Catholic Church backs Galle Face protests – The Island
By R Ramakumar, Professor of Economics, Tata Institute of Social Sciences
The island nation of Sri Lanka is in the midst of one of the worst economic crises it has ever seen. It has just defaulted on its external debts for the first time since independence, and the country’s 22 million people face crippling 12-hour power cuts and dire shortages of food, fuel and electricity. other essential items such as medicines.
Inflation is at an all-time high of 17.5%, with prices of food items like a kilogram of rice soaring to 500 Sri Lankan rupees when it would normally cost around 80 rupees. Amid the shortages, a 400g packet of powdered milk would cost upwards of Rs 250, when it usually costs around Rs 60.
On April 1, President Gotabaya Rajpaksa declared a state of emergency. In less than a week, he withdrew it following massive protests by citizens angry at the government’s handling of the crisis.
The country depends on the import of many essential items, including gasoline, food and medicine. Most countries will keep some foreign currency on hand in order to exchange these items, but a shortage of foreign currency in Sri Lanka is responsible for the exorbitant prices.
Many believe that Sri Lanka’s economic relations with China are one of the main drivers of the crisis. The United States has called this phenomenon debt trap diplomacy. This is where a creditor country or institution extends debt to a borrowing country to increase the political influence of the lender if the borrower extends and cannot repay the money they are at the mercy of the creditor .
However, loans from China only accounted for around 10% of Sri Lanka’s total external debt in 2020. The largest portion, around 30%, can be attributed to international sovereign bonds. Japan actually accounts for a higher proportion of their external debt, at 11%.
Defaults on Chinese infrastructure-related loans to Sri Lanka, particularly funding for the port of Hambantota, are cited as factors contributing to the crisis.
But these facts do not add up. The construction of the Port of Hambantota was financed by the Chinese Exim Bank. The port was making losses, so Sri Lanka leased the port for 99 years to the Chinese Merchant’s Group, which paid Sri Lanka US$1.12 billion.
So the Port of Hambantota fiasco did not lead to a balance of payments crisis (where more money or exports go out than come in), it actually bolstered foreign exchange reserves. of Sri Lanka of US$1.12 billion.
After independence from the British in 1948, agriculture in Sri Lanka was dominated by export crops such as tea, coffee, rubber and spices. Much of its gross domestic product came from foreign currency earned from the export of these crops. This money was used to import essential foodstuffs.
Over the years, the country also started exporting clothes and earning foreign exchange through tourism and remittances (money sent to Sri Lanka from abroad, perhaps by family members). Any drop in exports would be an economic shock and put a strain on foreign exchange reserves.
For this reason, Sri Lanka has frequently encountered balance of payments crises. From 1965, she obtained 16 loans from the International Monetary Fund (IMF). Each of these loans came with conditions, including that once Sri Lanka received the loan, they had to reduce their budget deficit, maintain tight monetary policy, reduce government subsidies for feeding the people of Sri Lanka and depreciate the currency (exports would thus become more viable).
But generally, during an economic downturn, good fiscal policy dictates that governments spend more to stimulate the economy. This becomes impossible under IMF conditions. Despite this situation, IMF loans continued to flow and a beleaguered economy fell deeper and deeper into debt.
The last IMF loan to Sri Lanka was in 2016. The country received US$1.5 billion over three years, from 2016 to 2019. Terms were familiar and the health of the economy plummeted over the course of this period. Growth, investment, savings and income have fallen, while the debt burden has increased.
A bad situation worsened with two economic shocks in 2019. First, there was a series of bombings in churches and luxury hotels in Colombo in April 2019. The explosions led to a sharp drop in tourist arrivals, with some reports indicating up to 80% decline and depletion of foreign exchange reserves. Second, the new government led by President Gotabaya Rajapaksa cut taxes irrationally.
Value added tax rates (similar to goods and services taxes in some countries) have been reduced from 15% to 8%. Other indirect taxes such as national construction tax, pay-as-you-go tax and economic service charges were abolished. Corporate tax rates have been reduced from 28% to 24%. About 2% of gross domestic product was lost in revenue because of these tax cuts.
In March 2020, the COVID-19 pandemic hit. In April 2021, the Rajapaksa government made another fatal mistake. To avoid the depletion of foreign exchange reserves, all fertilizer imports were completely banned. Sri Lanka has been declared a 100% organic nation. This policy, which was withdrawn in November 2021, led to a drastic drop in agricultural production and more imports became necessary.
But foreign exchange reserves remained under pressure. A decline in tea and rubber productivity due to the fertilizer ban also led to a decline in export earnings. Due to declining export earnings, there was less money available to import food and food shortages arose.
Because there is less food and other items to buy, but no drop in demand, the prices of these goods rise. In February 2022, inflation rose to 17.5%.
In all likelihood, Sri Lanka will now get a 17th loan from the IMF to overcome the current crisis, which will come with new conditions.
A deflationary fiscal policy will be followed, which will further limit the prospects for economic recovery and exacerbate the suffering of the Sri Lankan people. (PTI)