Sri Lankan Economic Crisis Explained

Sri Lanka is staring at a major power supply outage.

• According to officials at the Ceylon Electricity Board (CEB), the island nation's continuous electricity supply could be assured until January 22. Previously, it was said the supplies could be ensured until January 18.
• Sri Lanka is currently facing a severe foreign exchange crisis with falling reserves, which lead to immediate fuel and energy crisis.
  • The country is grappling with a shortage of almost all essentials due to the lack of dollars to pay for the imports.
  • Additionally, power cuts are imposed at peak hours as the state power entity is unable to obtain fuel to run turbines.
  • The state fuel entity has stopped oil supplies as the electricity board has large unpaid bills. The only refinery was recently shut as it was unable to pay dollars for crude imports.

Economic Crisis in Sri Lanka:

• In December 2021, the international rating’s agency Fitch downgraded Sri Lanka from “CCC to CC”. 
• Shortly before Fitch, an unmoved Standard & Poor’s had lowered Sri Lanka’s ratings from “CCC+ to CCC” citing greater sovereign default risk.
  • Sri Lanka has run up an external debt of more than $45 billion — about 60% per cent of its nominal GDP (2020) compared to India’s around 20% and Pakistan’s 40%.

• The Economic Crisis:
  • Sri Lankan President Gotabaya Rajapaksa has declared an economic emergency to contain soaring inflation after a steep fall in the value of the country's currency caused a spike in food prices.
    • On 31 August 2021, Sri Lanka declared a state of economic emergency, as it is running out of foreign exchange reserves for essential imports like food. 
  • The emergency move followed sharp price rises for sugar, rice, onions and potatoes, while long queues have formed outside stores because of shortages of milk powder, kerosene oil and cooking gas.
    • This is because prices skyrocketed to hitherto unseen levels, thanks mainly to a severely indebted island lacking dollars to pay for essential imports. 
    • The year ended with around 1500 shipping containers comprising essential items stuck at the port because the government had not released dollars to pay for them.
  • Inflation in December was 12.1 per cent, having risen from 9.9 per cent in November, with food prices having more than doubled in the past year. 
  • The government exacerbated inflation by printing money willy-nilly — as much as Rs 69,100 crore (US$3.4 billion) in 2021. 
  • With the focus on the dollar crisis, inflation, and food queues, what is not sufficiently covered concerns those going hungry.

• Factors that lead to the crisis:
  • Pandemic:
    • Sri Lanka’s foreign currency inflow has long depended on remittances, tourism and specific exports like garments and tea. 
    • The COVID-19 pandemic was bound to trouble these sectors.
      • The tourism industry, which represents over 10% of the country’s Gross Domestic Product and brings in foreign exchange, has been hit hard by the coronavirus pandemic. 
      • As a result, forex reserves have dropped from over $7.5 billion in 2019 to around $2.8 billion in July 2021. 
    • With the supply of foreign exchange drying up, the amount of money that Sri Lankans have had to shell out to purchase the foreign exchange necessary to import goods has risen. 
    • So the value of the Sri Lankan rupee has depreciated by around 8% so far this year. 
    • It has to be noted that the country depends heavily on imports to meet even its basic food supplies. 
    • So the price of food items has risen in tandem with the depreciating rupee.
    • The possibility that Sri Lanka may, for the very first time, default on its obligations is the reason Fitch Ratings downgraded it in December. 
    • The move raised predictable government hackles, but it reflects the balance of payments crisis facing the island. 
  • Debt Financing:
    • While COVID-19 exacerbated the balance of payments crisis, debt financing was a pre-COVID-19 predicament.
    • The government’s ban on the use of chemical fertilisers in farming has further aggravated the crisis by dampening agricultural production. 
      • Doing so would eliminate US$400 million per year of government fertiliser subsidies. 
    • The government promised an organic agricultural sector within ten years, but this hastily imposed policy negatively impacted farmers. 
      • They have since protested unceasingly against the government, joining teachers and others who are also demanding higher wages given the runaway cost of living. 
    • It now seems the rice shortage caused by the addle-brained decision to abruptly ban chemical fertiliser, weedicides, and herbicides will likely cost the government US$450 million in rice imports over the next few months.
    • Consequently, Sri Lanka must cough up around US$7 billion in 2022 to various creditors to service its debts, which between now and 2026 will amount to around US$26 billion. 
  • Scam allegations on Government:
    • The regime was also linked to various scams that worsened conditions. 
    • One such scam centred on the propane and butane ratio in cooking gas cylinders, which caused numerous household explosions and killed and injured individuals. 
    • Another centred on contaminated fertiliser from China, which the government was forced to return yet pay US$6.7 million for, apparently due to corrupt procurement. 
    • In a country now infamous for impunity, no one was held responsible for corruption or incompetence.
  • Chinese Debt trap:
    • Sri Lanka owes at least $8 billion to China alone.
      • Unable to service its debt, in 2017, Sri Lanka lost the unviable Hambantota port to China for a 99-year lease.
      • Nevertheless, Sri Lanka has increasingly relied on Chinese credit to address its foreign debt burden.
      • Many loans have been negotiated between Colombo and Chinese institutions, including a recent syndicated loan for budgetary support of $1.3 billion from China Development Bank and a $1.5 billion currency swap pact with the People’s Bank of China this March.
      • China’s exports to Sri Lanka surpassed those of India in 2020 and stood at $3.8 billion (India’s exports were $3.2 billion).
    • Owing to Sri Lanka’s strategic location at the intersection of major shipping routes, China has heavily invested in its infrastructure (estimated at $12 billion between 2006 and 2019).
    • In May, Sri Lanka passed the Colombo Port City Economic Commission Act, which provides for establishing a special economic zone around the port and also a new economic commission, to be funded by China.
      • Perhaps the charm of the Chinese developing the Hambantota Port and the nearby Mattala airport may be finally fading. 
      • When Sri Lanka couldn’t pay back its annual EMI on the Chinese loan, it was forced to lease the port over to the state-owned China Merchants agency for 99 years.
      • Perhaps the Sri Lankans are beginning to realise that something similar is afoot in the Colombo port city — that a $1.4 billion investment by China Harbour Engineering Company to reclaim 660 acres (2.4 sq km) of land there has meant that the Chinese firm gets 43% of the project on a 99-year lease.
• Government Response:
  • The Sri Lankan government has blamed speculators for causing the rise in food prices by hoarding essential supplies and has declared an economic emergency under the Public Security Ordinance. 
  • The army has been tasked with the duty of seizing food supplies from traders and supplying them to consumers at fair prices. 
    • It has also been given the powers to ensure that forex reserves are used only for the purchase of essential goods. 
  • The government has refused to end its aggressive push for complete organic farming claiming that the short-term pain of going organic will be compensated by its long-term benefits. 
    • It has also promised to supply farmers with organic fertilisers as an alternative.
  • Further, Sri Lanka’s central bank earlier this year prohibited traders from exchanging more than 200 Sri Lankan rupees for an American dollar and stopped traders from entering into forward currency contracts.
• Impact of Government Response:
  • The government’s drive to make Sri Lankan agriculture fully organic is likely to lead to a significant drop in domestic food production and cause a further rise in prices.
  • Also, the various steps taken by the government to tackle the crisis may actually make things worse. 
    • The capping of food prices, for instance, can lead to severe shortages as demand exceeds supply at the price fixed by the government. 
    • People have already had to queue up to buy essential goods due to rising shortages.
  • The strong-arm tactics of the army can also have unintended consequences. 
    • When supplies are seized from traders, there is a lesser incentive for them to bring in fresh supplies to the market. 
    • This can lead to a further drop in supplies and even higher prices for essential goods. 
  • It is also worth noting that speculative traders help contain price volatility by allocating scarce supplies rationally across time. 
    • So, to the extent the army’s actions discourage speculation, it can lead to greater volatility in food prices.
  • Further, the decision of the Sri Lankan central bank to ban forward contracts and the spot trading of rupees at above 200 rupees to an American dollar may affect essential supplies. 
    • For example, a rice trader who wants to pay more than 200 rupees for an American dollar to import rice may no longer be able to carry out the trade. 
    • In fact, the trading of currency in the spot market has dried up since the central bank’s order. 
    • Also, without forward contracts, which help traders offload the risk of currency volatility onto professional speculators, many traders may be unwilling to import essential supplies.

