Sri Lanka’s economy is currently facing a range of crises, including a major decline in foreign exchange revenues due to the COVID pandemic, difficulties in managing external debt obligations, a significant reduction in foreign exchange reserves, and the ripple effects of the conflict in Ukraine. From January 2020 to mid-March 2022, foreign exchange reserves dropped by around 70% to approximately $2.4 billion. Additionally, the Sri Lankan rupee has experienced a sharp depreciation, further compounding the economic challenges.
To address these issues, the Central Bank of Sri Lanka (CBSL) initially maintained an exchange rate of 200 rupees to the dollar for an extended period to avoid devaluation. However, in early March, the CBSL finally devalued the currency by 15%. This devaluation proved unsustainable, leading to further depreciation, with the rupee falling to around 300 rupees to the dollar by the end of March.
The underlying causes of the crisis are a combination of existing weaknesses that were exacerbated by the pandemic, particularly in the tourism and export sectors. Tourism earnings fell from $4.4 billion in 2018 and $3.6 billion in 2019 to just $682 million in 2020 and $534 million in 2021. Similarly, export revenues declined from $11.9 billion in 2019 to $10 billion in 2020, before slightly increasing to $12.5 billion in 2021.
The significant decline in foreign exchange earnings has severely impacted Sri Lanka due to its substantial external debt of approximately $35 billion. Much of this debt is a result of borrowing between 2004 and 2015 during the Mahinda Rajapaksa government. The country’s debt service payments for 2022 are estimated at $6.9 billion.
Combined with the decrease in foreign exchange earnings, these debt obligations have contributed to the depletion of foreign reserves, which stood at $2.8 billion at the end of July 2021. Temporary relief came from sources such as the International Monetary Fund, currency swap arrangements, and support from China and India, but this could only provide limited assistance.
Consequently, the Sri Lankan government has been forced to restrict imports to conserve foreign exchange and meet debt repayment obligations. An import clampdown imposed in 2020 has resulted in shortages of essential goods, including fuel, leading to long queues at gas stations. Hospitals have faced shortages of critical drugs, and there have been scarcities of basic necessities like milk, food, and cooking gas. The decline in agricultural production following the ban on chemical fertilizers and pesticides is further exacerbating the situation.
The depreciation of the rupee has also contributed to rising inflation and increased costs for imports, further worsening the economic crisis. Additionally, exporters have been reluctant to repatriate their earnings, and Sri Lankan workers abroad have resorted to informal remittance channels to take advantage of better exchange rates, adding to the foreign exchange shortfall.
These interconnected problems have pushed Sri Lanka to the brink of bankruptcy. The country’s economic woes existed prior to the Ukraine conflict but have been amplified due to the disruption in trade with Russia and Ukraine, which are important partners for Sri Lanka.
To navigate through these challenges, the Sri Lankan government has relied on assistance and credit from neighboring countries, particularly China and India. While historically favoring China, recent tensions between Beijing and Colombo have led to a shift in the dynamics. India has stepped in to provide emergency supplies of agricultural products and has initiated substitute projects in response to Sri Lanka’s security concerns regarding Chinese involvement in certain projects.
However, it remains uncertain how much support China and India can provide together to alleviate shortages, control inflation, and strengthen Sri Lanka’s foreign exchange reserves until the country’s dollar earnings recover. If this support proves insufficient, Sri Lanka may have to consider alternative measures to overcome its economic challenges.