Root cause for Sri Lanka’s present economic woes

At present, Sri Lanka is suffering from one of the worst economic crises in the history since its independence. Sri Lanka’s annual inflation rate surged to more than 70% in August 2022 as it struggles with its worst over seven decades. Official data also showed food prices rose by 84.6% compared to a year ago. An UN report in September 2022 highlighted that impunity of Sri Lankan officials for human rights violations and economic crimes in the country are reasons of its economic crisis.

Central Bank data says, national consumer price inflation has almost tripled from 6.2% in September 2021, to 17.5% in February 2022, mostly due to high food inflation which stood at 24.7 %, amid rising global commodity prices, adjustments to fuel prices, and partial monetization of the fiscal deficit of the country. Moreover, an abrupt ban on agro-chemical imports between May 2021 and November 2021, hit the agricultural activities pretty badly. As a result, food, fuel, gas and medicine have been in short supply, and the cost of basic commodities has skyrocketed. The astronomical increase in prices affected the ability of households to cover day-to-day expenses, leading to a deterioration of welfare and more food insecurity in the country.

According to the Central bank and World Bank website, the trade deficit of Sri Lanka has increased to US$ 8.1 billion in 2021 from US$ 6 billion in 2020 as a rising import bill offset the rise in export earnings, despite import restrictions on non-essential goods. Declines in remittances by 22.7% and revenue from tourism dropped by 61.7% are estimated to have further widened the current account deficit to US$ 3.2 billion or 3.8 % of the GDP in 2021.

According to the Central Bank annual report, which was issued on April 30, 2022, Sri Lanka’s real Gross Domestic Product (GDP) growth for 2022 is projected to decline to 1%, reduced from an earlier estimate of 5.5%. Per capita gross domestic product was US$3,815 in 2021 and is expected to further decrease to US$3,041 in 2022.

The Central bank report and the World Bank website reveal that the fiscal deficit is estimated to have remained at 11.1% of GDP in 2021, and public and publicly guaranteed debt to have increased to 117% of GDP. The fiscal deficit of the country was mostly financed by domestic resources, including the central bank. Fitch, S&P, and Moody’s downgraded the sovereign rating deeper into the substantial risk investment category.

The World Bank website notes the official reserves of the country was at US$ 2.3 billion in February 2022, equivalent to 1.3 months of imports, remained low, relative to foreign currency debt service, estimated at US$ 5.6 billion from April to December 2022, comprising of domestic instruments issued in foreign currency. Net foreign assets of the banking system dropped to US$ -4.9 billion in December 2021, showing a sharp drop in growing foreign exchange liquidity. After maintaining the exchange rate broadly fixed around 201 LKR/US$ for seven months, to stem reserve losses Central Bank of Sri Lanka floated the currency on March 7, 2022. By the end of March 2022, the Sri Lankan Rupee had depreciated by 46%. According to an IMF briefing, it is revealed that Sri Lanka has shrunk its reserves from US$6.9 billion in 2018 to US$2.2 billion this year.

The monetary scarcity has impacted the imports of fuel and other essentials of the country, and from February 2022 to date, Sri Lanka has imposed power cuts to deal with the fuel crisis that had sent prices soaring.

Sri Lanka owes US$50 billion to foreign creditors, but is unable to repay the debts due to the state of its economy. The Central Bank Governor stated that until there is a debt restructure, the country is unable to repay its debt to the creditors.

Sri Lanka defaulted the payment of US$78 million in interest on two sovereign bonds due by May 18, after a one-month grace period. It was the first time Sri Lanka has defaulted on its debt in its history.

Main reasons behind the present crisis

Sri Lanka is experiencing an unprecedented economic collapse, and hence, struggling to import basic necessities because of dwindling foreign reserves. For months, people have had to wait in long queues to buy essentials such as milk powder, fuel, LP Gas, medicines etc. 

• Reduction of Taxes
• Money Printing
• External debt
• Fall in foreign remittances
• Tourism
• Ban on Chemical Fertilizers
• Depreciation of LKR

1. Reduction of Taxes

In 2019, the Government, soon after coming to power, made large tax cuts that affected government revenue and fiscal policies, causing budget deficits to soar. As a result, the current crisis was accelerated.

