How did Sri Lanka get embroiled in an economic crisis?

EDIT: As of today (11th June 2024), Sri Lanka’s economy is showing some signs of recovery.

But it is still relevant to understand why Sri Lanka became bankrupt 2 years ago when Sri Lanka which had declared bankruptcy and has defaulted on its $51 billion loan is still struggling to come out of the crisis.

In this post, I would like to discuss three things:

• Historical background of Sri Lankan’s economy (after independence).
• Causes of the current crisis and its consequences
• What does the future hold for Sri Lanka?

So let us start with discussing Sri Lanka’s economic history which is our first topic.

1: Historical background of Sri Lanka’s economy (after independence):-For the sake of simplicity, I have decided to break this topic into two parts.

Part-1: Independence to 1977
Sri Lanka gained its independence from the British on 4th Feb 1948. At that time British left a fairly rich plantation export sector which brought in 90 percent of its foreign exchange earnings. Now the bulk of these
earnings was used in rice imports which accounted for nearly 25 percent of the country’s imports in the early 1950s. Further, most of Sri Lanka’s in the early independence period was from taxation of these plantations. Further, these exports were quite vulnerable to deterioration in the country’s terms of trade.

Source: Development in Independent Sri Lanka: What Went Wrong? on JSTOR

So, this period (1948–60) can be summed as:
There is a plantation export sector that picks up the cost of an extensive food-subsidy program, and the total import bill is dominated by imports of essential foodstuffs of this program. When export revenue falls the government has tended to take the softest short-term option. Cutting back expenditure is difficult and so is devaluation, and so successive governments have opted for selective controls on imports as a balancing measure, controls which were intended in governments have opted for selective controls on imports as a balancing measure, controls which were intended in the first instance as protective measures, but which ended up encouraging and protecting particular industries and firms.

Now for the economy to progress the revenue of the governments must go into development but in the case of Sri Lanka, only 10% (until 1956) to 13% (in 1960) of the GDP went into the development of industries. Even though production of rice doubled between 1948 and 1959 the diversification in any sector including agriculture remained non-existent. So, the country’s foreign reserves started depleting after 1955. The initial economic conditions in the country were interlocking — the welfare program —
depending on plantation taxes, these taxes depending on remunerative prices in the world market, world market price reductions leading to a foreign exchange problem, this problem calling for controls, and controls
leading to import substitution.

Source: Development in Independent Sri Lanka: What Went Wrong? on JSTOR

Here is the summary of interlocking conditions that the Sri Lankan economy was facing.

Import substitution industrialization (ISI)- It is a trade and economic policy that advocates replacing imports with domestic production. (In short like Aatamnirbhar Sri Lanka).

Because of all this, the country went into a foreign reserve crisis from the period of 1960 to 64 and thus the government adopted the scheme of partial liberalization to bring more foreign currency. This period of liberalization was marked by the years 1965–70. However, all the controls on the economy were reintroduced in 1970–77 since the government started thinking that non-essential items were being imported and squandered.

Now as I have told the early 1960s policy of saving foreign currency with the controls and ISI. However, the government failed to develop new forms of income and save the currency(foreign). The industries that were set up to save foreign currency came of no use since they were dependent on foreign imported intermediates. This further dried up foreign reserves. With all these factors combined the net growth of the economy during this time was 3.6%.

The partial liberalization was just a bad attempt(hesitant) at opening the Sri Lankan economy. The government at that time tried to address the Import substitution in agriculture as the best way to reduce foreign currency depletion. However, what it should have done was the reduction in subsidies. However, the emphasis on agriculture did help to increase GDP growth to 5.6% during this period. The export industry was dead since the industrial sector was already under strain due to low imports of raw materials. The International Labour Organization observed in 1971:

“Apart from Burma, Ceylon was the only country in Asia earning less foreign exchange in 1968 than in 1958.”

