By Dr. W.A. Wijewardena
Sri Lanka’s present economic crisis, the worst in its post-independence history, is not the result of the Easter bomb attacks of April 2019 and the outbreak of the Covid-19 pandemic in early February 2020 as conveniently claimed by the country’s political leadership. Surely, these two shocks made some negative impact on the country’s tourism industry by cutting down the tourist inflows significantly, but tourism is only a minor segment of the economy. Tourism brings about a gross income of USD 4 billion annually, adding a domestic value amounting to about 20-30 per cent. Hence, its contribution to real GDP stands at about 1.5 per cent.
Comparatively, the Covid-19 pandemic that led to prolonged lockdowns of the country and its economy in several waves delivered a bigger negative shock to growth derailing the economy from its normal growth path. But that was also less than four per cent and could have been corrected speedily through appropriate policies. Hence, the present acute crisis is not sudden, but the culmination of a gradual deterioration that Sri Lanka began to experience since around 2012. That was driven by an inappropriate economic strategy adopted by Sri Lanka after about 2005.
The strategy so adopted emphasised the development of the war-ravaged economy by concentrating on a domestic economy based economic policy, ignoring that the country had derived its wealth and prosperity through international trade for more than three millennia. As a result, exports did not receive the due recognition which they deserve.
This was evident from the decline of exports relative to the growth in the Gross Domestic Product (GDP). Accordingly, exports which had accounted for 26 per cent of GDP in 2005 fell to 15 per cent by 2010 and further to 13 per cent in 2015. This ratio remained at this level since then and in 2020 it amounted to 12 per cent. Meanwhile, since the domestic economy could not create the demand that could stimulate growth, the real economic growth began to fall from nine per cent in 2012 to 2.3 per cent in 2019. In 2020, hit by the Covid-19 pandemic, the economy contracted by 3.6 per cent. This was the economic environment in Sri Lanka when President Gotabaya Rajapaksa was voted to presidency in November 2019.
Though the new administration was expected to make a turnaround of the economy, economic conditions became worse due to several policy errors committed by it. There was an unsolicited tax concession offered to income tax and value-added taxpayers that resulted in the loss of revenue by about Rs 500 billion or four per cent of GDP annually.
The Government’s attempt at converting Sri Lanka’s agriculture to organic farming overnight backfired with a severe loss in the output forcing Sri Lanka to import its staple food, rice, at a drain of the still available scarce foreign exchange. The drop in the revenue was filled by government’s borrowing from the banking sector, that is, from the Central Bank and commercial banks, in unprecedented amounts. For instance, such borrowings shot up dramatically by Rs 4.2 trillion or 173 per cent during the 25-month period from December 2019.
The result was the increase in the money stock which the ordinary people refer to as ‘money printing’ by Rs 3 trillion or 40 per cent. It caused the foreign reserves to fall on one side, and accelerate the domestic inflation, on the other. Reserves fell from USD 7.6 billion in December 2019 to USD 2.3 billion at end-February 2022. Of this latter figure, when illiquid balances and a SWAP facility in Yuan from China amounting to USD 1.6 billion are removed, the usable foreign exchange balances are reduced to mere USD 400 million or less than one week’s imports.
The gravity of the situation is reflected by the fact that both the Central Bank and commercial banks have survived so far by accumulating short-term foreign debt converting the net foreign exchange balances to a negative of USD 3.2 billion in the case of the Central Bank and USD 2.8 billion in the case of commercial banks. Sri Lanka is seeking to meet its foreign debt obligations of USD 8.9 billion within the next 12-month period with this negative position. An urgent debt restructuring is therefore called for.
India to the rescue It was India which came to support
Sri Lanka in this crucial hour by extending urgent trade credit amounting to USD 1.5 billion on two separate occasions.
On the domestic side, inflation began to accelerate from 4.3 per cent in December 2019 to 17.5 per cent in February 2022. The worrisome feature was the increase in food inflation to 25 per cent mainly due to the shortage of food production due to the Government’s flash organic drive. The true inflation is underestimated when one looks at the long queues for fuel, LP gas, milk foods etc., to mention but a few.
Meanwhile, the decline in foreign reserves dried up the foreign exchange balances in the formal banking institutions creating a long queue for same and a thriving black market for dollars outside them. Despite these imbalances, the Central Bank insisted that the rupee-dollar rate is Rs 200 per dollar, but there were no dollars available at that rate. Consequently, the black-market rate increased dramatically to about Rs 250-60.
This called for quick action, but the Central Bank and the Government continued to refuse allowing the rupee to float or seeking a financial facility from IMF. It aggravated the situation and in early March 2022, the Government was forced to let the rupee go, while making some statements that it is ready to talk to IMF for a facility. The rupee started a free-fall and declined to Rs 295 a dollar or by nearly 50 per cent by the third week of March.
Since there was no assurance from IMF that it would stand-by Sri Lanka at this crucial hour, the Government failed to build confidence among foreign investors that it would manage the situation successfully. As a result, the International Sovereign Bonds or ISBs which had been issued by Sri Lanka started trading at a deep discount, on one side, and the rupee-dollar-rate becoming totally unstable with the black-market rate moving above Rs 300, on the other. For instance, the ISBs which are to mature in July 2022 are now being traded around USD 67 per USD 100 dollar bondskyrocketing its yield rate to 223 per centmaking it the highest yielding bond in the market.
Sri Lanka’s economy is now in shambles. The response of the President Gotabaya Rajapaksa has been to appoint a National Economic Council under his chairmanship made up of a select group of Cabinet ministers and top bureaucrats like the Governor of the Central Bank and Secretary to Ministry of Finance. An advisory group was appointed to advise the Council drawn up mainly from among the leading businessmen. This group has recommended to appoint further committees, sub-committees, experts and legal and financial advisers to work on a possible debt restructuring plan. It is simply a fire fighting exercise and not the way a National Economic Council facing a major economic catastrophe should approach the issue at hand.
India’s emergency trade support will enable Sri Lanka to live through the crisis for another month or so. But once that is totally exhausted, the country’s future will be bleak. Once that stage is reached, it will be painful for all Sri Lankans to find the way-out of the malaise. The present challenge is how to resolve it avoiding a catastrophic social and political uprising.
(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected] )