— Neeraj BR
Imagine going to your ration shop every month. Whom do you see? The store owner handles the supplies, and a small group of people line up to get them. What if the next time you go there, it is not the store owner but a military officer handling the supplies, and the store is surrounded by military personnel? The small group of people is now a long queue? And you have to wait longer to get less than what you usually got? Terrifying, right?
This sight was commonplace in Sri Lanka for three months when Sri Lankan President Gotabaya Rajapaksa declared an economic emergency on Aug 31 to contain the increasing inflation due to an increase in food prices.
Timeline
The three-month economic—and the consequent food—an emergency can be attributed to the currency depreciation of the Sri Lankan Rupee due to a fall in foreign exchange reserves and other poor economic choices by the Sri Lankan government. The Sri Lankan government declared an economic emergency under the Public Security Ordinance. Explain here more, what is the importance of this, does the next line explain this, if so, add: “That is,” The military was given powers to prevent hoarding, control the supply of essential goods and provide them to buyers at fair prices.
State stores sold only 1kg rice/person during the rationing phase which lasted a month from September to October, and similar rationing was enforced for sugar and lentils. Part of the food shortage could be attributed to the forex shortage. At least 1300 containers with milk powder and other essential commodities were stuck in the Colombo port for about three months from June to September, unable to acquire bank documents on letters of credit due to the forex crunch. The Central Bank of Sri Lanka had to authorize $50 million amid a foreign exchange shortage to secure the release of the containers.
The government finally lifted the rationing on essential items like rice, LPG, and milk powder on Oct 8. However, it is feared that there would be a 37% jump in food prices. The price of milk powder/kg has risen by 33.3% to 1300 Sri Lankan Rupees, and the price of gas is expected to increase by 35%. Furthermore, the price of rice and the black market for pulses have increased ever since the curbs were lifted.
Hence, it is critical to view the entire episode not from a food production perspective but from a macroeconomic mismanagement perspective.
A Brief Outline about the Sri Lankan Economy
Foreign trade is an important component of Sri Lanka, as it is an island nation. Imports of Sri Lanka include petroleum, consumables, machinery, and capital, while tea, rubber, and coconut are exported. Sri Lanka’s economic history can be traced to two phases: the post-independence phase (1948-1976) and the post-1977 liberalization phase.
The post-independence phase of Sri Lankan economic history followed a trajectory similar to that of India. It started out with the objectives of equity and economic growth through import substitution in manufacturing and food production. Welfare measures like food price subsidies, price controls on consumer goods, and free education and health services were implemented, which helped improve Sri Lanka’s overall human development.
However, these measures came at the cost of the country’s capital growth and ability to invest, leading to high unemployment and low wages. In 1953, Sri Lanka tightened up exchange controls with the Exchange Control Act. Sri Lanka partially placed controls on its economy in 1961-1964, relaxed it in 1965-70, reimposed controls following the 1967 Sterling crisis, and further tightened from 1970-to 77 in the wake of the collapse of the Bretton Woods system. Therefore, newly established industries could operate below full capacity due to a shortage of imports caused by trade deficit and increased government intervention and expropriation proved to be the death knell for industries.
The liberalization phase is aimed at stimulating private investment and increasing the country’s foreign exchange holdings through export-oriented economic activities. Though there were initial successes (a GDP growth rate of 5% and increasing per capita income), they are severely impeded by the ethnic conflict.
The persistent trade imbalance has led to increased reliance on foreign aid to meet the country’s import requirements, which added to its foreign debt. Foreign debt as a percentage of GDP reached as much as 75% in 1995, before falling down to 59% before the turn of the century. Sri Lanka faced the threat of bankruptcy in 2001, with foreign debts accounting for 101% of the GDP, which was averted through substantial foreign loans in the wake of a ceasefire agreement with the LTTE.
However, then Sri Lankan President Mahinda Rajapaksa halted the privatization process during his tenure from 2005to 2015, launching new companies and renationalizing previously state-owned enterprises. PSUs became less efficient and overstaffed, and nepotism in employment and frauds were discovered, leading to huge losses. The resurgence of the civil war from 2005 to 2009 led to a steep increase in defense expenditure. The unlawful situation prompted donors to cut aid to Sri Lanka. During this time, the EU also revoked its GSP plus preferential tariffs, which provided tariff reductions on various products from Sri Lanka, in 2010 due to alleged human rights violations, costing $500 million per year.
