Causes of the Sri Lanka Economic Crisis

Causes of the Sri Lanka Economic Crisis

The World Economic Forum ranked Sri Lanka 52nd in global competitiveness out of 142 countries surveyed in its 2011 Global Competitiveness Report. Note that country also ranked 45th in health and primary education, 32nd in business sophistication, 42nd in innovation, and 41st in goods market efficiency. The same report described the Sri Lanka economy as transitioning from the factor-driven stage to the efficiency-driven stage.

A 2016 Systematic Country Diagnostic by The World Bank further described Sri Lanka as a development success story. Its economy grew on an average of 6 percent during the previous years and it successfully met one of the Millennium Development Goals of the United Nations when it reduced poverty from 22.7 percent in 2002 to 6.1 percent between 2012 and 2013 while on track to meet other goals and outperforming other South Asian countries.

However, its debt soared to USD 64.9 billion in 2016. The government had been borrowing from foreign creditors since the term of former President Mahinda Rajapaksa to ramp up its infrastructure projects to the point of near bankruptcy. The International Monetary Fund had bailed out the country while The World Bank warned that its positive gross domestic product driven by non-tradable sectors was both unsustainable and inequitable.

Other economists had also raised concerns over numerous risks that could endanger its economic outlook. Nonetheless, after its per capita gross national product dropped from 3968 dollars in 2018 to 3741 dollars in 2019 while its per capita gross domestic capital dropped from 4079 dollars to 3852 during the same period, the World Bank downgraded Sri Lanka to a lower middle-income country from its previous upper middle-income status.

The Sri Lankan government declared in April 2021 that the country is in its worst economic crisis in 73 years. It has experienced an unprecedented level of inflation and an increase in prices of basic commodities, devaluation of its currency, near-depletion of its foreign exchange reserves, supply shortages in certain food items, and life-saving medicines and medical equipment, shortages in oil and gas, and sociopolitical unrest.

What exactly happened? How did Sri Lanka transition from one of the most promising economies in Asia to one of the worst performing economies in the world?  Economists have pinned down the problem to numerous factors ranging from economic mismanagement, precarious policies, and unfavorable political climate to major global events such as the coronavirus pandemic and the Russia-Ukraine conflict.

Identifying and Explaining the Causes of the Sri Lanka Economic Crisis

1. Excessive and Unsustainable Borrowing and Spending to Finance Large-Scale Infrastructure Projects

Former President Mahinda Rajapaksa ramped up government investments in large-scale infrastructure beginning his term in 2009. His administration has been credited for projects such as the Colombo Lotus Tower, Magampura Mahinda Rajapaksa Port, the Colombo Harbour South Container Terminal, the Mattala Rajapaksa International Airport, the Colombo–Katunayake Expressway, and the Mahinda Rajapaksa International Cricket Stadium.

Some of the projects have helped Sri Lanka to develop its economy further as evident from improvements in its Human Development Index. These include rural infrastructure development and the building of roads and highways to improve. However, critics have noted that the other infrastructure projects such as the Colombo Lotus Tower and Mahinda Rajapaksa International Cricket Stadium which costs hundreds of millions of dollars were uneconomical.

Investments in big-ticket infrastructure projects persisted in the succeeding administrations of former presidents Maithripala Sirisena and Gotabaya Rajapaksa. Of course, to finance these projects, the government had borrowed excessively from foreign creditors including the International Monetary Fund and Chinese banks and lenders. Note that Sri Lanka was nearing bankruptcy until the IMF intervened with a bailout.

The Asian Development Bank published a report in March  2019 that provided a narrative of the history of the twin deficit in Sri Lanka. It explained that the national expenditure of the country has exceeded its national income while its production of tradeable goods and services has dropped. The twin deficit in Sri Lanka has manifested in frequent balance-of-payment crisis that has been observed since 2017 and high macroeconomic volatility.