• 2% Nation Building Tax (NBT) has been abolished with effect from December 1, 2019
• 15% VAT has been reduced to 8% with effect from December 1, 2019
• Economic Service Charge (ESC) was abolished with effect from January 1, 2020.
• Debt Repayment Levy (DRL) was abolished with effect from January 1, 2020
• Corporate Income Tax (CIT) rates had been revised with effect from January 1, 2020 as follows:
  • small and medium enterprises (SMEs): 14%
  • Exports, tourism, education, and healthcare: 14%
  • Construction and agro processing dividends received from a resident company: 14%
  • Manufacturing: 18%
  • Liquor, tobacco, betting and gaming: 40%
  • Trading, banking finance, insurance, etc. 24%

There has been a decline in Sri Lanka’s tax base between 2019 and 2020 with 33.5% decline in the number of registered taxpayers (corporate and individual) in the country. This decline is most probably associated with the major changes in tax policy introduced in December 2019, particularly the increase in thresholds for Value Added Tax (VAT) and the abolition of Pay As You Earn (PAYE) tax. On January 1, 2020, the mandatory PAYE Tax on any employment receipts to any resident or non-resident person was removed and on April 1, 2020, it was replaced by the Advance Personal Income Tax (APIT) which is an optional scheme. The tax-free threshold for personal income tax was also increased from LKR 500,000 per annum to LKR 3,000,000 per annum, reducing a large number of tax payers from Sri Lanka’s tax base.

Further on January 1, 2020, the threshold for VAT registration was increased from LKR 12 million per annum to LKR 300 million per annum and an exemption for VAT was provided to the Information Technology and enabling services.

With the abolition of PAYE, employees are expected to file their own income tax returns if their annual income is above the tax-free threshold. However, the increase in individual income tax files between 2019 and 2020 was just 11,607, which is insignificant when compared to the decline in PAYE/APIT registered taxpayers of 485,055.

2. Money Printing

Sri Lanka has printed 1.2 trillion rupees in 2021, most of which has flowed out of the country as a balance of payments deficit official data shows on top of 505 billion rupees printed in 2019 mostly to keep interest rates down.

The Central Bank of Sri Lanka (CBSL) printed Rs. 1.2 trillion in 2021 and a further Rs. 146 billion in the first three weeks of this 2022. The Central Bank continues to print money, with Treasury Bills and Bonds increasing by billions of rupees overnight, as the incumbent Governor promotes Modern Monetary Policy Theory (MMT). 

The CBSL’s money printing spree has created inflationary pressure, as pointed out by local and international economists. Nevertheless, the Central Bank continued to print money, with a whopping Rs. 22.27 billion being printed.

3.External Debt

External Debt in Sri Lanka averaged US$ 47338.78 million from 2012 until 2021, reaching an all-time high of US$ 55915.96 million in the fourth quarter of 2019, and a record low of US$ 37098.10 million in the fourth quarter of 2012.

4. Fall of foreign remittances

Expatriate workers’ remittances have been a key pillar of Sri Lanka’s foreign currency earnings, providing a substantial cushion against the widening trade deficit, and thereby enhancing the external sector resilience of the country. Being a major source of foreign exchange earnings, expatriate workers’ remittances have covered around 80% of the annual trade deficit, on average, over the past two decades and remittance inflows have exceeded the trade deficit in 2020.

Moreover, unlike many merchandise export categories, there is no import content involved in this source of foreign exchange earnings. Therefore, strengthening remittance inflows to the country brings several macro-economic and socio-economic benefits, mainly narrowing of the current account deficit of Balance of Payments (BOP), support economic growth, improve FOREX liquidity in the banking system, alleviation of poverty, reducing income disparities and regional disparities, and reducing the fiscal burden on social security. payments.

5. Tourism

Sri Lanka recorded over 1.9 million tourist arrivals in 2019, a 21% drop from the previous year owing to the aftermath of the April 2019 Easter Sunday suicide attacks on churches and tourist hotels where a handful of tourists became victims. It is estimated that the sector earned around US$3.5 billion in 2019. Approximately 570,000 tourists visited the country in 2020.

Tourism industry pumped in US$4.4 billion to Sri Lanka and contributed 5.6% to GDP in 2018, but this had dropped to just 0.8% in 2020. However, arrivals topped 100,000 in March for the first time in two years, according to the Sri Lanka’s Tourist Board. The overall volume of tourist arrivals were higher than they were in 2021, marking what many thought would be a pandemic revival.

6. Ban on Chemical Fertilizers

In April 2021, the Government suddenly announced an abrupt ban in the import of chemical fertilizers in a push to promote organic farming, without proper planning. It was a surprise to the farmers.

In April 2021, Sri Lanka’s President Gotabaya Rajapaksa announced a ban on the import of agro-chemicals. The move was meant to save Sri Lanka around US$300 – US$400 million in foreign exchange, which the country spends each year for importing agro-chemicals. The President also justified that the right of Sri Lankans “to a non-toxic diet” was guaranteed with this policy. Furthermore, according to him, the country’s huge expenditure on agro-chemicals has not increased the yield in the agricultural sector. Rather, he insisted, agro-chemicals are exacerbating soil infertility, the decline in yields and the loss of bio-diversity. Rajapaksa even promised to compensate any farmer who encountered a decrease in production after switching to organic farming. The savings made from the agro-chemical ban and ending fertilizer subsidies would provide the money for this indemnity.

