Causes Of Economic Crisis In Sri Lanka & Lessons For A New Age

By H. N. Thenuwara –MAY 20, 2022

Dr. H. N. Thenuwara

The Crisis

The fourteenth-century painter Ambrogio Lorenzetti has painted magnificent frescoes entitled Consequences of Good and Bad Government on the walls of the historic city council chamber in Siena, Italy. Those frescoes show that when bad policy decisions are made death and destruction are everywhere in the city. When the government makes good policy decisions, peace, justice, wisdom and harmony triumph. With good policy judgments, citizens engage in all forms of productive labour, and abundance prevails.

In the twenty second year of the twenty-first century, Sri Lanka faced a textbook case of economic and political crisis as a result of a series of incompatible and unsound public policies, and unchecked anti-competitive practices and corruption. Shortages in essential food, medicine, energy, and other industrial inputs are everywhere, while social disharmony prevails.

In early April 2022, Sri Lanka’s Central Bank disclosed quite abruptly that it had run out of foreign reserves. The Central Bank did not warn the general public that it was going to run out of reserves, nor did it have any plans to avert the adverse outcomes. The result was the inability to import and supply essential consumption goods such as fuel and medicine, and honour foreign debt obligations. Sri Lanka defaulted on foreign debt and faced the consequence of being downgraded to the default grade (junk) by the international rating agencies. The default grade makes it harder to borrow further from financial markets. Meanwhile, the stubbornness of the government and severe economic hardships have led to a political revolt akin to an ‘Arab Spring’.

Immediate Response

The government is pursuing the only immediate response available to them. That is to use its diplomatic connections and international relations to secure funds to maintain an uninterrupted supply of energy, food and medicine. It is the prime responsibility of all government institutions involved in policy making.

The controls on exchange rate have to be dropped for it to freely float. Initially there will be over-depreciation. But, it will discourage non-essential imports, and encourage domestic production, exports, tourism and inward remittances.

The government may request that all individuals give up corruption voluntarily, or severely crack down on it. The new Prime Minister has already warned the country of impending hardships. It is unavoidable that people have to practice a frugal way of living. At the same time, the government has to look after the poor and vulnerable groups of the society. Assistance has to be given immediately, utilizing existing government structures.

It is the responsibility of all political parties to come together to find a solution to ease political agitation by the general public. In the long-run a set of sound economic policies needs to be implemented after carefully analysing the causes of this crisis.

Comparison with East Asia and Greece

The East Asian crisis began in 1997 in Thailand. Thailand was maintaining a fixed and overvalued exchange rate. In addition, Thailand had an open capital account where private firms and individuals freely sent or received foreign exchange. When the exchange rate was unsustainable and had the risk of sudden depreciation, foreign exchange flew out of the country. The government and private sector could not meet their debt obligations. The crisis propagated to several other East Asian countries such as Indonesia, Philippines, South Korea, Taiwan, Malaysia and Singapore. Most of the countries sought assistance from the International Monetary Fund (IMF). As the exchange rate stabilized, and interest rates raised, foreign funds began to flow back. However, even during the worst times, all those countries had international reserves sufficient for more than three months of imports according to data from the World bank.

The Greek crisis began in 2009 with the government’s inability to honour debt repayments. The exchange rate was not an issue because Greece had adopted the Euro as its currency, the common currency of many European countries.

Greece had a large government expenditure and low tax revenue. Greece had been borrowing from international markets to fill this gap, but an accurate accounts of those borrowings had not been maintained. At a point when the Greek government could not borrow to repay loans, the government had to be bailed out by the IMF and other strong European countries. The recovery was very slow because the economy was weak, government revenue was weak and any changes to government expenditure were not flexible.

Sri Lanka’s crisis is different from the East Asian Crisis but somewhat similar to the Greek crisis. Sri Lanka has a problem of inability to pay government foreign debt, and inability to afford energy imports. However, availability of energy was not a serious problem in East Asian countries or Greece. The recovery in Sri Lanka would not be easy since the net inflow of foreign exchange has to come from further borrowings and foreign aid.

Causes of the Crisis

Sri Lanka has been living with a series of severe political and economic problems caused by successive governments. The collective errors caused by the government in the recent past were the ‘last straw that broke the camel’s back’.

The already strained public finances had an unbearable negative shock with massive tax cuts initiated by the new government. The government began to lose over Rs 500 bn annually. The hitherto unseen commitment to fix the exchange rate at Rs 200 per US dollar decimated the country’s reserves. In the past, when the reserves came closer to three months of imports, the Central Bank sought help from the IMF. This time the Central Bank remained taking no action until the last dollar was gone. Furthermore, the country was given shock therapy with the fertilizer policy. These shocks were too much to bear for an economy already compromised by the COVID-19 pandemic.

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