Economic Collapse in Sri Lanka (HSC SSCE Economics): Revision Notes

Economic Collapse in Sri Lanka

Introduction

In July 2022, Sri Lanka experienced the worst economic crisis in its 74-year history. The government defaulted on its debt for the first time, the country was declared bankrupt, and the currency lost half its value. Severe shortages of food, fuel and medicine, combined with soaring prices and power disruptions, triggered widespread protests that ultimately forced the president to flee the country. This case study demonstrates how external economic shocks, when combined with poor policy decisions, can create a devastating economic collapse.

Background

Prior to the crisis, Sri Lanka had been one of South Asia's more successful economies. However, the country's economic stability proved fragile when faced with a combination of global economic pressures and flawed domestic policies.

The crisis reveals important lessons about economic management in an increasingly interconnected global economy.

Causes of the crisis

The collapse of Sri Lanka's economy resulted from a combination of external shocks and domestic policy failures that compounded each other.

External shocks

Three major external events weakened Sri Lanka's economic position:

• Tourism collapse (2019): Terrorist attacks in 2019 devastated Sri Lanka's tourism industry, eliminating a crucial source of foreign exchange earnings. Tourism had been a significant contributor to the economy, and its sudden loss reduced the country's ability to earn foreign currency.
• COVID-19 pandemic: The pandemic further disrupted economic activity and international trade, reducing both domestic output and foreign exchange inflows. Like many countries, Sri Lanka faced lockdowns, business closures and reduced consumer demand.
• Commodity price surge (2021): Rising global commodity prices from 2021 onwards significantly increased the cost of essential imports such as fuel, food and raw materials. This placed additional pressure on Sri Lanka's foreign exchange reserves as the country had to pay more for the same volume of imports.

Policy failures under President Rajapaksa

After President Rajapaksa's election in 2019, the government implemented several policies that transformed manageable economic challenges into a full-blown crisis:

Protectionist policies: Rather than pursuing conventional strategies for integrating with the global economy, the government adopted protectionist policies designed to reduce imports and save foreign currency. However, this approach failed to address the underlying problems and created new difficulties.

Fertiliser import ban: In an attempt to conserve foreign exchange, the government banned fertiliser imports overnight, claiming this represented a national shift to organic farming. This policy had catastrophic consequences:

• Agricultural output declined sharply
• Food production fell, creating domestic shortages
• The country needed to import more food, increasing rather than reducing foreign exchange outflows
• The currency crisis worsened

Ill-timed tax cuts: President Rajapaksa announced massive tax cuts designed to stimulate economic growth. However, this policy emptied government revenue just as the COVID-19 pandemic struck, leaving the government unable to fund essential services or provide economic support during the crisis.

Soft peg exchange rate system: Sri Lanka used a soft peg approach to manage its exchange rate, where the currency was allowed to fluctuate within a limited range. This system enabled foreign currency outflows to exceed inflows because:

• The central bank had to sell foreign reserves to maintain the exchange rate target
• As confidence in the currency fell, more people and businesses sought to convert rupees into foreign currency
• The system was unsustainable given the declining reserve position

The economic collapse

The combination of external pressures and policy failures led to a severe economic crisis characterized by the exhaustion of foreign exchange reserves and the collapse of the currency.

Depletion of foreign exchange reserves

Foreign exchange reserves are crucial for:

• Defending the currency's value in foreign exchange markets
• Paying for essential imports (food, fuel, medicine)
• Servicing foreign debt obligations

Sri Lanka's foreign reserves fell from almost US$8 billion in 2019 to near-zero by 2022 as the government struggled to defend the currency value and meet foreign debt payments.

Once reserves were exhausted, the government could no longer:

• Prevent currency depreciation
• Import essential goods
• Service foreign debt

The diagram above illustrates the relationship between reserve depletion and currency depreciation. The black line shows total foreign reserves falling dramatically from around US$8,000 million in 2018-2019 to below US$2,000 million by 2021-2022. The purple line shows the Sri Lankan rupee exchange rate, which remained relatively stable around 180 rupees per US dollar until 2021, then spiked sharply to approximately 360 rupees per US dollar during 2022.

