Explaining Sri Lanka’s economic crisis

The current situation of the country is due to wrong policies and lack of external advice

The current situation of the country is due to wrong policies and lack of external advice

Sri Lanka’s economy is in crisis due to a serious balance of payments problem. Its foreign exchange reserves are quickly exhausted. It is becoming increasingly difficult to import essential consumer goods. The country is unable to repay past debts. This article is an attempt to pinpoint the immediate causes of the current crisis and document the roles of various groups and organizations in creating it.

Of course, the roots of the crisis can be traced back to Sri Lanka’s colonialism and post-war development trajectory, but let’s stick to the last decade for our purposes. Even into the 21st century, Sri Lanka’s economic fortunes were still tied to the export of primary commodities such as tea and rubber, and clothing. It mobilized foreign exchange reserves through primary commodity exports, tourism and remittances, and used it to import essential consumer goods, including food.

Editorial | Crisis in Sri Lanka

When Sri Lanka emerged from a 26-year war in 2009, economic growth was expected to recover. Possibly due to pent-up demand, Sri Lanka’s post-war GDP growth was fairly high at 8-9% per year between 2009 and 2012. However, the economy was in a tailspin after 2013 when global commodity prices fell and exports slowed and imports rose. The average GDP growth rate has almost halved since 2013. A counter-cyclical fiscal policy was ruled out as the hands of the then Mahinda Rajapaksa government were tied up by a $2.6 billion loan obtained in 2009 from the International Monetary Fund (IMF). During the war, budget deficits were high. Furthermore, the capital flight that accompanied the 2008 global financial crisis has depleted Sri Lanka’s foreign exchange reserves. The IMF loan in 2009 was obtained in this context, with the condition that budget deficits would be reduced to 5% of GDP by 2011.

With no growth or exports to pick up, and the continued draining of foreign exchange reserves, the new coalition government led by the United National Party (UNP) approached the IMF in 2016 for another $1.5 billion loan for a three-year period between 2016 and 2016. 2019. The IMF’s condition was that the budget deficit must be reduced to 3.5% by 2020. Other conditions included a reform of tax policy and tax administration; expenditure control; commercialization of public companies; flexibility in exchange rates; improving competitiveness; and a free environment for foreign investment.

The IMF package led to a deterioration in Sri Lanka’s economic health. GDP growth decreased from 5% in 2015 to 2.9% in 2019. The investment rate decreased from 31.2% in 2015 to 26.8% in 2019. The savings rate decreased from 28.8% in 2015 to 24.6 % in 2019. Government revenues decreased from 14.1% of GDP in 2016 to 12.6% of GDP in 2019. Government gross debt increased from 78.5% of GDP in 2015 to 86.8% of GDP in 2019. GDP in 2019.

New shocks to the economy

In 2019, there were two more shocks to the economy. First, the April 2019 Easter bomb explosions at churches in Colombo resulted in the deaths of 253 people. As a result, the number of tourists fell sharply, which led to a decrease in foreign exchange reserves. The explosion dealt a serious blow to the prospects for economic recovery.

Second, 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 expanded sops for farmers during their campaign. At first glance, these promises seemed to deviate from the IMF package. However, in the absence of a concrete policy alternative to the IMF’s neoliberal package, these promises were hollow.

Gotabaya Rajapaksa was quick to implement the ill-advised plan to cut taxes. In December 2019, the VAT rates were reduced from 15% to 8%. The annual VAT registration threshold was raised from LKR 12 million to LKR 300 million. The annual income threshold for income tax exemption was raised from LKR 500,000 to LKR 3,000,000. The Nation Tax, the PAYE Tax and the Economic Service Fee were abolished.

Estimates show that the number of registered taxpayers fell by 33.5% between 2019 and 2020 and that almost 2% of GDP was lost to taxes thus foregone. GST/VAT revenues halved between 2019 and 2020.

The COVID-19 pandemic in 2020 has exacerbated the bad situation. Exports of tea, rubber, spices and clothing suffered. Tourist arrivals and income continued to fall. The pandemic also necessitated an increase in public spending: the budget deficit exceeded 10% in 2020 and 2021 and the government debt-to-GDP ratio rose from 94% in 2019 to 119% in 2021.

Sri Lanka spent about $260 million (or about 0.3% of GDP) annually on fertilizer subsidies. Most fertilizers are imported. To prevent the draining of foreign exchange reserves, the Gotabaya government came up with a new but thoroughly bizarre solution in 2021. From May 2021, all fertilizer imports were completely banned and Sri Lanka was declared a 100% organic agricultural nation overnight. This policy, which was repealed in November 2021 after protests by farmers, literally pushed Sri Lanka to the brink of disaster. Agricultural scientists were unanimous in warning the Gotabaya government of the potential losses of organic farming policy. They wrote to the government that yields could fall by 25% in paddy rice, 35% in tea and 30% in coconut if chemical fertilizers are banned.

Manure ban fiasco

The scientists were right. In February 2022, the IMF ruled that there was a “worse-than-expected impact of the fertilizer ban on agricultural production,” which was likely to diminish the prospects for economic recovery. As agricultural production declined, more food imports became necessary. But increasing imports has been difficult because of the foreign exchange shortages. Inflation rose to 17.5% in February 2022. A decline in the productivity of tea and rubber also led to lower export income. And so organic farming policy, which was aimed at reducing the pressure on reserves, put them under even more pressure.

The current economic crisis in Sri Lanka is thus the product of the historical imbalances in the economic structure, the loan-related conditions of the IMF, the misguided policies of authoritarian rulers and the official embrace of pseudoscience. The future also looks bleak. The government could approach the IMF again for a new loan with new terms. With the global outlook looking bleak, a renewed push for such deflationary policies would not only limit the prospects for economic recovery but also exacerbate the suffering of the Sri Lankan people.

(R. Ramakumar is a professor, Tata Institute of Social Sciences, Mumbai)

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