Sri Lanka is facing the worst economic crisis in its modern history. Its population of 22 million is grappling with huge increases in the prices of food, electricity, medicine and other basic necessities. That’s if they can get them, with private motorists spending hours queuing for their fuel quota.
This is why Sri Lankans demonstrated in the streets and stormed the President’s House.
How did we get here ?
The immediate cause of the crisis is simple: Sri Lanka ran out of foreign exchange reserves, the currencies its government and citizens need to pay for imports.
How he ended up in this situation requires more explanation. It is a story of fiscal recklessness, unsustainable exchange rate policy and chronic mismanagement.
Read more: Behind the crisis in Sri Lanka – how political and economic mismanagement combined to throw the nation into turmoil
Short of foreign currency
Since the start of 2020, Sri Lanka’s demand for foreign exchange has increased while its ability to earn foreign exchange – through exports, loans and other capital inflows – has declined.
This is reflected in the steady decline in official foreign exchange reserves held by the Central Bank of Sri Lanka from around $8 billion to less than $4 billion. (The Sri Lankan currency is “closed”, which means that it is not exchanged outside the country, so foreign exchange transactions must go through the central bank).
As bad as these numbers are, the reality is worse.
Gross reserves are not the same as money in a bank account that can be used for payments. They include, for example, currency already committed for payments and loans with conditions restricting imports from certain countries.
The actual amount of “usable” foreign currency is lower. At the beginning of May, it stood at just $50 million, a tiny level for an economy which, at the end of 2021, needed around $75 million a day to pay for its imports. This led to the Sri Lankan government not paying interest of $78 million at the end of May.
Decline in foreign currency inflows
The decline in foreign currency inflows and the increase in foreign exchange outflows from Sri Lanka are due to imports exceeding exports, Sri Lankans sending less money abroad, the devastation of the tourism sector and increased debt repayments.
In two years, Sri Lanka’s annual trade deficit has grown from around US$6 billion to US$8 billion.
Two other key sources of foreign exchange, remittances from Sri Lankans living abroad and international tourism, have also been hit hard.
At their peak, they more than offset the goods trade deficit.
But since 2019, the value of remittances has fallen by more than 20%. Tourism revenues, devastated by the 2019 Easter bombings in which 269 people were killed, fell nearly 90% from their 2018 peak.
Support exchange rate
Ordinarily, a nation can avoid running out of foreign currency in two ways.
One way is to borrow money. However, Sri Lanka was already heavily indebted before this crisis. Successive governments have borrowed to finance infrastructure projects and support loss-making public services. With debt servicing costs estimated at US$10 billion, Sri Lanka is now a bad bet for lenders.
The second, and best, is a floating exchange rate modeled on those of Australia, Britain, Japan and the United States.
A floating rate helps balance trade value because the value of the currency changes based on demand.
Read more: The crisis in Sri Lanka is not just about the economy, but about a long history of discrimination against minority groups
Technically, Sri Lanka has a floating currency, but it is a “managed float” – the government, mainly through the Central Bank of Sri Lanka, pegging and replicating the value of the rupee to the US dollar .
A government can do a number of things to maintain the value of its currencies, but the main way is to buy the currency itself, using foreign exchange reserves. This is what the central bank of Sri Lanka did.
As foreign exchange reserves dwindled, the government adopted other riskier policies. The April 2021 decision to ban fertilizer imports was particularly disastrous.
This was marketed as a policy to promote organic farming, but it was really to reduce the demand for foreign currency.
The subsequent fall in agricultural production only aggravated the economic crisis.
Just as short-term fixes can create longer-term problems, long-term fixes can also mean short-term pain.
Allowing the (pegged) rupee to depreciate by more than 40% against the US dollar drove inflation up to 54%.
The help the Sri Lankan government is seeking from the International Monetary Fund is likely to hit people hard, at least initially.
Based on past experience, the IMF will want major commitments on government spending and other economic indicators before bailing out Sri Lanka.
But without action, life in Sri Lanka seems even more grim.
With shortages of imported raw materials, industrial production will decline, creating a downward spiral of low production, low investment and consequent low economic growth.
On the other hand, Sri Lanka has some natural advantages – from its natural beauty to the most literate population in South Asia. What it needs now is principled political leadership, competent economic management and appropriate policies.