It’s been a rocky start to the year for the global economy. Just as the impacts of Omicron, the latest variant of COVID-19, were fading, Russia invaded Ukraine, thereby sending commodity prices to sky-high levels while also spooking consumers and investors alike. What’s more, the Federal Reserve’s commitment to raising rates will, in no uncertain terms, tighten global financial conditions. These shocks will weigh on growth for most economies around the world, but they perhaps come at the worst possible time for the island nation of Sri Lanka.
Sri Lanka is undergoing an economic collapse currently. There are food and energy shortages across the country. Households and businesses are forced to go without power for several hours at a time. Prices for goods and services are rising at an alarming rate, with the March inflation reading at 19% in year-over-year terms. Investors have moved capital out of the country quickly leading to a 50% drop in the Sri Lankan rupee in the last four weeks alone. Higher commodity prices and a loss in investor confidence due to the war in Ukraine have made matters worse for Sri Lanka.
There are several reasons for why economic conditions have deteriorated to this extraordinary degree. One important, if not the most important reason, is the many years of financial mismanagement by the government. From the 2014 to 2019 period, Sri Lanka racked up millions in foreign debt as authorities pushed forward infrastructure projects. The external debt burden rose close to 100% over this period. The government serviced this debt by heavily relying on revenues from the tourism industry and remittances from Sri Lankan expats. In addition to accumulating liabilities, the government weakened its fiscal position by undertaking tax cuts in 2019.
The next big reason why Sri Lanka is in an economic crisis is due to the pandemic. COVID-19 brought a sudden stop to tourism in the country and remittances dried up as expats faced economic uncertainty in their home countries. Sri Lanka’s foreign reserves rapidly diminished. From 2019 to February 2022, foreign reserves were down 70%, and were only valued at $2.3 Billion (~3% of GDP). With foreign reserves dwindling, the government is facing heightened external liquidity challenges. Sri Lanka has been unable to purchase essential food and energy imports, which are priced in foreign currencies. The lack of foreign reserves also forced the Central Bank of Sri Lanka to remove the fix on the Rupee and float the currency in March.
The significant drop in the Rupee’s value has resulted in a sharp increase in import prices. Domestic food prices are also on a tear due to a decline in food supply which was brought on by an ill-advised government policy to ban non-organic fertilizers in April 2021. Even though this decision was reversed after protests, only a limited amount of chemical fertilizers was accessed by farmers. Agriculture experts had indicated that paddy yields could drop by at least 30% this year.
With economic conditions worsening by the day, the local population have taken to the streets to call for change in the Sri Lankan government. The ruling Rajapaksa government is not blameless in this matter. Amending the constitution in 2020, it elevated its power while blundering on the policy front. The government did not seek assistance for months, until the crisis was too large to ignore. It is now turning to its neighbours in the region and international institutions to provide some economic relief. India has provided an $2.5 billion line of credit and is beginning to supply rice to the island. China is considering providing an additional $2.5 billion in loans as well. The Sri Lanka authorities had also discussed a bailout with the International Monetary Fund.
Still, there is a chance the country could default on their loans. According to Fitch Ratings, Sri Lanka will have to pay close to $7 billion in debt obligations this year, three times the amount currently in foreign reserves. Even if it avoids defaulting, bailout assistance will come with stringent conditions. The Sri Lankan government will have to tighten its purse strings considerably, and this will weigh on the economy for some time. Indeed, it may get worse before it gets better for Sri Lanka.
Sri Thanabalasingam is Principal, Economic Research at OMERS.