For the next 7 years, the economy saw a wave of nationalization to counter the depletion of foreign currency and the enactment of the Business Acquisition Act. A similar need to control private-sector leakages of foreign exchange led to the establishment of state trading corporations, export-oriented public-sector firms, and the tightening of regulations. The government launched a “Grow Food” campaign to counter food shortages. The regime was severely affected by external shocks such as the oil price hike effected by the Organisation of Petroleum Exporting Countries (OPEC). Consequently, it was not uncommon to find some firms using more foreign exchange than they saved.

Source: Development in Independent Sri Lanka: What Went Wrong? on JSTOR

Sources GDP for 1951–56 was obtained from the National Accounts of the Department of Census and Statistics. GDP for 1956 onwards was obtained from the Central Bank Annual Reports. Expenditure figures were obtained from Treasury Estimate.

Now even though the situation of external reserves increased in 1974–75, the government was unable to use them to its full benefit due to the restriction on imports. Thus the key industrial areas were starved of inputs. Sri Lanka had done an astonishing job in welfare policies (around 10% of GDP until 1977) but it performed poorly in other sectors. It had increased its per capita by only 60$ to reach 200$ and for comparison, the GDP per capita of Singapore at the same time was 900$.

This very broad picture emerged due to several key factors:

• Lack of a long-term vision.
• Welfare policies.
• Uncertainty in the key economic sector.
• The policy of export pessimism.
• Lack of openness in the economic regime.
• Lack of external assistance.

There was very little external assistance in averting the foreign exchange crisis. L A Wickremaratne observes that in the 1950s policy-makers felt that

“Even if there was a downward trend in export earnings Sri Lanka need not resort to foreign aid and foreign loans”.

RS Olson observes that by nationalizing petroleum Sri Lanka became the first country to which the Hickenlooper Amendment, which envisaged suspension of United States aid for expropriating American property without compensation, was applied. In general, the ideological perspectives of the 1956–65 and 1971–77 regimes on external assistance made the regimes somewhat unpopular within the Western donor community. The very partial nature of the liberalization exercise of 1965–70 made the community reluctant to fully back the exercise with massive assistance. But it could be argued realistically that had there been adequate foreign assistance, Sri Lanka might have opened up more in 1965–70.

In a nutshell, the period 1948–77 witnessed attempts to overcome a foreign exchange crisis by controlling the economy and partially opening it up. It became difficult during this period to identify an appropriate strategy. The ‘capitalism vs socialism’ debate was far from settled, and the initial
conditions in Sri Lanka made explicit action to modify the economy “difficult and risky and hence easily optionable.

Part 2: 1977 to 2000
By 1977 the economy was in an exceptionally unfortunate position. The country sorely needed help. A radical departure from welfare-oriented and inward-looking policies thus occurred in 1977. This departure was characterized by economic liberalization and the implementation of economic growth. Encouraging export-led industrialization by offering domestic entrepreneurs incentives and encouraging foreign direct investment in the newly established export processing zone were key features of the new policy regime. Implementing the first budget of the new regime was by no means an easy task. The majority of those in the existing private sector who were used to the ‘licensing raj’ were against any attempt to liberalize the economy. So were the bureaucracy, most parliamentarians of the ruling party, including some leading cabinet members, and the media. Despite this resistance, a small group around the minister of finance pushed boldly ahead with the backing of the prime minister. The bold measure of getting rid of the food subsidy was made possible by the massive mandate given to the new government. The mandate was given to the new government. The government embarked on a massive public investment program centred on the Mahaweli scheme.

The Mahaweli development program also gave the economic growth process a boost. The only five-year period since independence during which Sri Lanka’s average growth rate exceeded 6 per cent was 1977–1982. Three positive external developments assisted the liberalization initiative namely:

• Remittances from abroad, in particular, west Asia, increased from 0.8 to 5.5 per cent of GDP between 1978 and 1982).
• The exports of garment industries increased from 2.1 to nearly 16 per cent of all exports between 1977 and 1982.
• The annual arrival of tourists increased from 1,92,592 in 1978 to 4,07,230 in 1982 (bringing in large sums of foreign exchange and providing employment to many people).

