Sri Lankan economic crisis

The Sri Lankan economic crisis started in 2019. It was the country's worst economic crisis since its independence in 1948. It led to unprecedented levels of inflation, near-depletion of foreign exchange reserves, shortages of medical supplies, and an increase in prices of basic commodities. The crisis is said to have begun due to multiple compounding factors like tax cuts, money creation, a nationwide policy to shift to organic or biological farming, the 2019 Sri Lanka Easter bombings, and the impact of the COVID-19 pandemic in Sri Lanka. The subsequent economic hardships resulted in the 2022 Sri Lankan protests.

Sri Lanka had been earmarked for sovereign default, as the remaining foreign exchange reserves of US$1.9 billion as of March 2022 would not be sufficient to pay the country's foreign debt obligations for 2022, with $4 billion to be repaid. An International Sovereign Bond repayment of $1 billion is due to be paid by the government in July 2022. Bloomberg reported that Sri Lanka had a total of $8.6 billion in repayments due in 2022, including both local debt and foreign debt. In April 2022, the Sri Lankan government announced that it was defaulting, making it the first sovereign default in Sri Lankan history since its independence in 1948 and the first state in the Asia-Pacific region to enter sovereign default in the 21st century.

In June 2022, then Prime Minister Ranil Wickremesinghe said in parliament that the economy had collapsed, leaving it unable to pay for essentials.

Background

Since 2010 Sri Lankan government Debt-to-GDP ratio gradually increased.

According to W. A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, the country was a long way into an economic crisis in 2015. The government that came into power in 2015 knew this and had been warned by the Institute of Policy Studies of Sri Lanka about a number of risks. While the then Prime Minister Ranil Wickremesinghe in 2015 had presented a strong economic policy to address the situation, the coalition government could not get the policy pushed through Parliament, which would eventually result in further policy confusion in the coming months.

The government did not adequately address the economic warnings and emerging dangers, consuming itself in other government related activities such as "constitutional reforms". Certain practices, including those used by the Ministry of Finance led by Ravi Karunanayake, were globally frowned upon. Election related economic decisions were pushed such as excessive distribution of freebies. The Institute of Policy Studies of Sri Lanka's 2014 State of the Economy Report highlighted hot money, worrying borrowing practices, temporary and superficial quick-fixes and monopoly of foreign direct investment flow into the hospitality sector.

Further political turmoil in 2018 worsened the economic outlook. By that time the government had carried out several reforms under an IMF supported program towards fiscal monetary consolidation and had successfully controlled inflation. These reforms included an automatic fuel pricing formula which significantly reduced fiscal risks posed by state-owned enterprises (SOEs), raised the value-added tax (VAT) rate from 11 percent to 15 percent, and broadened the VAT base by removing exemptions. Many of the reforms were reversed by the new government after the 2019 elections.

The last administration also drafted the 2019 Central Bank Bill to make the Central Bank independent from political influence by banning the Treasury Secretary and any member of the Government from becoming members of the Monetary Board. Money printing was also to be banned, as the bill states: "The Central Bank shall not purchase securities issued by the government, by any government-owned entity, or any other public entity in the primary market." Then Central Bank Governor, Indrajit Coomaraswamy, noted Balance of Payments issues, increased inflation, and asset bubbles as reasons for the ban. The Sri Lanka Podujana Peramuna Party opposed an independent Central Bank and discarded the bill as soon as they came to power.

Many experts compared Lebanon's economic situation with that of Sri Lanka and had warned that Sri Lanka too was on the way to defaulting on its sovereign bonds. Both nations had similar issues, including deep economic crises occurring after their successive governments piled up unsustainable debts following the end of civil wars.

Causes

Tax cuts and money creation

The Government of Sri Lanka under president Gotabaya Rajapaksa made large tax cuts that affected government revenue and fiscal policies, causing budget deficits to soar. These cuts included increased tax-free thresholds that resulted in a 33.5% decline in registered taxpayers, reducing VAT to 8%, reducing corporate tax from 28% to 24%, the abolishment of the Pay As You Earn (PAYE) tax and the 2% “nation-building tax” which financed infrastructure development. The massive loss of tax revenue resulted in rating agencies downgrading the sovereign credit rating making it harder to take more debt. In 2021 P. B. Jayasundera stated that President Rajapaksa was aware of the loss of revenue but considered it an "investment" and had no plans of increasing taxes for another 5 years.

