Sri Lanka's economy is primarily driven by agriculture, services, and light industry. Approximately 21% of the country's GDP and 38% of the workforce are employed in agriculture, which produces both cash crops (tea, rubber, and coconuts) and food crops (mainly rice). Manufacturing industries contribute to about 19% of the GDP and employ about 17% of the workforce, with textiles, ceramics, petroleum products, vegetable oils, fertilizers, and cement being the main products. The service sector is the largest component of the economy, providing employment to 45% of the workforce and contributing around 60% of the GDP. This sector is dominated by tourism, banking, finance, and retail trade. Sri Lanka is a mixed economy that encourages foreign investment, with well-developed banking systems, a liberal foreign trade regime, and free zones established to promote economic growth. This marks a significant shift from the Sri Lankan economy during the first three decades following the country's independence from Great Britain in 1948.
Following the end of the civil war in 2009, Sri Lanka's economic crisis deepened each year, and by 2015, the country was facing a severe economic downturn. The Institute of Policy Studies of Sri Lanka had warned the government about a number of risks, but the government failed to adequately address the situation, preoccupied with other government-related activities such as constitutional reforms. Despite presenting a strong economic policy in 2015 to address the situation, the coalition government could not get it passed through Parliament. Instead, certain practices such as excessive distribution of freebies were pushed, including election-related economic decisions. The economic outlook worsened with further political turmoil in 2018. However, the government had earlier implemented several reforms under an IMF-supported program, which included fiscal and monetary consolidation, automatic fuel pricing formula, raising the value-added tax (VAT) rate, and broadening the VAT base. These reforms successfully controlled inflation and reduced fiscal risks posed by state-owned enterprises. Unfortunately, many of these reforms were undone by the new government after the 2019 elections.
These factors are the primary causes of the crisis.
Tax cuts and money creation
President Gotabaya Rajapaksa's government in Sri Lanka implemented significant tax cuts that had a negative impact on government revenue and fiscal policies, causing budget deficits to rise sharply. These tax cuts included increasing tax-free thresholds, which resulted in a 33.5% reduction in registered taxpayers, reducing VAT to 8%, reducing corporate tax from 28% to 24%, and abolishing the Pay As You Earn (PAYE) tax and the 2% “nation-building tax” that financed infrastructure development. The significant loss of tax revenue resulted in rating agencies downgrading the sovereign credit rating, making it more challenging to take on more debt. To cover government spending, the Central Bank began printing money at a record rate, despite advice from the International Monetary Fund (IMF) to stop printing money and instead increase interest rates, raise taxes, and cut spending. The IMF warned that continuing to print money would lead to an economic implosion.
External debt
Prior to the mid-2000s, the majority of Sri Lanka's debt came from multilateral lending agencies. However, under the leadership of Mahinda Rajapaksa, the country's debt was reoriented towards foreign investors and lenders. In 2007, Sri Lanka issued its first international sovereign bond with high interest rates to encourage investors. However, according to commentators, the funds raised were used to finance vanity projects rather than projects of national significance. As a result, Sri Lanka's foreign debt increased substantially, rising from US$11.3 billion in 2005 to $56.3 billion in 2020.
Debt trap
The Exim Bank of China's loans to Sri Lanka for the Hambantota International Port and the Mattala Rajapaksa International Airport have been widely criticized by numerous observers as examples of predatory lending and debt-trap diplomacy. China is currently the largest bilateral lender to Sri Lanka. In 2007, China Harbour Engineering Company and Sinohydro Corporation, state-owned Chinese firms, were contracted to construct the port for $361 million, with 85 percent of the project financed by Exim at an annual interest rate of 6.3 percent. However, after the project began to lose money and Sri Lanka's debt-servicing burden increased, the government decided to lease the project to state-owned China Merchants Port for cash on a 99-year lease, which amounted to $1.12 billion. Sri Lanka utilized the funds to address balance-of-payment problems.
Fall of foreign remittances
The Central Bank of Sri Lanka, under Cabraal, aimed to maintain the peg of the Sri Lankan rupee while engaging in substantial money printing and enforcing strict exchange controls. Consequently, the market value of the rupee declined sharply. Despite the government's efforts to maintain the currency pegged at Rs. 200/- to the US dollar as of February 2022, the rupee's unofficial market value exceeded 248 to the dollar. This resulted in foreign workers using unofficial channels to remit money, causing Sri Lankan banks to run out of foreign currency, and official remittances to decline significantly, with a 61% reduction in January 2022.