The optimism regarding economic growth that prevailed from 1977 to 1982 soon faded away. The ethnic conflict that started in 1983 came as a major “internal shock” to the economy. The regime found it difficult to further liberalize the economy due to the political and economic instability that resulted from this shock. Growth rates started decelerating in 1983 and averaged 3.7 per cent between 1983 and 1989.

Many factors other than the ethnic conflict such as — the Southern rebellion, policy mismanagement, and political-economy factors, disturbed the policy regime, but the ethnic war’s contribution to this was significant. Although Sri Lanka liberalized its economy three years before the World Bank embarked on its first structural adjustment loan, the reform process substantially slowed down by the mid-1980s. Sri Lanka was one of the pioneers among the developing countries in opening up.

In 1977 the Soviet bloc was still powerful, the received evidence from the East Asian success stories was quite weak, neighbouring countries, including India, had closed economies, and above all, there was no consensus on the virtues of an open economy. Given this situation, there could also have been some reservations about pushing the liberalization process too far. Hardly any new liberalization measure was adopted between 1983 and 1988, and policymakers were, inter alia, preoccupied with the ethnic conflict.

So what hindered Sri Lanka’s ability to have high growth in the 1977–97 Period? Let us discuss some of the major factors:

• The North-East War: The uncertainty created by the ethnic war was the main deterrent to foreign investment. Harris Corporation even started building a plant with an initial employment capacity of 1,850. However, the company withdrew from the country after the 1983 ethnic riots leaving a half-built plant. Sri Lanka is perhaps the only country in the world to offer extraordinary biodiversity of sea beaches, mountains, and wildlife, not to mention ancient cities, within short travelling distances. Unfortunately, the country couldn’t be able to take advantage of this because of the conflict.
• Macroeconomic Instability: The government was of the view that the deficits would decrease once the projects under the Mahaweli scheme were completed in the mid-1980s and that the environment for private sector investment would turn conducive thereafter. But this objective could not be achieved due to escalating defence expenditure from the mid-1980s, and the 1985–1996 period witnessed budget deficits that averaged above 10 per cent of GDP. Switching from a welfare-oriented economy to an investment-oriented one at a time of war thus turned out to be switching from ‘welfare to warfare’.

Source: Development in Independent Sri Lanka: What Went Wrong? on JSTOR

• Low Investments Domestic Savings: The East Asian high- performers in aggregate invested 35 percent of their GDP and saved 37 percent in 1990. As a group, they were thus net exporters of capital. By 1990, Sri Lanka’s investment, at 22 per cent of GDP, was still stagnating at a little above East Asia’s 1965 investment level, while savings were not more than 17 per cent of GDP — which East Asia had achieved in 1965. Low growth explains low savings and this, in turn, explains low investment.

This explains the poor condition of the economy of Sri Lanka from 1948 to 2000.

So, this brings us to our second topic — “Causes of the current crisis and its
consequences”

Let us talk about the causes of the recent debt crisis in Sri Lanka.

