Explaining Sri Lanka’s economic crisis

• The Sri Lankan economy has been facing a crisis owing to a serious balance of payments (BoP) problem.
• Its foreign exchange reserves are depleting rapidly.
• It is becoming increasingly difficult to import essential consumption goods. The country is unable to repay past debts.

Causes of the current crisis

• One can trace the roots of the crisis to colonialism and Sri Lanka’s post-war developmental pathway but let us stick to the last decade for our purposes.
• When Sri Lanka emerged from a 26-year long war in 2009, it was expected that economic growth would revive.
• Possibly because of pent-up demand, Sri Lanka’s post-war GDP growth was reasonably high at 8-9% per annum between 2009 and 2012.
• However, the economy was on a downward spiral after 2013 as global commodity prices fell, exports slowed down and imports rose.
• The average GDP growth rate almost halved after 2013.
• A counter-cyclical fiscal policy was ruled out, as the hands of the then Mahinda Rajapaksa government were tied by a $2.6 billion loan obtained from the International Monetary Fund (IMF) in 2009.
• During the period of the war, budget deficits were high. Further, the capital flight that accompanied the global financial crisis of 2008 drained Sri Lanka’s foreign exchange reserves.
• The IMF loan in 2009 was obtained in this context, with the conditionality that budget deficits would be reduced to 5% of the GDP by 2011.
• The IMF’s conditionality was that the fiscal deficit must be reduced to 3.5% by 2020. Other conditionalities included a reform of the tax policy and tax administration; control of expenditures; commercialisation of public enterprises; flexibility in exchange rates; improvement of competitiveness; and a free environment for foreign investment.

Resultant

• GDP growth rates shrank from 5% in 2015 to 2.9% in 2019.
• Investment rate fell from 31.2% in 2015 to 26.8% in 2019.
• Savings rate fell from 28.8% in 2015 to 24.6% in 2019.
• Government revenues shrank from 14.1% of the GDP in 2016 to 12.6% of the GDP in 2019.
• Gross government debt rose from 78.5% of the GDP in 2015 to 86.8% of the GDP in 2019.

New shocks to economy

• The Easter bomb blasts of April 2019 in churches in Colombo led to the death of 253 people. Consequently, the number of tourists fell sharply leading to a decline in foreign exchange reserves.
• The UNP-led government was replaced in November 2019 by a new government led by the Sri Lanka Podujana Peramuna (SLPP), headed by Gotabaya Rajapaksa. The SLPP had promised lower tax rates and wide-ranging sops for farmers during their campaign.
• In December 2019, the value added tax (VAT) rates were reduced from 15% to 8%.
• The annual threshold for VAT registration was raised from LKR 12 million to LKR 300 million. The annual income threshold for waiver of personal income tax was raised from LKR 500,000 to LKR 3,000,000. The nation building tax, the PAYE tax and the economic service charges were abolished.
• Estimates show that there was a 33.5% decline in the number of registered taxpayers between 2019 and 2020, and close to 2% of the GDP was lost in taxes thus foregone. GST/VAT revenues were halved between 2019 and 2020.
• Exports of tea, rubber, spices and garments suffered. Tourism arrivals and revenues fell further.
• The pandemic also necessitated a rise in government expenditures: the fiscal deficit exceeded 10% in 2020 and 2021, and the ratio of public debt to GDP rose from 94% in 2019 to 119% in 2021.
• Sri Lanka annually spent about $260 million (or about 0.3% of its GDP) on fertiliser subsidies. Most of the fertilisers are imported.
• To prevent the drain of foreign exchange reserves, the Gotabaya government came up with a novel, but thoroughly bizarre, solution in 2021.
• All fertiliser imports were completely banned from May 2021, and it was declared that Sri Lanka would overnight become a 100% organic farming nation.
• This policy, which was withdrawn in November 2021 after protests by farmers, literally pushed Sri Lanka to the brink of a disaster.
• Agricultural scientists were unanimous in warning the Gotabaya government of the potential losses from the organic farming policy. They wrote to the government that yields may drop by 25% in paddy, 35% in tea and 30% in coconut if chemical fertilisers were banned.

Fertilizer ban fiasco

• The scientists were proven right. In February 2022, the IMF assessed that there was a “worse-than-anticipated impact of the chemical fertilizer ban on agricultural production”, which was likely to drag down the prospects of economic recovery.
• As agricultural production fell, more imports of food became necessary. But increasing imports was difficult in the face of foreign exchange shortages. Thus, inflation rose to 17.5% in February 2022.

Conclusion

• The IMF’s loan-related conditionalities, misguided policies of authoritarian rulers and the official embrace of pseudo-science.
• The future looks bleak too. The government might approach the IMF once again for a new loan with fresh conditionalities.

Exam Track

Prelims Take Away

• India-Srilanka International boundary line
• Location based question