Tourism
The tourism industry was a significant contributor to Sri Lanka's economy, accounting for more than 10% of its GDP. Unfortunately, the sector was adversely impacted by both the 2019 Easter bombings and the COVID-19 pandemic, and recovery has been slow. In 2018, tourism generated $4.4 billion and contributed 5.6% to GDP, but by 2020, this had dwindled to just 0.8%. Despite a failed prediction in April 2021 by the World Bank that the Sri Lankan economy would recover in 2021, challenges persist. The 2022 Russian invasion of Ukraine has further complicated matters by exacerbating the country's economic woes. Since Russia is the second-largest market for Sri Lanka's tea exports, the invasion has hit the economy hard. The tourism industry, which heavily relies on Russia and Ukraine as most of the tourists come from these countries, has also been severely affected.
The collapse
The Sri Lankan Government made an official announcement in 2021, declaring the country's most severe economic crisis in 73 years. In August 2021, a food emergency was also declared due to the crisis. As a result of shortages, there have been significant declines in the consumption of electricity, fuel, and cooking gas, leading to the closure of almost 1000 bakeries. In recent months, there have been long queues of vehicles waiting to fill up at petrol stations. The fuel shortage has been worsened by a surge in global oil prices.
In February 2022, the inflation rate in Sri Lanka was recorded at 17.5%. Food items experienced a much higher inflation rate of 24.7%, compared to non-food items which had a rate of 11%. The year-on-year increase for local red chilis, local potatoes, and Nadu rice was significant, with rates of 60%, 74.8%, and 64%, respectively.
In March 2022, a shortage of paper triggered by a lack of foreign reserves to import paper led to several schools in Sri Lanka announcing that their term/mid-year examinations would be postponed indefinitely. Despite the initial plan to hold the exams island-wide on 28 March 2022, the shortage of printing paper and ink ribbons made it necessary to either cancel or reschedule the exams.
Due to fuel shortages, government-owned public and state-approved private schools remained closed for a month and only reopened on 25 July 2022. On 9 May 2022, Sri Lankan Prime Minister Mahinda Rajapaksa resigned from his position in response to violent protests that erupted over the country's economic crisis. His resignation was aimed at helping to form an interim unity government that could address the protests related to fuel and other essential imported goods.
The recently appointed Prime Minister, Ranil Wickremesinghe, announced on 16 May 2022 that the government is facing significant financial challenges. There are no usable dollar reserves and even acquiring a million dollars is proving to be difficult. Additionally, the revenue generated is insufficient to cover the expenses. The revenue forecast of Rs. 3.3 trillion is significantly less than the total government expenditure of around Rs. 4 trillion. This has resulted in a deficit of around Rs. 2.4 trillion. The inflation rate is expected to rise, and power outages may increase up to 15 hours a day. The shortage of essential medicines, especially for heart disease, and surgical equipment has become severe. The government has not made payments for these supplies for four months, and they owe the suppliers around Rs. 34 billion. As a result, the pharmaceutical suppliers are blacklisting the State Pharmaceuticals Corporation. According to Wickremesinghe, this period is the most challenging one in the lives of Sri Lankans and could be more difficult than any previous difficult periods they have experienced.
The recovery
As of November 2022, there had been a significant improvement in the economic situation. The inflation rate had decreased considerably. It was reported that the tourism industry had slowly started to pick up, resulting in a billion-dollar revenue in the first 10 months of the year. The fuel and gas queues had disappeared, and the frequency of power cuts had reduced. Despite the shrinkage of the economy and job losses, the situation had dramatically improved since Gotabaya's departure. As a result, a large portion of Sri Lankans were willing to give Wickremesinghe a chance. Furthermore, the country was declared safe, and tourists resumed visiting again. The budget for the next fiscal year aimed to increase tax and self-finance to alleviate the economic crisis. However, it was noted that a complete economic recovery would take until 2026.
References: https://www.nationsencyclopedia.com/economies/Asia-and-the-Pacific/Sri-Lanka-OVERVIEW-OF-ECONOMY.html
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