Buzz Update What is happening in Sri Lanka and how did the financial crisis start? TOU

Buzz Update What is happening in Sri Lanka and how did the financial crisis start?

 TOU

What is happening in Sri Lanka and how did the financial crisis start?


The island nation of Sri Lanka is facing one of the worst economic crises ever seen. It defaulted on its foreign debt for the first time since independence and 22 million people in the country are facing 12-hour power cuts and severe shortages of other important commodities such as food, fuel and medicine.

Inflation peaked at 17.5 per cent, with prices of food items such as rice per kilogram generally rising by Rs 80 (A $ 0.34) to Rs 500 (A $ 2.10). Among the shortages, a 400g milk powder packet costs 250 rupees (A $ 1.05), which is usually around 60 rupees (A $ 0.25).

On April 1, President Gotabhaya Rajapaksa declared a state of emergency. Within a week, he withdrew from the crisis after massive protests by angry citizens over the government’s handling of the crisis.

The country relies on imports of many essential commodities, including petrol, food and medicine. Most countries hold foreign currencies in their hands to trade for these goods, but the shortage of foreign exchange in Sri Lanka has led to skyrocketing prices.

Why do some blame China?

Many believe that Sri Lanka’s economic ties with China are the main cause of the crisis. The United States calls this phenomenon “debt-trap diplomacy.” The lender extends the loan to the borrowing country to increase the political leverage of the lender country or organization – if the borrower expands on his own and is unable to repay the money, they will be at the mercy of the lender.

However, in 2020, loans from China accounted for only 10 percent of Sri Lanka’s total foreign debt. The largest component – about 30 percent – can be attributed to international sovereign bonds. Japan actually has an 11 percent higher debt ratio.

Defaults on China’s infrastructure loans to Sri Lanka, especially financial assistance to the Hambantota port, have been cited as factors contributing to the crisis.

But these facts are not added. Exim Bank of China funded the construction of the Hambantota port. The port is suffering losses, so Sri Lanka leased it to China Merchant Group for 99 years, paying US $ 1.12 billion to Sri Lanka.

So the failure of the Hambantota port did not lead to a balance of payments crisis (more money or exports going out here than coming in), which actually increased Sri Lanka’s foreign exchange reserves to US $ 1.12 billion.

What are the real causes of the crisis so far?

After independence from the British in 1948, Sri Lankan agriculture was dominated by export-oriented crops such as tea, coffee, rubber and spices. Most of its gross domestic product comes from foreign exchange earned by exporting these crops. The money was used to import essential food items.

Over the years, the country began to export garments and began to earn foreign exchange from tourism and payments (remittances sent to Sri Lanka from abroad, possibly by family members). Any decline in exports comes as an economic shock and puts pressure on foreign exchange reserves.

Due to this, Sri Lanka often faces a balance of payments crisis. Since 1965, it has received 16 loans from the International Monetary Fund (IMF). Each of these loans came on the condition that Sri Lanka reduce their budget deficit, maintain austerity monetary policy, reduce government subsidies for food and reduce the currency for Sri Lankans after borrowing (so exports change. More viable).

But in times of recession in general, good economic policy dictates that governments spend more to inject stimuli into the economy. This is impossible with IMF conditions. Despite this situation IMF loans continued to come in and the troubled economy sank further into debt.

The last IMF loan to Sri Lanka was provided in 2016. The country received US $ 1.5 billion for three years from 2016 to 2019. The conditions were familiar and the health of the economy was badly damaged during this period. As growth, investment, savings and returns slowed, so did the debt burden.

The negative situation worsened in 2019 with two economic shocks. First, in April 2019, a series of bomb blasts rocked churches and luxury hotels in Colombo. Tourist arrivals have plummeted due to the blasts – some reports have even mentioned one. 80 percent decline – and foreign exchange reserves drained. Second, the new government led by President Gotabhaya Rajapaksa has unreasonably reduced taxes.

Value-added tax rates (similar to those on goods and services taxes in some countries) have been reduced from 15 percent to 8 percent. Other indirect taxes such as country building tax, tax you pay as you earn and financial service charges are waived. Corporate tax rates have been reduced from 28 per cent to 24 per cent. As a result of these tax cuts, it lost about 2 percent of its GDP.

In March 2020, the COVID-19 pandemic struck. In April 2021, the Rajapaksa government made another fatal mistake. To prevent the depletion of foreign exchange reserves, all imports of fertilizers were completely banned. Sri Lanka has been declared a 100 percent organic farming country. This policy, which was withdrawn in November 2021, led to a sharp fall in agricultural production and required more imports.

But foreign exchange reserves are under pressure. Decreased productivity of tea and rubber due to the ban on fertilizers has also led to a decline in export earnings. Low export earnings meant less money was available to import food and food shortages ensued.

As there is less food and other items to buy, the demand does not decrease and the prices of these items increase. Inflation rose to 17.5 percent in February 2022.

What happens now?

In all likelihood, Sri Lanka will now receive the 17th IMF loan to overcome the current crisis with the latest developments.

Each inflationary economic policy will be pursued, which will further limit the chances of economic recovery and further aggravate the suffering of the people of Sri Lanka.

(PTI / Conversation)


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