Debt Sustainability
One of the reasons why Sri Lanka is in the situation it is now is due to its lack of debt sustainability, which the IMF defines as the ability of a government to meet its debt obligations without extensive financial assistance or defaulting. For many years, Sri Lanka had received long-term concessionary loans to meet its needs. However, it is forced to search for alternate means of financing once it became a middle-income country. By the end of 2019, 56% of Sri Lanka’s foreign loans were commercial borrowings, mostly International Sovereign Bonds.
The government of Sri Lanka had to pay around 900 million Sri Lankan Rupees in 2019 as interest for non-concessionary loans taken by successive governments to finance various (some virtually unproductive) projects like the Lotus Tower in Colombo.
Sri Lanka’s debt-GDP ratio was at 101% in end-2020 and is projected to rise to 108% by 2022. It is also estimated that around $4.5 billion will be needed by Sri Lanka annually to meet its foreign debt obligations.
Meeting this target is a Herculean task for Sri Lanka, given that it is running on a “twin deficit”- budget deficit and balance of payments deficit. Forex reserves of Sri Lanka have shrunk to $2.8 billion following the settling of a $1 billion bond in July 2021. Moreover, the low credit ratings Sri Lanka has received have made it harder to acquire loans. The under subscription of the Sri Lanka Development Bonds means dwindling investor confidence and thereby dwindling finances.
Sri Lanka has resorted to short-term measures like currency swaps with China and Bangladesh to stay afloat. However, this measure comes at a price- it has high-interest rates and short repayment periods and cannot be used as the beneficiary pleases.
Despite the worsening situation, Sri Lanka is hell-bent on not availing of an IMF bailout loan, but circumstances are most likely to push Sri Lanka there.
Forex Shortage
Sri Lanka’s foreign exchange reserves went from $6.93 billion in August 2020 to $2.36 billion in July 2021. The value of the Sri Lankan Rupee went down by 7.5% against the USD, which forced the Central Bank of Sri Lanka to increase the domestic interest rates to support the local currency.
Given that Sri Lanka is a net importer, depending heavily on imports even to meet its basic food needs, a fall in the rupee value means an increase in the cost of imports, which translates to a rise in the price of food items. Around 57% of the imports are intermediate goods, while only 20% are consumption goods. With the increase in commodity prices, Sri Lanka will need more dollars to purchase imported goods, which it has very little of at present.
In early 2021, the Central Bank of Sri Lanka prohibited traders from exchanging more than 200 SLR/USD and stopped traders from entering into forwarding currency contracts. Additionally, the Central Bank notified private banks that they have to seek dollars in the market as the Bank will no longer lend dollars to them. Exporters in possession of dollars are not willing to give them up in hopes of scoring high from a further fall in the value of the Sri Lankan Rupee.
Sri Lanka received a non-debt inflow equivalent to $787 million (544.8 SDR) using the IMF’s Special Drawing Rights aimed at helping countries recover from COVID-19 and another $3.5 billion through currency swaps, like $150 million from Bangladesh. But this will amount to only about six weeks to two months of imports, which may be shortened if one considers the upcoming debt settlements, especially the $6.1 billion in dollar-denominated debt repayment in the next two years.
Tourism used to bring in around $3.5 billion every year as foreign exchange. Till July 2021, only 19300 tourists have visited Sri Lanka, about 1% of the approximately 2.3 million tourists annually. There is a fall in tourism, which accounts for 10% of Sri Lanka’s GDP and is the third-largest contributor of forex for Sri Lanka. 2019 saw an 18% dip in tourism, a first in a decade of consistent growth.
Monetary Policy
Sri Lanka follows a managed floating exchange rate system, where the central bank intervenes in the market with its forex reserves or by adjusting the interest rates to keep the valuation of the domestic currency within a specific range. The Central Bank of Sri Lanka has vehemently protected the Sri Lankan Rupee over the years with the dollar reserves. This has led to a fall in forex reserves and an overvaluation of the rupee to the extent that the Central Bank cannot intervene in the market to control the forex rate any further.