After several months of upheaval instigated by an acute food crisis, on November 21, Secretary to the Sri Lanka’s Agricultural Ministry declared that it was easing agro-chemical import restrictions and that chemical fertilizers, agro-chemicals, and essential plant nutrients required for a large category of crops would be once again allowed. The widespread assumption that the country’s food security was at risk without agro-chemicals forced the government to seemingly backtrack. A few days later, on November 24, it announced the complete revoking of the agro-chemical import ban.

7. Depreciation of LKR

As a core component of the economic liberalization policy package launched in November 1977, a managed float exchange rate system was adopted in Sri Lanka, replacing the fixed exchange rate system that had been in operation until then. Accordingly, the CBSL announced buying and selling rates for the US dollar for its transactions with commercial banks, and the banks were required to quote buying and selling rates for currencies within the specified margin for their customers. The margin between the CBSL’s buying and selling rates was gradually raised over the years.

The CBSL abandoned the managed floating regime in January 2001, as it failed to tackle the severe balance of payments crisis and heavy drain of foreign reserves encountered in the latter part of 2000. Instead, the CBSL shifted to an independent floating regime which helped to lessen the foreign reserve outflows and reduce market expectations for greater rupee depreciation and thereby to stabilize the exchange rate.

The recent decision of the CBSL to shift from a free float to a managed float regime is exactly the opposite of the previous policy decision adopted 21 years ago, shifting from managed float to free float.

The exchange rate is currently under tremendous pressure due to the continual deterioration of the balance of payments and the drain of foreign reserves. In the first quarter of this year, the trade deficit rose to US$ 2,402 million from US$ 2,059 million in the same period in 2021 due to an increase in imports. Expatriate workers’ remittances were down by 58% in the first quarter of this year. Tourist earnings too remained remarkably low.

The short supply of dollars resulting from the deteriorating balance of payments, as explained above, exerts constant pressure on the exchange rate compelling further depreciation of the rupee. Hence, it would be extremely difficult to reduce foreign exchange market volatility through the newly-introduced managed floating, as expected by the CBSL.

While depreciation of the local currency leads to an increase in import prices and domestic prices, the resulting inflation triggers pressure on the exchange rate calling for a further round of depreciation of the local currency. This goes on in the form of a vicious circle of exchange rate depreciation and inflation. Sri Lanka is already experiencing such a vicious circle recording a year-on-year rupee depreciation of 85% against the US dollar and a year-on-year inflation rate of 30% by now.

On the demand aspect, the country is already experiencing inflationary pressures emanating from excessive money printing by the CBSL to finance the widening budget deficit. The Government is to raise the Treasury Bill limit shortly from Rs. 3,000 billion to Rs. 4,000 billion to meet wage bills and other essential payments in the coming months. This will lead to further increases in Treasury Bill yield rates which have already reached 25% per annum for all maturities.

As the market seems unable to absorb the entire Treasury bill issues at acceptable yield rates weekly, the CBSL will have to purchase the unsold stock resulting in continuous money printing and inflationary pressures.

All in all, inflation causes an appreciation of the real exchange rate calling for depreciation of the rupee to reduce imports and to maintain export competitiveness.

The Rupee depreciation is unstoppable given the severe balance of payments difficulties, foreign reserve depletion, and galloping inflation, the CBSL will find it extremely difficult to sustain the recently-announced exchange rate margins under the managed float for long and prevent further depreciation of the rupee.

As long as the official exchange rate band is kept below the market clearing level, black market foreign exchange transactions will continue to thrive despite CBSL’s stern warnings.

Abbreviated

Sri Lanka’s current economic crisis is a result of several years of mismanagement, corruption, short-sighted policy-making, and an overall lack of good governance. Insufficient foreign reserves with Sri Lanka’s Central Bank and loss of access to international capital markets resulted in the country defaulting on debt for the first time in history. Unchecked external borrowings, tax cuts that widened the existing budget deficit, the chemical fertiliser imports ban and the sudden floating of the Sri Lankan rupee are among several factors that contributed to the economic collapse. Tourism, together with apparel and tea exports – some of Sri Lanka’s main income sources – were affected in recent years due to various internal and external factors such as the 2019 Easter Sunday suicide attacks followed by COVID-19 pandemic in 2020. Now, the economic crisis presents multiple challenges, including severe threats to nutrition, food security, healthcare and education.

Hasitha Kasun Hapuarachchi

(Hasitha Kasun Hapuarachchi is Colombo based independent researcher mainly in the field of economics. He has completed his Bachelor of Economics special degree with first class honors at Gujarat University, Ahmedabad, India)