Understanding Sri Lanka's Economic Crisis: How Did the Country Fall into Financial Ruin?

Picture a nation where millions of students are unable to take exams because their country lacks the funds to purchase paper for answer sheets. Hospitals have ceased performing surgeries because the country can no longer afford medical equipment and medication. Doctors are now conducting operations using mobile phone lights, as the country experiences power cuts exceeding 13 hours a day, which are becoming more frequent. It is difficult to fathom an entire country going bankrupt and being unable to acquire even the most necessities for survival. This is the harsh reality facing the once idyllic Paradise Island, Sri Lanka.

What Triggered the Financial Crisis?

The island nation borrowed more than it could repay:

Sri Lanka has found itself in a precarious financial situation, having borrowed significantly more than its earning capacity. This has led to a sharp decline in the nation's foreign reserves, which now stand at a mere $1.9 billion while facing a daunting debt repayment of $8.6 billion this year. It is perplexing how a country with such strong social indicators could be facing such dire economic challenges.

Among the nations of the South Asian Association for Regional Cooperation (SAARC), Sri Lanka has always stood out for its promising social indicators. Geopolitically, Sri Lanka holds a strategic position in the Indian Ocean, serving as a crucial link between the East and the West and playing a vital role in international trade. The country's ports have the potential to become key hubs for global trade, rivaling the likes of Shanghai, Mumbai, and Osaka.

Following its independence in 1948, Sri Lanka was viewed as a promising island nation with the potential to become a major player in the global economy. However, the country faced financial constraints in developing its ports, with limited funds available due to the focus on national security during the civil war that raged from 1983 to 2009. By the time the conflict ended, Sri Lanka had lost much of its reputation and allure for foreign investors looking to capitalize on its port development opportunities.

Hopes of Becoming a Trade Hub:

Sri Lanka persevered in the face of adversity, determined to establish a thriving port that would serve as a key trade hub. The ambitious vision for the Hambantota Port project became a reality, despite skepticism from global investors and analysts who doubted its feasibility. However, China's involvement proved to be a game-changer, as the country made a significant investment in the project, propelling it towards success.

Development Based on Debt:

Regrettably, the concerns of investors and analysts were realized as the project ultimately failed to generate commercial success, resulting in Sri Lanka accumulating significant debt owed to China. Unable to meet its financial obligations, Sri Lanka was compelled to sell the project to China at a reduced price, subsequently leasing the port to China for 99 years. This transaction proved to be highly beneficial for China, as it not only yielded profits and interest but also bolstered its standing on the global stage.

Conversely, Sri Lanka found itself at a disadvantage, having initiated development projects that ultimately did not yield the desired outcomes. The nation had relied heavily on Chinese funding, with 70% of all development funds being sourced from loans. Unfortunately, these projects were undertaken without a clear strategy for repayment, leaving Sri Lanka in a precarious financial situation.

COVID-19:

Sri Lanka's economy is heavily reliant on tourism and agricultural exports, with key products being garments, rubber, tea, and coconuts. However, the global impact of the COVID-19 pandemic brought international travel to a standstill, causing all tourism-related industries in Sri Lanka to come to a halt for approximately two years.

In December 2019, the government increased the Value Added Tax (VAT) from 8% to 15%, anticipating a surge in consumer spending, particularly from tourists. Unfortunately, this prediction did not materialize as expected. A significant portion of Sri Lanka's annual tourists, 16% to be exact, were Russians. The conflict between Russia and Ukraine further exacerbated the situation, leading to a prolonged downturn in Sri Lanka's tourism sector.

The ripple effects of the Russia-Ukraine war were felt across global markets, resulting in price hikes for petroleum products, gold, and other semi-valuable metals, as well as increased shipping costs. These factors, combined with a decrease in tax rates promised by the Rajapaksa government during the 2019 election campaign, created a perfect storm for a financial crisis in Sri Lanka.

Currently, Sri Lanka's net exports are valued at a negative $10 billion, and the country's Foreign Exchange Reserve is insufficient to cover necessities such as medicine, fuel, and paper. The challenges facing Sri Lanka's economy are significant, and urgent action is needed to address the ongoing crisis.

Restricted Agriculture:

Despite agriculture being a primary source of income in Sri Lanka, farmers in the country failed to diversify their crops. The focus was mainly on exporting agricultural products rather than meeting domestic demand. When the Russia-Ukraine war began, the supply of wheat and sunflower oil to the country was disrupted as Russia, the world's largest exporter of wheat, stopped exporting these commodities. This led to a decrease in supply while demand remained high, causing international prices to rise. This situation further strained Sri Lanka's already dwindling FOREX reserves.

In 2021, the Rajapaksa government implemented a ban on all chemical fertilizers, which exacerbated the challenges faced by the agricultural sector. This decision resulted in a rapid decline in cultivation, agro-production, and crop yields. By the time the government reversed its policy, the damage had already been done. Farmers had experienced poor harvests and suffered significant losses, contributing to the overall economic downturn in the country.

The lack of crop diversification, overreliance on exports, and policy decisions have had a detrimental impact on Sri Lanka's agricultural sector and economy as a whole. Moving forward, the government must implement sustainable agricultural practices and policies that prioritize both domestic consumption and export markets to ensure the resilience and growth of the agricultural sector in Sri Lanka.

What Will Happen to Sri Lanka?

As of February 2022, Sri Lanka's debt was estimated to be approximately $4 billion, while the nation's reserves were valued at $2.31 billion. Analysts anticipate that Sri Lanka may need to secure a 17th loan from the International Monetary Fund (IMF) to address the crisis. However, this loan will likely come with additional conditions.

A recent review conducted by the IMF on Sri Lanka's economy, released in March, revealed that the country's public debt had reached unsustainable levels with no clear strategy for repayment. In response, a deflationary fiscal policy is being considered to stimulate the economy and alleviate the challenges faced by the Sri Lankan people. The country must restructure its debt to restore economic stability.

Currently, the Sri Lankan rupee has been identified as the worst-performing currency in the world. The currency has been devalued with further declines expected. This devaluation was intended to make exports more competitive internationally, but low national production levels, exacerbated by power cuts and shortages of essential goods, have hindered the country's ability to export effectively.

In light of these challenges, Sri Lanka has sought assistance from major economies and neighboring countries, such as China and India. India, in particular, has extended a $500 million credit line for diesel shipments and a $1 billion credit line for the importation of essential commodities like food and medicine. This support is crucial for Sri Lanka as it navigates its current economic difficulties.

On the contrary, China has agreed to provide the necessary "urgent assistance." Despite global analysts accusing China of pushing Sri Lanka into a debt trap by encouraging unsustainable and unproductive development projects that ultimately fail, the mega-nation is offering a $1 billion credit facility and an additional $1 billion loan. This generous offer comes after China previously provided the Central Bank of Sri Lanka with a $1.5 billion swap and a $1.3 billion syndicated loan to the Rajapaksa government.