Nevertheless, the foreign debt of Sri Lanka increased from USD 11.3 billion in 2005 to USD 56.3 billion in 2020. The foreign debt accounted for 42 percent of the GDP in 2019 and rose further to 119 percent of the GDP in 2021. The country eventually declared a pre-emptive negotiated default in April 2022 because of its inability to pay most of its foreign debt. This marked the beginning of the 2022 Sri Lankan Sovereign Debt Crisis.

2. Allegations of Corruption and Misplaced Political Motivation as Factor of the Sri Lanka Economic Crisis

Individuals and groups vocal against the government have put forward numerous allegations of corruption, mismanagement of funds, and inappropriate political motivation. Government opposition and several economists and analysts have argued that one of the major causes of the Sri Lanka economic crisis can be attributed to the unfavorable political climate characterized by anomalies, incompetence, crony capitalism, and protectionism.

The elite Rajapaksa political family has been specifically accused of being responsible for decimating the economy. For example, the construction of the Hambantota Harbour and Colombo Port City was alleged to be politically motivated because their chosen locations are known strongholds of the Rajapaksa family. Several critics previously raised concerns about the capacity of these projects to generate revenues for the government.

Sri Lanka eventually leased 80 percent of Hambantota Harbour to China Merchants Port Holdings Company for 99 years for USD 1.12 billion. Reports suggested that this money was not used to pay off debts associated with its construction but was instead added to the foreign reserves and used to repay unrelated foreign debts. The Colombo Port City failed to meet its vision of becoming a hub similar to ports in Dubai and Singapore.

Writing for Foreign Policy, Sri Lankan political analyst Amita Arudpragasam explained that the Sri Lanka economy began to unravel in 2005 when Mahinda Rajapaksa was elected president. The country experienced spectacular economic growth but it was driven by infrastructure projects that were tainted with corruption and lined the pockets of the so-called parasitic class of businesspeople while providing unfavorable returns.

Maithripala Sirisena succeeded Mahinda Rajapaksa when he became president from 2015 to 2019. He was the common candidate of the opposition coalition and his administration saw Sri Lanka achieving its first major primary budget surplus in 60 years in 2017 and another one in 2018. He planned to make reforms needed to make Sri Lankan exports more competitive but political instability ensued and derailed relevant plans.

Mahinda Rajapaksa asserted his political right to be the prime minister. Sirisena sacked then Prime Minister Ranil Wickremesinghe and replaced him with Mahinda Rajapaksa. Critics noted that the Rajapaksa family orchestrated this crisis and upon regaining political capital, they were instrumental in opposing numerous economic reforms needed to stabilize the economy. Gotabaya Rajapaksa, brother of Mahinda, was elected president in 2019.

3. Fiscal Policy Through Tax Cuts and the Subsequent Monetary Policy Through Overprinting of Money

The fiscal policy and monetary policy of the government under the administration of former President Gotabaya Rajapaksa have also been considered the two major causes of the Sri Lanka economic crisis. To be specific, the fiscal policy of his administration prevented the government from generating enough internal revenues needed to repay its foreign debts while its monetary policy has been attributed to be one of the causes of high inflation.

Gotabaya Rajapaksa ran for the presidency in the 2019 national elections under the promises of large tax cuts. Remember that the Rajapaksa family had been opposing several economic reforms such as tax hikes proposed under the Sirisena administration. Nevertheless, during his bid for the presidency, he appealed to the voting public using populist tax reforms that promised significant tax reductions. He won and served as the 8th President of Sri Lanka.

His administration fulfilled its promise. Gotabaya Rajapaksa introduced massive tax cuts in late 2019. These included lowering taxes for wealthy individuals and increasing tax holidays for corporations. His administration also slashed value-added tax from 15 percent to 8 percent while also abolishing seven other taxes. A report published by the International Centre for Tax and Development noted that Sri Lanka had been experiencing declining tax revenues.

The same report contained an explanation from political economist Mick Moore. He said that both the tax cuts in 2019 and the failure to restructure its debt were key contributors to the sovereign debt crisis and the overall economic crisis in Sri Lanka because they compelled creditors to raise their interest rates. The government continued accumulating debts to finance its ongoing and future projects amidst increasing interest rates.