• Tax cuts and money creation: It is important to note that there were several key tax policy changes made in late 2019 that contributed to the decline in revenue. (https://www.veriteresearch.org/2021/10/27/why-did-sri-lankas-budget-deficit-increase-in-2020/) Some of these were:
  (1) The abolition of the nation-building tax, economic service charge, and PAYE tax.
  (2) The exemption of withholding tax for residents.
  (3) The changes in various tax rates such as the standard corporate income tax rate being reduced from 28% to 24%, VAT (other than financial services) being reduced from 15% to 8%, tax rates for sectors such as construction and manufacturing being reduced and exemptions being granted for other sectors such as IT and agriculture, and the
  threshold is increased for the registration for VAT from Rs. 3 million per quarter (Rs. 12 million per annum) to Rs. 75 million per quarter (Rs. 300 million per annum), and finally.
  (4) The government ban on the importation of most motor vehicles from April 2020, could have led to a significant reduction in the excise duty revenue from motor vehicles.
• Agriculture: In April 2021, to revive the falling foreign exchange reserve, President Gotabaya Rajapaksa
  announced a complete shift to organic farming banning all chemical and inorganic fertilizers. A part of the nation’s economy is spent on importing chemical fertilizers (https://scientist.lk/2021/06/08/sri-lanka-going-organic-rethink-the-strategy-agriculturists-write-to-president/#google_vignette).
  Instead, it hurt the economy, causing huge economic losses. The decision to shift organic farming in the coming decade was a good idea but the overnight shift impacted negatively. Transforming the production of tea and other agricultural products to organic farming led to lower yields that resulted in a loss of $425 million. Sri Lanka which was self-sufficient in rice production ended up importing rice within 6 months. Tea was a major contributor to export but it was no longer the case (https://en.m.wikipedia.org/wiki/Sri_Lankan_economic_crisis_(2019%E2%80%93present)#:~:text=The%20crisis%20is%20said%20to,19%20pandemic%20in%20Sri%20Lanka.)
• Fall in currency and foreign exchange reserves: Sri Lanka lacks sufficient foreign currency for paying for imports or debt servicing. As of mid-2020, Sri Lanka had reserves sufficient to pay for four to five months of imports. These reserves have only further declined since then, and by the end of 2021 the situation became critical when reserves dropped to the equivalent of only one month of import payments. The government managed to make it to 2022 through currency swaps with India and Bangladesh. However, the lack of foreign currency reserves undermined confidence in Sri Lanka and made it impossible to open import letters of credit necessary for facilitating imports.

Source: https://www.nippon.com/en/in-depth/d00840/

• External debt: Since 2010 Sri Lanka’s foreign debt more than doubled between 2010 and 2020. While foreign debt was about 42% of the GDP in 2019, it rose to 119% of its GDP in 2021. By the end of 2022, the country is due to pay US$4 billion to debtors, whereas in April 2022, government reserves amounted to US$2.3 billion. (https://www.colombotelegraph.com/index.php/sri-lankas-foreign-debt-crisis-forecast-for-2021/) To resolve the debt crisis, Sri Lanka would need a credible fiscal plan and monetary policy, taxes have to be hiked to repay debt, and interest rates and opening of imports would allow taxes to flow back to the Treasury ( 2019-present Sri Lankan economic crisis - Wikipedia). A massive foreign debt burden of approximately $5 billion with China alone is a major contributor to this crisis. Sri Lanka is repaying a $1 billion loan acquired from Beijing in 2021. It also owes a large sum of money to India and Japan.

https://www.dw.com/en/sri-lankas-foreign-debt-default-why-the-island-nation-went-under/a-61475596 | https://tradingeconomics.com/sri-lanka/external-debt

• The International Sovereign Bond Debt Trap: In historic terms, Sri Lanka’s current external debt ratio is hardly a precedent. The country endured higher external debt burdens, crossing 60 per cent of GDP, in the 1990s, but managed to avoid a total default. The difference between now and then is that a greater share of the country’s external debt is borrowed from international capital markets at high interest rates. From 2010 to 2021, the ISB share of Sri Lanka’s external debt stock tripled, going from 12 per cent to 36 per cent. Yet in 2021, ISBs accounted for a monster 70 per cent of the government’s annual interest payments. These figures highlight the extent to which high-interest borrowing from international capital markets can eat into the foreign currency cash flows of a country, especially when it is wracked by external shocks such as the COVID-19 pandemic and conflict in Ukraine.

