The economic crisis endangering Sri Lanka’s future

The damage of the COVID-19 pandemic has combined with a mounting financial crisis to pose a serious threat to Sri Lanka’s development, Jeevethan Selvachandran writes.

Since March 2020, the COVID-19 pandemic has all but halted movement across the world and dominated global headlines. While attempts to return to normalcy are progressing in developed countries, still-developing countries are a long way from discussions of complete pandemic recovery and future development. One of these is the democratically fragile and war-ravaged Sri Lanka.

As well as the pandemic, Sri Lanka has been facing a borrowing crisis. By 25 July, Sri Lanka had managed to repay a billion dollar bond in foreign currency debt, but two more payments – two bonds of $1.5 billion and $1.25 billion – of debt are due in 2022 and 2023.

The first payment was financed through foreign exchange reserves, and as such the government has introduced capital controls, limiting outgoing of foreign currency. This has prompted calls for International Monetary Fund’s (IMF) assistance to solve the economic crisis.

The proposal was denied by Sri Lanka, as it has been pursuing its own solution – securing financial assistance via foreign exchange swaps with China, South Korea, Bangladesh, and India to bolster its reserves and finance imports.

Despite achieving some pay-off and financial assistance from this approach, the economy remains in a precarious state. This in turn led President Gotabaya Rajapaksa to proclaim an economic emergency to contain soaring inflation, which had in turn led to a spike in food prices.

Since 2020, in order to curb the outflow of foreign currency, Sri Lanka also imposed import restrictions on motor vehicles, agricultural products, and consumer durables.

Prior to this, Sri Lanka’s foreign reserves had fallen to $2.8 billion at the end of July, from $7.5 billion in November 2019, when the Rajapaksa-led government assumed office.

More on this: A surging crisis in Sri Lanka

The Sri Lankan Rupee has lost more than 20 per cent of its value against the United States Dollar since 2019 – forcing the Central Bank of Sri Lanka to increase its interest rates in order to strengthen the local currency.

The weakening of the rupee is expected to make repayments more costly. Despite undertaking measures to curb the crisis, imports are outpacing the country’s exports of tea, rubber, seafood, and garments due to rising expenditure and limited revenue.

Then, the country’s credit rating was downgraded to CCC by Fitch Ratings, indicating that investment is a substantial risk.

Atop it all, Sri Lanka’s lucrative preferential trade status of the European Union, worth $360 million annually, has come under threat due to alleged violations of human rights. If the decision to cancel this is upheld by the European Union, then the United Kingdom could also follow suit. This would be a huge additional economic blow, as combined exports to these markets account for 30 per cent of Sri Lanka’s total exports.

All this raises a central question: how long can the Sri Lankan government rely on financial assistance from trading partners without a concrete strategy and plan?

Notably, the government is primarily relying on China for additional support, as it’s an integral part of the ambitious Belt and Road Initiative. But this raises its own question of whether China is willing to lend money that may end up going nowhere.

For now, China seems willing to lend, but in the longer term, things are less clear. Since India seems unwilling to do the same, the strategic incentive for China to lend to Sri Lanka may dwindle as time goes on.

More on this: Better late to the party than never?

To make things worse, the foreign exchange crisis has combined with the heavy economic backlash of the pandemic to severely impact Sri Lanka’s growth, which was highly dependent on tourism, investments, exports, and remittances – all sectors vulnerable to the pandemic.

Whether Sri Lanka is optimistic about economic revival and growth is another case, but the World Bank says it is hopeful that the island nation will bounce back – though it says this with caution.

In its 2021 development report, it recommends an export-oriented and private investment-led growth model as the best way for the country to sustainably develop.

If Sri Lanka sticks to this pattern and promotes trade and private investment – including foreign direct investment – it could create the necessary conditions for a thriving economy. To do this, it must facilitate public-private partnerships in key sectors like infrastructure, health, and tourism.

Other steps Sri Lanka can take include removing bans on fertilisers, as the country isn’t fit for organic-based agricultural production. This could help ease the soaring inflation and reduce food prices.

Secondly, the government should turn to the IMF to uphold its foreign exchange reserves, while also collaborating with international economic experts to make a blueprint to tackle the economic crisis amidst the pandemic – similar to the neighbouring Indian state of Tamil Nadu.

Still, Sri Lanka’s dire financial state clearly shows that restructuring is required in order to make progress. Against the backdrop of the ongoing crisis, financial expert Dr Nishan De Mel noted that, most of all, Sri Lanka needs “a publicly-backed plan that will establish [investment] credibility.”

To achieve this though, steps like these must be begin now. Otherwise, Sri Lanka’s position could deteriorate further.

This article is part of Policy Forum’s In Focus: Developing Asia section, which brings you analysis from experts on the policy challenges facing its least developed members.