Nevertheless, the populist tax reforms have far-reaching consequences. Data from PublicFinance.lk of the independent think tank Verité Research showed that registered individual and corporate taxpayers declined to 33.5 percent from 2019 to 2020 due to the increase in thresholds for VAT and abolition of Pay As You Earn tax. Additional data showed that the country lost more than half-a-million taxpayers each in 2020 and 2021.

The government was essentially not generating enough revenues from taxes to pay off its debts. To cover its spending, the Central Bank of Sri Lanka started printing money in record amounts against warnings from the International Monetary Fund. By the end of 2022, the central bank added a total of 432.76 billion Sri Lankan rupees in circulation. The excess money supply is a key contributor to the rising inflation rates in the country.

Increasing the money supply erodes the value of the local currency while raising the prices of essential goods and services. Simply put, when there is more money in circulation, the law of supply and demand dictates that more people have the means to chase a limited number of goods and services. This phenomenon has also been observed in Venezuela and Zimbabwe which have experienced record-breaking hyperinflation due to overprinting.

4. Rushed Transition to Organic Farming and the Resulting Collapse of the Agriculture Sector

Another major blunder committed under the administration of Gotabaya Rajapaksa was the ill-conceived reforms in agriculture. Note that Sri Lanka had a productive and stable agriculture sector. It had been self-sufficient in rice production. Furthermore, it is one of the major sources of important agricultural products in the global market such as tea, rubber, and coconut. These three exports are a critical source of foreign exchange reserves.

However, in April 2021, the government announced that it would ban the importation of inorganic fertilizers and other chemicals used in farming in its attempt to shift to organic farming and become the first country in the world to promote and implement the use of organic and natural chemicals in food production. Some analysts noted that this was motivated in part by the need to preserve foreign exchange reserves by reducing dependence on imports.

Members of the scientific and farming communities earlier warned that the ban on inorganic fertilizers and other chemicals can lead to a possible collapse of the agriculture sector. True enough, rice production dropped by 20 percent within the first six months while reversing rice self-sufficiency and forcing the country to import rice for USD 450 million. Tea production also dropped and resulted in economic losses of around USD 425 million.

The abrupt transition to organic farming was disastrous. Prices of food products increased and food shortages ensued. The foreign exchange reserves depleted further as the government tried to import food products to address the shortages. Farmers were left with no income to buy necessities. The government abandoned its shift to organic farming in November 2021 but the damage to the agriculture sector was already done.

5. Impacts of the Global COVID-19 Pandemic and Russia-Ukraine Conflict on the Sri Lanka Economic Crisis

Major global events such as the global COVID-19 pandemic that began in the first quarter of 2021 and the conflict between Russia and Ukraine that escalated in February 2022 have also been considered important factors in understanding and explaining the causes of the economic crisis in Sri Lanka. Note that these two events have also affected several economies across the world, including the economics of developed countries.

It is important to reiterate the fact that Sri Lanka was already in its fragile state as early as 2019. However, the emergence of the novel coronavirus in China and its subsequent spread in different parts of the globe further decimated its weakened economy. For starters, its tourism sector, which was set to recover from the impacts of the 2019 Easter Bombings, declined further due to the suspension of international flights that barred foreign tourists.

Major financial markets were also affected. The Colombo Stock Exchange experienced an eight-year low in March 2020 and trading was halted for at least 30 minutes on 13 March 2020. Findings from a before-and-after study by A. M. A. Jayawardena, P. A. S. Madhubhashini, and U. H. S. L Bandara showed that the Sri Lankan stock market became more inefficient after the first wave of the pandemic spanning from the first quarter of 2020.

Other macroeconomic indicators were also unfavorable. The Sri Lankan rupee depreciated against the United States dollar to 191.99 on 27 March 2020 and depreciated further to 200.47 on April 8 of the same year. The contribution of the tourism sector to the GDP dropped from 5.6 percent in 2018 to 0.8 percent in 2020. The unemployment rate increased by 0.7 percent and the economy contracted by 3.6 percent during the same year.