Therefore, the Central Bank increased the Statutory Reserve Ratio and interest rates to reduce pressure on the dollar. However, this measure will do little to ameliorate the effects of the exchange rate due to the excess liquidity in the market due to currency overprinting.
Sri Lanka has been having trouble with its Balance of Payments ever since the establishment of the Central Bank of Sri Lanka in 1950 when it was given wide-ranging money printing powers to curb interest rates. This has led to chronic currency collapses, leading to sovereign default and dollarisation.
Reduction of Taxes
President Gotabaya Rajapaksa brought in a new tax regime soon after he became president. This new tax regime abolished Pay As You Earn taxes and cut down corporate taxes and value-added services taxes, costing Sri Lanka 560 Sri Lankan Rupees in tax revenue.
This situation was aggravated with the arrival of COVID-19. The reduced tax bases mean difficult for the government to mobilize funds to fight the pandemic and support struggling citizens through income provisions. Reducing taxes was an ill-advised move, given that Sri Lanka was running on a budget deficit for over two decades.
In 2020, the budget deficit was 1.6 trillion Sri Lankan Rupees, its highest ever. The budget deficit was about 6% of GDP for a few years; in 2020, it became 11.2%. Moreover, successive governments add around 100000 jobs each in the civil services, which eat up to 58% of the government revenue. The number goes to 80% when pensions are included.
Shift to Organic Farming
On Apr 29, 2021, Sri Lanka banned the import of chemical fertilizers and other agrochemicals. The sudden ban on chemical fertilizers in a push to make Sri Lanka the first fully organic-farming country is feared to bring down agricultural production. The sudden implementation of the organic farming regime, citing health concerns from the use of chemical fertilizers, can be attributed to the crunch in forex reserves, as Sri Lanka spends around $250 million every year to import fertilizers.
The sudden shift is believed to cause severe repercussions for domestic agricultural production in Sri Lanka. Tea production will be cut, resulting in a loss of $625 million and would affect the income prospects of three million people dependent on the Sri Lankan tea industry. Similar repercussions could also be felt in the pepper, cinnamon, and most importantly, the food and vegetable production, which will mean reduced food production and increased import bills, both unwelcoming for Sri Lanka.
Furthermore, renowned tea expert Herman Gunaratne believes that the forced push for organic farming would cut crop production by half and worsen the food crisis. The government, on the other hand, is firm on its push for organic farming, saying that the long-term benefits will cover the short-term shocks. It has also promised the farmers organic fertilizers as an alternative.
Effects of the Macroeconomic Mismanagement
The Balance of Payment crisis led to an increase in the prices of sugar, rice, and other commodities, while there were (and could later be) long queues outside stores to buy milk powder, cooking gas, and kerosene. Even though the government imposed rules against hoarding, it categorically denied any food shortage.
The month-by-month inflation rate increased from 5.7% in July 2021 to 6% in August 2021. The price ceiling led to severe shortages and more people queuing up. It was one of the reasons for lifting the curbs.
A cap on the amount to be spent on imports decided by the Central Bank discourages the import of essential goods. Without the forward contacts that help traders offload the risk of currency volatility onto professional speculators, there will be less incentive in importing essential supplies.
Furthermore, the army seizing the supplies from the traders would have disincentivized them from bringing fresh supplies into the market. This would have reduced the supply of essential goods during the rationing phase, leading to a hike in food prices, as is currently seen in Sri Lanka. Speculative traders often contain price volatility to a limited extent by allotting scarce supplies rationally across time. The army’s action would have discouraged speculation, adding to the price volatility.
The three-month ordeal of the people of Sri Lanka is a reminder that a country’s politics impacts its economics. The soaring debts and the dwindling foreign exchange reserves, coupled with the government’s poor economic priorities, have sent the country’s economic situation into a tailspin. It is beyond doubt that a fate similar to, if not worse than what was witnessed in Sri Lanka during the second half of 2021, awaits any country that seeks to squander government resources for political gains without checking the country’s purse regularly.
Design by Shatabdi Deori
Edited by Madhumitha R
Article 19 