Explained: Sri Lanka's Foreign Exchange And Economic Crisis

Currently, Sri Lanka is facing is huge shortage of necessities, a paucity of fuel and import restrictions.

Sri Lanka's attempt to recover from its ongoing economic hardships - its worst in decades - has seen the country take some extraordinary steps.

Rising financing costs for importing paper has lead to exams being cancelled and several newspapers expressing their inability to keep circulating physical copies of their paper. The Sri Lankan government in late 2021 indicated that it would be shutting down three of its missions abroad due to its inability to finance them.

The country, early in March, also put restrictions on the import of nearly 350 "non-essential items" that the country considered to be luxuries - like exotic fruits, whisky, kitchen appliances - with items like chocolates, cheese and pasta not being allowed too unless the government grants an exemption. The move came two days after it devalued the Sri Lankan rupee by 15%, thus making it more attractive for remittances and exporters.

But despite these steps, the island country is in deep economic trouble. Sri Lanka currently lacks adequate foreign exchange reserves to finance imports; including daily necessities like fuel. This has led to reported war-like rationing of fuel, and long queues at petrol bunks, with deaths being reported due to them. It also has a shortage of essentials like milk powder, sugar, wheat and medicines.

Data from the Central Bank of Sri Lanka shows that the country had $2.31 billion worth of reserves at the end of February, which could sustain the country's forex obligations for a month.

Second, Sri Lanka also faces tall debt repayments this year, and the lack of foreign exchange reserves does not help. Sri Lanka has $12.55 billion worth of outstanding debt, of which $1 billion of bonds mature in July. Should Sri Lanka be unable to repay them, it would be a sovereign default. Though its central bank has indicated that it is committed to meeting these obligation and denying that the country is on the verge of default, those studying the fiscal crisis do not look so convinced. A Citi research report indicates that Sri Lanka would have to restructure its debt by July.

The International Monetary Fund (IMF) too has raised red flags about Sri Lanka's debt. "In (the IMF) staff's view, Sri Lanka's public debt is unsustainable", the IMF has said on its Article IV consultation report released on March 25 this year. This report is an annual publication released by the IMF for its member countries and is a part of its economic surveillance. For 2021, the report says that Sri Lanka's public debt - or that of its government - is at 119% of its economy. In total, the IMF sees $7 billion of foreign exchange debt servicing obligations this year.

Lastly, Sri Lankans are feeling the pinch for ordinary goods and services. Headline inflation - raw inflation numbers for a basket of goods and services - has been in double digits since last November in Sri Lanka. Data from the Central Bank of Sri Lanka shows that the country saw 11.10%, 14%, 16.8% and 17.5% inflation in November 2021, December 2021, January 2022 and February 2022 respectively as compared to the the corresponding months in the last calendar year. February's inflation was highest in country since 2015.

Together, these issues have caused the people to take to the streets, lashing out against the government along with protests and unrest.

What caused these issues?

The IMF's Article IV report states that these issues are not of recent making, but have certainly been made worse due to the pandemic. Here's what the problems can be traced to.

1. The Easter bombings

The Easter bombings by Islamic extremists took place in Sri Lanka in April 2019, leading to the death of 269 people.

The events targeting three churches took a huge toll on the inflow of tourism to the country, one of its largest generators of foreign exchange revenue. This left the country vulnerable to external shocks, leaving it with high levels of debt and one of the highest gross financing needs (need for external debt) among emerging economies.

2. A tax cut

The government, led by incumbent President Rajapaksa, promised a new people-centric policy, tax cuts and a reduced cost of living. In this context, value-added tax and income tax were cut in 2019. But the cut was largely believed to be ill-advised, as it was aimed at promoting growth and employment but it ended up hitting governmental revenues, putting it on an even weaker foot right before the pandemic.

The IMF puts an estimate to the loss of tax at 2% of GDP.

3. A sudden shift to organic farming

In April 2021, the government suddenly banned the use of chemical fertilizers and promoted widespread organic farming, President Rajapaksa cited health concerns as well as the country's reducing monetary reserves.

However, farmers were not prepared for such a sudden shock. Though the ban was partially lifted last November, it did not augur well for farmers, who reported only a fraction of output compared to what they were getting using chemical fertilisers.

This also took a toll on the country's economic output. The IMF cites this ban as one of the factors that will drag down Sri Lanka's economic recovery in the fourth quarter of 2021, and a driver of higher inflation.

4. The COVID-19 pandemic

Like countries around the globe, Sri Lanka took to government spending in an attempt to stimulate the economic during the pandemic. Steps included cash transfers to the vulnerable, tax exemption on the import of medicines and personal protective equipment, leeway in tax payment deadlines. The IMF estimates, that Sri Lanka's COVID-19 response was worth 0.8% of its GDP in 2020, and 1.2% of its GDP in 2021.

Coupled with the spending excesses in 2019, the Sri Lankan government ran fiscal deficits of 8% of GDP in 2019, 12.8% of GDP in 2020 and 11.4% of GDP in 2021 (projected),

These slippages also caused international rating agencies to downgrade Sri Lanka's credit rating to CCC, and lower (called 'junk' category), as a result of which Sri Lanka lost access to several international capital markets to raise foreign exchange.

The IMF's report can be read here.

Also Read: BOOM FAQ #4: What Is Fiscal Deficit?

Where does Sri Lanka go from here?

For now, Sri Lanka's wealthier benefactors have provided some rescue to it in forms of grants and lines of credit.

China, one of Sri Lanka's largest lenders, is in discussions with the country to provide it with a line of credit of $1.5 billion and a loan worth $1 billion. However, concerns are being raised in Sri Lanka about the true intention behind Chinese debt, as it has been used to fund what is considered to be white elephant projects with little returns. Sri Lanka has also asked China to get its debt restructured.

India has already offered a line of credit to Sri Lanka worth $1 billion through the State Bank of India when Finance Minister Basil Rajapaksa visited India in mid-March. Reuters has reported that Sri Lanka has requested an additional $1.5 billion from India as a line of credit.

As of writing this story, Indian Minister of External Affairs, Subrahmanyam Jaishankar is in Colombo to attend the BIMSTEC Summit happening today.

However, as part of larger rescue plan, Sri Lanka will reportedly be seeking an IMF bailout. Though there is opposition from within the government and central bank against this measure, Basil Rajapaksa will reportedly travel to Washington DC mid-April to present his country's proposal to the IMF. Such bailout typically consists of monetary relief from the IMF in exchange for measurable and observable reforms towards repayment of this debt.

A source told the Economic Times that India is supportive of an IMF resolution for Sri Lanka.

Also Read: Bangladesh Highest Recipient Of Indian Lines Of Credit Since 2016

Updated On: 2022-03-29T15:29:55+05:30
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