Impact on key economic indicators

By the end of 2022, Sri Lanka's economic indicators showed the severity of the crisis:

Shortages and disruptions

The economic collapse created severe shortages of essential goods:

• Food: Agricultural production declined and the country could not afford food imports
• Fuel: Without foreign currency to pay for petroleum imports, fuel shortages led to long queues at petrol stations and transport disruptions
• Medicine: Shortages of imported medicines created a health crisis
• Electricity: Power cuts disrupted daily life and economic activity

These shortages particularly affected the manufacturing and construction sectors, which rely on imported inputs and reliable energy supplies.

International response

The severity of Sri Lanka's crisis prompted support from neighboring countries and international financial institutions. However, this assistance came with conditions requiring policy reforms.

External financial support

Multiple international actors provided financial assistance to prevent complete economic collapse:

World Bank: Lent US$600 million to support basic services and economic recovery programs.

India: As Sri Lanka's closest neighbor, India provided over US$4 billion in support through loans and credit lines. This assistance helped Sri Lanka pay for essential imports.

International Monetary Fund (IMF): Approved a US$2.9 billion debt relief program that was later extended to 2027. This program provided:

• Immediate financial support
• More time for the government to restructure its external debt
• A framework for policy reforms

G7 economies: The group of seven major advanced economies committed to helping Sri Lanka secure debt relief from various creditors.

China: The Export-Import Bank of China announced a two-year moratorium on debt repayments, providing temporary relief from debt service obligations.

Government policy responses

The Sri Lankan government implemented several policy measures, partly to satisfy conditions for IMF support:

Contractionary monetary policy: The central bank raised interest rates by 10 percentage points to combat inflation. Higher interest rates:

• Reduce consumer spending and borrowing
• Slow economic activity
• Help bring inflation under control
• Make the currency more attractive to hold

Fiscal consolidation: The government took measures to improve its budget position:

• Increased value-added tax (VAT) to 15% to raise government revenue
• Cut government spending to reduce the budget deficit
• These measures aimed to restore fiscal sustainability but also reduced aggregate demand further

Structural reforms: The government began reforming state-owned enterprises (SOEs), which often operate inefficiently and drain government resources. These reforms were partly required as conditions for IMF support.

Mass emigration: Approximately 300,000 Sri Lankans emigrated in 2022 seeking employment abroad. While this reduced domestic unemployment, it also represented a loss of skilled workers and human capital.

Recovery and outlook

Recovery from the crisis has been extremely slow, with the economy continuing to face significant challenges.

Short-term outlook

The IMF's forecasts for Sri Lanka's economic recovery were pessimistic:

• 2023: A further contraction of 3% was expected, meaning the economy would continue shrinking
• 2024: Growth of just 1.5% was forecast, representing minimal recovery

These projections suggest a prolonged period of economic difficulty before the country can return to pre-crisis living standards.

Continuing challenges

Several indicators showed the crisis was far from resolved:

Currency depreciation: The rupee remained around 40% below its pre-crisis level in 2023, meaning imports remained expensive and purchasing power remained reduced.

Persistent inflation: Inflation remained high at almost 30% in 2023, continuing to erode real incomes and living standards.

Lessons from the crisis

The Sri Lankan crisis demonstrates several important economic principles:

Integration with the global economy: In an age of globalisation, protectionist policies that attempt to isolate the economy from international trade are likely to fail. Modern economies depend on imports for essential goods and exports for earning foreign currency.

Policy credibility matters: Simplistic policies that ignore fundamental economic principles create more problems than they solve. The fertiliser ban, for example, was implemented without considering its impact on agricultural production and food security.

Exchange rate management: A soft peg exchange rate system can only work if a country has sufficient foreign exchange reserves. Without adequate reserves, the system becomes unsustainable and eventually collapses.

Fiscal responsibility: Tax cuts that deplete government revenue during an economic crisis leave the government unable to respond effectively to external shocks or provide support to affected citizens.

The cost of crisis: Economic collapse imposes enormous costs on society. For Sri Lanka, restoring stability, confidence and living standards will require many years of difficult reforms and slow recovery.

Remember!