Source: https://www.nippon.com/en/in-depth/d00840/ | https://thediplomat.com/2023/03/the-real-cause-of-sri-lankas-debt-trap/

• A Fragile Economic Structure: Even though the Gotabaya administration’s tax cuts and agricultural policy failures were responsible for the crisis. However, problems with Sri Lanka’s overall financial and economic policies are also major contributors to Sri Lanka’s current situation. First, the government knew that repaying foreign loans required the accumulation of foreign currency. Sri Lanka’s main sources of foreign currency come from exports, tourism, and remittances from Sri Lankan workers abroad. However, Sri Lanka’s ratio of exports to GDP, which was just 33.3% in 2000, has only continued to decline. If Sri Lanka enjoyed a positive net export balance due to a low level of imports, then exports being a small percentage of GDP would not be a major problem. However, Sri Lanka relies heavily on imports for raw materials, intermediate goods, and investment goods, and has a persistent trade deficit. Sri Lanka, therefore, has only a small buffer in the event of contingencies that affect tourist income and remittances.

Source: https://www.nippon.com/en/in-depth/d00840/

• Tourism: Sri Lanka used to get around 10% of its GDP and around 455 million dollars of foreign currency from tourism. Thus, it formed a major source of income for the government. But in 2019, the bombings took a toll on the tourism sector. (https://en.m.wikipedia.org/wiki/2019_Sri_Lanka_Easter_bombings)

Source: https://www.orfonline.org/expert-speak/how-tourism-in-sri-lanka-went-downhill

• Effect of covid 19 on tourism: Sri Lanka’s tourist arrivals had fallen by 70.8% from a year earlier to 71,370 in March 2020, amid the COVID-19 crisis, the latest data released by the Sri Lanka Tourism Development Authority (SLTDA) showed. As I have said earlier foreign currency that came through tourists fell to around $3 million in July 2021. (https://bizenglish.adaderana.lk/covid-19-impact-sri-lanka-tourist-arrivals-down-70-8-in-march-2020/)

Source: https://doi.org/10.1016/j.jhtm.2023.03.013

These are the main reasons of economic crisis in Sri Lanka.

Now let’s look at the consequences of the crisis. In 2022, Sri Lanka has defaulted on all of its debt payments of $51 billion.

https://www.thehindu.com/news/international/sri-lanka-opts-for-pre-emptive-debt-default-to-combat-crisis/article65314691.ece#:~:text=Sri%20Lanka%20on%20Tuesday%20announced,with%20a%20grave%20economic%20crisis.

Furthermore, in January 2022, Sri Lanka was reluctant to take a loan from the IMF but now it has agreed to ask the IMF for a bailout as well. See it may seem strange why Sri Lanka was reluctant to take a loan from the IMF but it was pretty much what every country would do. The reason is many people think it is easy to take loans from IMF but no, it isn’t. IMF has its terms and conditions for granting loans and one of them is that the IMF will dictate to the country how to spend the money which is interference in the government of a country and no country wants interference. So that is why governments are pretty much reluctant to take loans from the IMF. Instead, they try to find other countries that would give them money. Sri Lanka, instead of asking IMF asked China for help and India as well. India gave a $1 billion credit line to Sri Lanka to run its government. (https://www.google.com/amp/s/www.aljazeera.com/amp/news/2022/3/18/sri-lanka-secures-1bn-credit-line-from-india-as-imf-signals-help)

Also, India witnessed that large number of refugees coming from the Sinhala Land to India through the Palk Strait & Gulf of Munnar. India may find it difficult to handle such a big influx of refugees. We witnessed it in the nineties but this time it is going to be more severe. A large number of refugees have already started coming and India needs to form a strong policy to handle this issue. (https://www.google.com/amp/s/m.timesofindia.com/india/19-more-flee-lanka-for-tamil-nadu-total-arrivals-in-rameswaram-hit-39/amp_articleshow/90768573.cms)

Furthermore, Since China has acquired ports in Sri Lanka it may pose a threat to India’s sovereignty since Sri Lanka is only 54 km away from India. Also with such an economic situation and with the fact that the Sri Lankan government has asked for a $2.5 billion emergency aid from China, there is a threat that China may gain its influence in the island country. It has been trying a lot for the last few years but owing to Indian diplomacy, things could not succeed the way Dragon wanted but currently things are different now. Since the location of Sri Lanka is strategic, India must be cautious of every Chinese attempt to influence Sri Lanka. (https://www.google.com/amp/s/www.india.com/news/india/sri-lankan-economic-crisis-five-reasons-how-it-can-affect-india-5315898/amp/)

So, finally, we come to our last topic, “What does the future hold for Sri Lanka?”