The global economy eventually reopened in the second quarter of 2021 after vaccines became available and as communities acclimatized to living amidst the pandemic. Several economies experienced a considerable level of rebound. However, in Sri Lanka, hopes for a possible recovery of its economy dampened when the Russia-Ukraine conflict escalated to a full-blown invasion of Ukraine by the Russian Armed Forces in February 2022.

Russia is the second largest market of Sri Lankan tea exports and the tourism sector is heavily dependent on tourist arrivals from both Russia and Ukraine. The economic sanctions in Russia have fueled global energy and food crises. The prices of oil and gas in the global market have increased alongside shortages and price hikes in food imports. Major industries and sectors from food production to manufacturing in Sri Lanka are dependent on oil and gas.

A Rundown and Note on the Causes of the Sri Lanka Economic Crisis

Sri Lanka is undergoing its worst economic crisis since gaining independence in 1948 and the government has declared a major economic crisis in September 2021. Inflation hit a record high of 54.6 percent in July 2022 while the prices of food rose to 81 percent. There is a shortage in supply of essential goods and services including life-saving medicines and medical equipment,  oil and gas for transportation, and electricity.

The worsening economic crisis has compelled citizens to launch a series of protests beginning in March 2022. Protesters took to the streets to call down the resignation of Gotabaya Rajapaksa and other government officials. They stormed down the official residence of the President of Sri Lanka on 9 July and also broke into the private residence of Prime Minister Ranil Wickremesinghe on 13 July and set it on fire.

Rajapaksa resigned from office on 14 July 2022. The Rajapaksa family has been considered responsible for the economic crisis in Sri Lanka. The economic mismanagement and leadership incompetence that began in 2005 during the term of former President Mahinda Rajapaksa and persisted throughout the succeeding presidencies of Maithripala Sirisena and Gotabaya Rajapaksa have alleged far-reaching consequences.

Of course, the cause of the Sri Lanka economic crisis is a mixed bag of different factors. Major global events such as the COVID-19 pandemic and the Russia-Ukraine conflict, as well as the related 2021-2022 Supply Chain Crisis and 2021-2022 Global Inflation Surge, have indeed worsened the situation. However, remember that the country has been at risk of a probable collapse prior to 2019 due to its mounting debt and ill-conceived socioeconomic agenda.

The accumulation of debt worth billions of dollars has played a central role in the economic crisis. Debt can bring forth substantial economic gains when done right but the approach of the Sri Lankan government proved that excess borrowing and unsustainable spending on projects with little to zero economic value, coupled with policies that do not promote the growth of tradable goods and services, can have disastrous consequences.

FURTHER READINGS AND REFERENCES

  • Arudpragasam, A. 2022. “How the Rajapaksas Destroyed Sri Lanka’s Economy.” Foreign Policy. Available online
  • International Centre for Tax and Development. 2022. “The Tax Story Behind the Sri Lankan Crisis.” International Centre for Tax and Development. Available online.
  • Jayawardena, A. M. A., Madhubhashini, P. A. S., and Bandara, U. H. S. L. 2022. “Efficiency of the Sri Lankan Stock Market During the COVID 19 Period.” International Journal of Trend in Scientific Research and Development. 6(3)
  • lk. 2022. “Erosion of the Tax Base: A 33.5% Decline in Registered Taxpayers from 2019 to 2020.” PublicFinace.lk. Verité Research. Available online
  • Schwab, K. ed. 2011. The Global Competitiveness Report 2011-2012. World Economic Forum. ISBN: 978-92-95044-74-6. Available via PDF
  • The World Bank. 2016 “Sri Lanka: A Systematic Country Diagnostic.” The World Bank. Available online
  • Weerakoon, D., Kumar, U., and Dime, R. 2019. Sri Lanka’s Macroeconomic Challenges: A Tale of Two Deficits. Asian Development Bank. DOI: 22617/WPS190024-2