Trade and Investment

Why Sri Lanka is facing one of its worst economic crises

Sri Lanka crisis

Sri Lanka economic crisis - Inflation has reached an all-time high of 17.5% Image: Unsplash/Raissa Lara Lütolf (-Fasel)

R. Ramakumar
Professor of Economics, Tata Institute of Social Sciences
Share:
Our Impact
What's the World Economic Forum doing to accelerate action on Trade and Investment?
The Big Picture
Explore and monitor how Sri Lanka is affecting economies, industries and global issues
A hand holding a looking glass by a lake
Crowdsource Innovation
Get involved with our crowdsourced digital platform to deliver impact at scale
Stay up to date:

Sri Lanka

Loading...
  • For the first time since its independence, Sri Lanka has defaulted on its foreign debts.
  • It's now in the midst of one of the worst economic crises it’s ever seen.
  • The population faces long power cuts, high prices, and a scarcity of essential items like food and medicines.
  • But how did it happen? A professor of economics explains.

The island nation of Sri Lanka is in the midst of one of the worst economic crises it’s ever seen. It has just defaulted on its foreign debts for the first time since its independence, and the country’s 22 million people are facing crippling 12-hour power cuts, and an extreme scarcity of food, fuel and other essential items such as medicines.

Inflation is at an all-time high of 17.5%, with prices of food items such as a kilogram of rice soaring to 500 Sri Lankan rupees (A$2.10) when it would normally cost around 80 rupees (A$0.34). Amid shortages, one 400g packet of milk powder is reported to cost over 250 rupees (A$1.05), when it usually costs around 60 rupees (A$0.25).

On April 1, President Gotabaya Rajpaksha declared a state of emergency. In less than a week, he withdrew it following massive protests by angry citizens over the government’s handling of the crisis.

The country relies on the import of many essential items including petrol, food items and medicines. Most countries will keep foreign currencies on hand in order to trade for these items, but a shortage of foreign exchange in Sri Lanka is being blamed for the sky-high prices.

Why are some people blaming China?

Many believe Sri Lanka’s economic relations with China are a main driver behind the crisis. The United States has called this phenomenon “debt-trap diplomacy”. This is where a creditor country or institution extends debt to a borrowing nation to increase the lender’s political leverage – if the borrower extends itself and cannot pay the money back, they are at the creditor’s mercy.

However, loans from China accounted for only about 10% of Sri Lanka’s total foreign debt in 2020. The largest portion – about 30% – can be attributed to international sovereign bonds. Japan actually accounts for a higher proportion of their foreign debt, at 11%.

Defaults over China’s infrastructure-related loans to Sri Lanka, especially the financing of the Hambantota port, are being cited as factors contributing to the crisis.

People gathered in a large group protesting.
The state of emergency was withdrawn after just one week following large-scale protests in Sri Lanka. Image: AAP/CHAMILA KARUNARATHNE

But these facts don’t add up. The construction of the Hambantota port was financed by the Chinese Exim Bank. The port was running losses, so Sri Lanka leased out the port for 99 years to the Chinese Merchant’s Group, which paid Sri Lanka US$1.12 billion.

So the Hambantota port fiasco did not lead to a balance of payments crisis (where more money or exports are going out than coming in), it actually bolstered Sri Lanka’s foreign exchange reserves by US$1.12 billion.

Discover

How is the World Economic Forum ensuring sustainable global markets?

So what are the real reasons for the Sri Lanka crisis?

Post-independence from the British in 1948, Sri Lanka’s agriculture was dominated by export-oriented crops such as tea, coffee, rubber and spices. A large share of its gross domestic product came from the foreign exchange earned from exporting these crops. That money was used to import essential food items.

Over the years, the country also began exporting garments, and earning foreign exchange from tourism and remittances (money sent into Sri Lanka from abroad, perhaps by family members). Any decline in exports would come as an economic shock, and put foreign exchange reserves under strain.

For this reason, Sri Lanka frequently encountered balance of payments crises. From 1965 onwards, it obtained 16 loans from the International Monetary Fund (IMF). Each of these loans came with conditions including that once Sri Lanka received the loan they had to reduce their budget deficit, maintain a tight monetary policy, cut government subsidies for food for the people of Sri Lanka, and depreciate the currency (so exports would become more viable).

But usually in periods of economic downturns, good fiscal policy dictates governments should spend more to inject stimulus into the economy. This becomes impossible with the IMF conditions. Despite this situation, the IMF loans kept coming, and a beleaguered economy soaked up more and more debt.

The last IMF loan to Sri Lanka was in 2016. The country received US$1.5 billion for three years from 2016 to 2019. The conditions were familiar, and the economy’s health nosedived over this period. Growth, investments, savings and revenues fell, while the debt burden rose.

A bad situation turned worse with two economic shocks in 2019. First, there was a series of bomb blasts in churches and luxury hotels in Colombo in April 2019. The blasts led to a steep decline in tourist arrivals – with some reports stating up to an 80% drop – and drained foreign exchange reserves. Second, the new government under President Gotabaya Rajapaksa irrationally cut taxes.

People protesting with handmade signs
The population is facing food shortages and high prices. Image: AAP/Eranga Jayawardena

Value-added tax rates (akin to some nations’ goods and services taxes) were cut from 15% to 8%. Other indirect taxes such as the nation building tax, the pay-as-you-earn tax and economic service charges were abolished. Corporate tax rates were reduced from 28% to 24%. About 2% of the gross domestic product was lost in revenues because of these tax cuts.

Have you read?

In March 2020, the COVID-19 pandemic struck. In April 2021, the Rajapaksa government made another fatal mistake. To prevent the drain of foreign exchange reserves, all fertiliser imports were completely banned. Sri Lanka was declared a 100% organic farming nation. This policy, which was withdrawn in November 2021, led to a drastic fall in agricultural production and more imports became necessary.

But foreign exchange reserves remained under strain. A fall in the productivity of tea and rubber due to the ban on fertiliser also led to lower export incomes. Due to lower export incomes, there was less money available to import food and food shortages arose.

Because there is less food and other items to buy, but no decrease in demand, the prices for these goods rise. In February 2022, inflation rose to 17.5%.

What will happen now?

In all probability, Sri Lanka will now obtain a 17th IMF loan to tide over the present crisis, which will come with fresh conditions.

A deflationary fiscal policy will be followed, which will further limit the prospects of economic revival and exacerbate the sufferings of the Sri Lankan people.

Loading...
Don't miss any update on this topic

Create a free account and access your personalized content collection with our latest publications and analyses.

Sign up for free

License and Republishing

World Economic Forum articles may be republished in accordance with the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International Public License, and in accordance with our Terms of Use.

The views expressed in this article are those of the author alone and not the World Economic Forum.

Share:
World Economic Forum logo
Global Agenda

The Agenda Weekly

A weekly update of the most important issues driving the global agenda

Subscribe today

You can unsubscribe at any time using the link in our emails. For more details, review our privacy policy.

Why Africa could provide the next semiconductor ecosystem for the chip business

Nii Simmonds and Ayodele Okeowo

July 17, 2024

About Us

Events

Media

Partners & Members

  • Sign in
  • Join Us

Language Editions

Privacy Policy & Terms of Service

© 2024 World Economic Forum