As of now, it is difficult to predict what is gonna happen to Sri Lanka in the near future. Since Sri Lanka has now defaulted on all of its loans it may get a bailout package from the IMF. The protests against the Sri Lankan government have intensified with a lot of people vandalizing shops, offices, cars, etc. A national emergency has been imposed in Sri Lanka as well and the army has come to take control. The governor of the Central bank of Sri Lanka said:

“We want to give a firm signal. We are serious about what we are doing and wanted independence in what we are doing. And as a result, we took the necessary and sufficient actions today immediately to address the situation. With this situation I would expect some stability in the market confidence and the positive reaction from the Monday when markets open,”.

The central bank of Sri Lanka has further hiked the interest rate to 14.5% to avoid depreciation of SL rupees against the dollar to stabilize the country. Neendal Weerasinghe, the bank’s governor, claimed attempts in the previous year to regulate foreign exchange markets and maintain interest rates artificially low led to unprecedented economic instability. He said:

“We are now in damage control mode. We would not have had to make such a sharp increase if rates had been raised incrementally over a period of time,”

Some other things they may do are;

• As I have mentioned in the very first topic Sri Lanka didn’t try to expand the export items that is it never diversified. Exporting traditional products such as tea, rubber, and coconut should not be halted. So if Sri Lanka wants to never diversify. Exporting traditional products such as tea, rubber, and coconut should not be halted. So if Sri Lanka wants to increase its exports it has to diversify to other export items.
• Further, since Sri Lanka has a lot of tourist attractions it may try to improve tourism to new places and further focus more on curtailing the terror attacks and improving the security of the tourist attractions. Sri Lanka needs a well-organized plan for promoting
  tourism. Here, implementing new tourism concepts should be encouraged.
• Also, as said earlier Sri Lanka doesn’t have a great pool of entrepreneurs to improve its private sectors. Before the pandemic period, Sri Lanka had a low presence of entrepreneurs — less than 1.5% of the total population. The government needs to encourage those entrepreneurs with skills, capital, and guidance to increase their production for both domestic and international markets. Here, providing education about entrepreneurship, training to start and develop a business, excluding entrepreneurs from higher tax requirements, and other policies should be prioritized.
• Encourage people to take up other professions which are in high
  demand today and leaving the demand today and leaving the
  traditional professions like agriculture. Also, on the other hand,
  encouraging self-employment in traditional areas such as the handloom and batik industries, coconut-related industries, or spice production among the people who don’t have access to education or computers is important. Students and graduates in Sri Lanka can also consider freelancing as a new experience rather than seeking a government job.
• Also, the Rajapaksa dynastic rule has to be got away with. As of now, 9 members of the clan are sitting at the top of the Sri Lankan politics
  and they have their people sitting at nearly every important position like the prime minister, the president, the finance minister, the chief of staff, etc.

There are ways with which Sri Lanka can recover but as of now, the situation is hopeless. Sri Lanka first needs to get enough to stabilise the economy. Further, there has been a lot of instability in the politics of SL owing to the economic crisis.

Resignation of 26 cabinet ministers notified through Gazette - Breaking News | Daily Mirror

Footnotes:

Is Sri Lanka Really a Victim of China's 'Debt Trap'?

The Real Cause of Sri Lanka's Debt Trap

Explainer: Sri Lanka on the edge as debt burden mounts

Explained: 10 things about Sri Lanka's worst economic crisis - Times of India

Colonialism Anew. Sri Lanka enmeshed in Western Debt 'Nets'

Sri Lanka's China 'debt trap' fears grow as Beijing keeps investing

Economic Crisis in Sri Lanka: An Assessment

Sri Lanka - national debt 2022 | Statista