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Lessons to Learn from SRI LANKA Economic Crisis – Causes and Remedial Action

The recent drop in the Sri Lanka economy is an interesting topic to analyse. The country has faced huge forex reserves are depleting, resulting in currency depreciation, inflation, and a supply crunch.  Due to the supply shortages, people are waiting outside shops to stock up on essential goods.  The unexpected surge in demand and panic purchasing has resulted in rising prices.  This prompted the Sri Lankan government to declare an emergency, which allowed authorities to confiscate goods and determine the rates at which they would be sold.  A former army commander has been appointed to confiscate food stockpiles held by merchants and retailers and control their pricing.  The rapid depletion of foreign reserves is the underlying cause of the whole crisis, and it has been a concern for over a decade.  The problem started with the debt trap, and the Covid 19 has added fuel to an already raging fire.  Forex reserves have dropped from over $7.5 billion in 2019 to around $2.8 billion in July 2021.  Here are a few causes as found in media of late.


Sri Lanka was promoted from a low-income nation to a middle-income country in 1997, hoping that the country’s economic growth would improve.  However, the civil conflict intensified after the upgrade, and the country’s economic growth slowed.  The promotion limited its capacity to get concessionary loans from international organisations and bilateral sources.  As a result, Sri Lanka was forced to seek other international funding sources.  Sri Lanka issued its first International Sovereign Bond (ISB) for $500 million in 2007 and began obtaining funds via international financial market.  These ISBs, classified as commercial borrowings, differ from concessionary loans because they have a short repayment term, high interest rates, and no grace period.  Most ISBs have a 5-10 years repayment term with an annual interest rate of more than 6% paid biannually.  On top of that, principle payments are made – that is, the entire borrowed amount of an ISB is paid all at once at the bond maturity date.  Consequently, when an ISB matures, the amount of foreign debt that must be repaid skyrockets, resulting in a significant outflow of foreign currency.  As a result, there are substantial BOP vulnerabilities.  The country’s debt dynamics have changed to a new paradigm.  Sri Lanka’s foreign debt composition has shifted dramatically as a result of its dependence on ISBs.  Commercial loans accounted for just 2.5 % of Sri Lanka’s foreign loans in 2004, but by the end of 2019, they accounted for 56 % of the country’s foreign loans, the majority of which were ISBs.


Debt trap diplomacy is a form of diplomacy that involves providing projects/loans on conditions that are too onerous for nations to repay, forcing them to make political or economic concessions.  China is a master at this diplomacy, with Sri Lanka bearing the brunt of the consequences.  China-Sri Lanka relations were established during Sri Lanka’s civil war, China offered political cover by using its veto to prevent UN resolutions against Sri Lanka from being passed.  Following the civil war, when Sri Lanka was isolated from the international world for war crimes, China was the only country that maintained ties with the country during this time; in 2007, a deal to construct the Hambantota Port was reached.  Sri Lanka has been obliged to China since then, and the country owes China $5 billion.  Many analysts see Chinese loans as difficult because they include many hidden stipulations designed to influence the recipient nation.  China, for example, designs its loans in such a way that they can never be repaid.  When China provided a loan for building a 1.5-billion-dollar port in Sri Lanka, it stipulated that the materials be sourced from China and that the bulk of the employees, from engineers to laborers, be Chinese.  As a result, China offers loans to purchase Chinese goods and hire Chinese employees, with the bulk of the money returning to China apart from the interest and principal.  Chinese during the Covid provided Sri Lanka 1 billion USD loan agreement looks straightforward on paper, with a maturity period of 10 years and a grace period of three years, China appears to have obtained informal assurances from Colombo that it will drop any plans to renegotiate the 99-year lease of Port of Hambantota, and that it will fast-track controversial legislation thought to give a monopoly on the port.

  1. COVID 19

The Covid 19 has exacerbated the already failing Sri Lankan economy by reducing foreign currency inflows and increasing outflows.  The tourist sector in Sri Lanka, which accounts for more than 10% of the country’s GDP and generates foreign currency, has been affected the worst of all.  Consequently, currency reserves fell from more than $7.5 billion in 2019 to approximately $2.8 billion in July of this year.  With the availability of foreign currency dwindling, the amount of money that Sri Lankans have had to pay to buy the foreign currency required to import products has increased.  As a result, the Sri Lankan rupee has devalued by about 8% this year.  It should be emphasized that the nation relies significantly on imports to fulfill even its most basic food needs.  As a result, food prices have increased in line with the rupee’s depreciation.


Earlier this year, the Sri Lankan government declared its intention to become Sri Lanka the first nation in the world to have 100% organic agriculture.  The government prohibited the use of pesticides and fertilizers in agriculture, which had a significant impact on agricultural yield.  Sri Lanka, one of the world’s leading producers of tea and spices, is expecting a significant decrease in output in the following days.  The decrease in supply, along with a rise in demand, necessitated the need for additional imports, which were already under pressure owing to currency depreciation and forex depletion.


  • It has expanded an import ban list to save scarce foreign currency reserves, including automotive spare parts and the nutritional staple turmeric, which are now off-limits to Sri Lankan customers.  Imports from toothbrush handle to strawberries, vinegar, and wet wipes have been prohibited or subjected to specific licensing procedures.
  • Rising gasoline costs, as economies worldwide open up, are an additional hardship for the nation, prompting motorists to conserve on petrol to preserve the country’s foreign reserves for purchases of vital medications and vaccines.  A presidential adviser has warned that fuel restriction may be implemented unless usage is decreased.
  • The country has also entered currency swap deals with China ($1.5 billion) and India ($400 million) to tide over its foreign exchange liquidity crisis.
  • The central bank of Sri Lanka banned merchants from exchanging more than 200 Sri Lankan rupees for an American dollar and from engaging in forwarding currency contracts.

A long-term solution to the present crisis will address the underlying source, which is dwindling currency reserves.  As a result, a long-term solution to the problem will only emerge if the government takes steps to restore the country’s currency reserves.  The government should establish a balance in the balance of payments to build reserves (BOP).  The BOP may be revived by addressing structural weaknesses such as trade contraction, low tax revenue, a lack of “reliable” foreign direct investment (FDI), and decreasing dependence on commercial loans.  The World Bank demoted Sri Lanka from upper-middle-income to lower-middle-income on July 1.  The Sri Lankan government could take advantage of the downgrade by getting concessional loans and channelling them into industries that would increase exports, such as agriculture, textiles, and tourism.

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