To cover government spending, the Central Bank began printing money in record amounts ignoring advice from the International Monetary Fund (IMF) to stop printing money and instead hike interest rates and raise taxes while cutting spending. The IMF warned that continuing to print money would lead to an economic implosion. The tax cuts were also opposed by the former Finance Minister Mangala Samaraweera who noted that as the Sri Lankan government already had far less tax revenue relative to most countries which combined with its high debt load tax cuts would be dangerous. Samaraweera predicted that “If these proposals are implemented like this not only will the entire country go bankrupt, but the entire country will become another Venezuela or another Greece.”

On 6 April 2022, the CBSL allegedly printed 119.08 billion rupees, making it the highest reported amount printed on a single day by the CBSL for the year 2022. The total money added to financial markets for the year 2022 increased to Rs. 432.76 billion.

External debt

Until mid-2000s, the Sri Lankan debt was mainly from multilateral lending agencies, after which it was reoriented under the leadership of Mahinda Rajapaksa to foreign investors and lenders. Sri Lanka issues its first international sovereign bond in 2007, with high interest rates to incentivise investors. According to commentators, the money was used to fund vanity projects rather than projects of national utility.

Sri Lanka's foreign debt increased substantially, going from US$11.3 billion in 2005 to $56.3 billion in 2020. While foreign debt was about 42% of the GDP in 2019, it rose to 119% of its GDP in 2021. By February 2022, the country had only $2.31 billion left in its reserves, yet faces debt repayments of around $4 billion in 2022, which also includes a $1 billion international sovereign bond (ISB) maturing in July.

In 2020, US economist Joseph Eugene Stiglitz, published a report that blamed the quantitative easing policy made by US banks after 2008, for exporting debt bubbles to developing countries including Sri Lanka. In the same year, Chatham House published a report that concluded that Sri Lanka's debt crisis was primarily "a result of domestic policy decisions and was facilitated by Western lending and monetary policy". Their research pointed that after 2008, western central banks had favored a monetary policy of quantitative easing, which created low global interest rates, and had largely facilitated Rajapaksa’s borrowing-and-spending spree as he borrowed low interest ISBs heavily. However the winding-down of quantitative easing in the US after 2013, had later sharply increased Sri Lanka's borrowing costs, and the interests rates doubled, to approximately 10 percent for short term loans, while long-term rates had jumped from 7 to 8 percent to 11–13 percent . Failure to defend their currency, further shrank Sri Lanka’s foreign reserves to only $6 billion by 2016.

In 2020, S&P Global Ratings said Sri Lanka's existing funding sources did not appear sufficient to cover its debt servicing needs, estimated at just over $4.0 billion in 2021. According to the agency Bellwether, "To solve Sri Lanka's 'budgetary problem' in repaying debt, Treasuries auctions have to succeed. When that is done, the 'transfer problem' of foreign exchange will be automatically solved... Instead, with failed Treasury bill auctions filled with printed money, the country is slipping deeper into debt."

Solution:

To resolve the debt crisis, Bellwether noted that Sri Lanka would need a credible fiscal plan and monetary policy, increasing taxes to repay debt, and interest rates and opening of imports would allow taxes to flow back to the Treasury. While it is possible to raise rates and generate dollars to repay the foreign debt by curtailing domestic credit, it is not practical to do so on an ongoing basis for many years. If investors see foreign reserves going up after debt repayments, confidence may come back but it is an arduous affair, which may or may not work given the current ideology.

Sri Lanka resolved its debt crisis by securing a bailout package from the International Monetary Fund (IMF) and negotiating with its creditors to restructure its debt. This involved creating an Official Creditor Committee, led by India, Japan, and France, to coordinate with bilateral lenders. Sri Lanka reached agreements with both official and private creditors to extend repayment periods and lower interest rates. The government also implemented austerity measures, including tax increases and utility price hikes, to stabilize the economy and regain investor confidence.