What broke the Pearl of the Indian Ocean?

by Renon Prasad L6G

Sri Lanka, otherwise known as the pearl of the Indian Ocean, has recently been marred by

economic turmoil. What happened to this country known for its spiritual rich landscape and

tourism?

One could argue the root cause of Sri Lanka’s economic crisis has been persistent and large

fiscal deficits, which were increasingly financed by unsustained public debt, particularly foreign

commercial borrowings. In this environment of rising fiscal deficit and debt, the real economy

stagnated at around 3.6% annual real GDP growth in the 10 years before 2022 and grew at an

average of just 1.5% in the five years before the crisis.

After the civil war ended in 2009, then President Mahinda Rajapaksa took out massive foreign

loans to pay for war expenses and, more importantly, to start flashy infrastructure projects to

attract tourism. In a vicious cycle, the government had to turn to foreign lenders, such as the

Chinese to help service already existing debt because they had limited foreign reserves. Rather

than focus on economic reforms that might increase those reserves, the Rajapkshas implemented

several tax cuts to shore up political support. This lost $1.4 bn in revenue for the government

annually.

Sri Lanka also ran persistent current account deficits, averaging about 2.8% of GDP in the 10

years before the crisis. These issues, influenced by global and domestic factors, had depleted

the economy’s foreign reserves. As a result, the country experienced intense pressure on its

balance of payments (BOP), leading to a shortage of foreign exchange.

A weakened exchange rate followed as the Sri Lankan rupee depreciated against the US dollar.

This weak exchange rate led to imports becoming more expensive and less price competitive

and exports becoming cheaper and more price competitive. The inflation rate, thus, soared. The

Sri Lankan interest rates were at an astoundingly high 49.72%, a 42.71% increase from 2021.

These extortionately high levels of inflation also stemmed from global oil and commodity price

hikes (cost-push inflation). As a result, Sri Lankans started experiencing power cuts and shortages

of basics such as fuel so this caused petrol and diesel prices to rise dramatically.

The government blamed the Covid pandemic, which badly affected Sri Lanka’s tourist trade - one

of its biggest foreign currency earners. At the end of its civil war in 2009, Sri Lanka chose to

focus on providing goods to its domestic market, instead of trying to boost foreign trade. This

meant its income from exports to other countries remained low, while the bill for imports kept

growing. Sri Lanka now imports $3bn more than its exports every year, and that is why it ran out

of foreign currency.

Now, Sri Lanka is showing signs of recovery, with green shoots emerging in the second half of

2023. Inflation has decelerated to single digits, foreign exchange reserves continue to be built up

and the exchange rate has appreciated, Tourist arrivals and remittance inflows continue to show a

commendable recovery while supply conditions have improved. Timely completion of external

debt restructuring will also support Sri Lanka’s debt sustainability efforts.

References:

https://www.sciencedirect.com/science/article/abs/pii/S1572308923001134#:~:text=The%20root%

20cause%20of%20Sri,reprofile%20 domestic%20and%20 foreign%20 debt.

https://www.bbc.co.uk/news/world-61028138

https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/statistics/otherpub/information_ser

ies_note_20231221_bitcoin_inflation_public_enemy_number_one_e.pdf