for decisions taken by policymakers.

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About The Author

Neron Sifflore

Neron is an economics undergraduate at the university of Nottingham Malaysia Campus. He is very passionate about the subject and aspires to become the best version of himself. By joining the NES research team, Neron seeks to develop on a personal level and from an academic standpoint.

References

Why Sri Lanka is facing one of its worst economic crises. Available at: What has caused one of Sri Lanka's worst economic crises? | World Economic Forum (weforum.org)

This visual breaks down the economic crisis in Sri Lanka. Available at Sri Lanka's political and economic situation, visualized | World Economic Forum (weforum.org)

How crisis unfolded in Sri Lanka. Available at How crisis unfolded in Sri Lanka | Reuters

Sri Lanka is facing an economic and political crisis. Here's what you need to know. Available at Sri Lanka's economic crisis, explained - CNN

How Has Sri Lanka’s Crisis Impacted Indian Ocean Security? Available at How Has Sri Lanka’s Crisis Impacted Indian Ocean Security? - Lawfare (lawfareblog.com)