• Impact of this crisis on India:
  • India’s ‘Neighbourhood First’ policy towards Sri Lanka had resonated with Sri Lanka’s ‘India First’ foreign and security policy in 2020.
  • However, relations between the two neighbours seem to have plummeted since the beginning of this year.
    • In February, Sri Lanka backed out from a tripartite partnership with India and Japan for its East Container Terminal Project at the Colombo Port, citing domestic issues.
    • Later, the West Coast Terminal was offered under a public-private partnership arrangement to Adani Ports and Special Economic Zones Ltd.
  • Sri Lanka’s economic crisis may further push it to align its policies with Beijing’s interests.
    • This comes at a time when India is already on a diplomatic tightrope with Afghanistan and Myanmar.
    • Other South Asian nations like Bangladesh, Nepal and the Maldives have also been turning to China to finance large-scale infrastructure projects.
  • The Colombo port is crucial for India as it handles 60% of India’s trans-shipment cargo. 
• How does India respond?
  • Recently, India announced a USD 500 million credit line to help Sri Lanka purchase petroleum products as the island nation struggles with a massive fuel and energy crisis.
  • Early this week, the Indian government announced a billion-dollar assistance package in addition to other balance of payment support to Sri Lanka.
    • The billion-dollar loan credit facility is to be used to avert a food crisis while allowing for the import of items and medicines.
  • India’s assistance to Sri Lanka during the pandemic has been varied and need-based.
    • India has sent about 150 tonnes more oxygen to Sri Lanka to help the island nation combat the third wave of the COVID-19 pandemic.
    • A currency swap of $400 million was provided in July 2020.
    • The first consignment of vaccines, which was donated by India in January 2021, enabled Sri Lanka to roll out its vaccination programme ahead of the schedule.
  • New Delhi eased Colombo from its stressful economic situation by extending a $912 million loan as well as another $1.5 billion for two credit lines involving the purchase of food and fuel from India.
  • India and Sri Lanka agreed to a four-pronged approach to discuss initiatives on food and energy security to help mitigate Sri Lanka’s economic crisis.
    • The decisions included a four-pillar initiative, comprising
      • lines of credit for food,
      • medicines and fuel purchases granted by India,
      • a currency swap agreement to deal with Sri Lanka's balance of payment issues,
      • an “early” modernisation project of the Trinco oil farms that India has been pursuing for several years, and a Sri Lankan commitment to facilitate Indian investments in various sectors.