Sri Lanka on Wednesday began imposing record nationwide 10-hour daily power cuts as it ran out of hydroelectricity on top of a severe shortage of fuel.
The South Asian nation of 22 million people is in its worst economic crisis since independence in 1948, because of a severe shortage of foreign currency to pay for imports.
Why is this happening?
One argument is that the real reason why Sri Lanka has fallen into the dilemma of foreign exchange depletion is because of its weak economic foundation, insufficient self-sustaining capacity, and the government’s long-term excessive borrowing and improper debt structure arrangement.
In early February this year, as Sri Lankan President Gotabaya Rajapaksa requested visiting Chinese Foreign Minister Wang Yi to provide a moratorium on debt repayments, the issue of “problematic Chinese debts” once again came into the global spotlight.
But this is an unfair prognosis. Neither China nor Chinese loans are the main causes behind Sri Lanka’s economic challenges. After all, China has not forced Sri Lanka to borrow money.
The Covid-19 pandemic has led to a global slump with productivity dropping and supply chains getting disrupted across the world. As global food prices have risen, countries like Sri Lanka have borne the brunt given their reliance on imports to sustain themselves.
The tourism sector has been hit due to the pandemic and this is a sector which generates maximum revenue for the island nation. The result has been a depreciation in Sri Lankan rupee, thereby putting more pressure on the country’s foreign exchange reserves.
The country already was so short of hard currency that authorities had restricted imports of cars and fertilizer. It’s now having to scrape into dwindling reserves to pay for ever more costly oil needed to keep the economy running.
Authorities have announced countrywide power cuts extending up to 10 hours a day because they can’t supply enough fuel to power stations. Hydro power, the other energy mainstay, often runs short during the dry season. It will only end with monsoonal rains that usually begin in May.
Is the current government to blame?
The current Government of Sri Lanka, led by president Gotabaya Rajapaksa, made continuous cascading policy errors which resulted in a huge economic crisis for Sri Lanka.
The government, which came to power following a landslide victory in the 2019 presidential election subsequent 2020 parliamentary elections, committed multiple blunders in it's economic policy, which included imposing huge tax cuts which took a toll on government revenue and fiscal policies.
The incumbent government announced the tax cuts as part of its populist agenda to win the elections. Due to the slashing of taxes, budget deficits soared from 5% in 2020 to 15% in 2022.
The implementation of bad monetary policies has resulted in a catastrophic situation for Sri Lanka, triggering social unrest and protests as ordinary citizens in Sri Lanka are unable to bear the soaring cost of living.
Sri Lanka is on the brink of bankruptcy, as the remaining foreign reserves of US$2.3 billion as of March 2022 would not be sufficient to pay the country's foreign debt obligations for 2022, with US $7 billion to be paid, including an International Sovereign Bond (ISB) payment of US$1 billion, which is pending in July 2022. The national inflation rate increased to 17.5% in February 2022, according to the National Consumer Price Index.
How bad is it?
Since November, credit ratings agencies like Moody's, Fitch and Standard & Poor's have all downgraded Sri Lanka on debt default worries. This makes it even more difficult and expensive for Sri Lanka to borrow money, as lenders will now charge it ever higher interest rates.
Fitch estimates Sri Lanka will also need to arrange for $2.4 billion to help state-owned and private firms in the country honour 2022 debt obligations; these will be over and above the $4.5 billion central government debt. The country also needs around $20 billion for essential imports such as fuel, food and intermediate goods for exports.
In 2020, a New York based agency said Sri Lanka's existing funding sources did not appear sufficient to cover its debt servicing needs estimated at just over $4.0 billion in 2021.
Can it be fixed?
According to the agency BELLWETHER, "To solve Sri Lanka’s ‘budgetary problem’ in repaying debt, Treasuries auctions have to succeed. When that is done, the ‘transfer problem’ of foreign exchange will be automatically solved. But this is beyond the ken of Keynesians. Instead, with failed Treasury bill auctions filled with printed money under Modern Monetary Theory, the country is slipping deeper into debt."
To resolve the debt crisis, BELLWETHER noted that Sri Lanka would need a credible fiscal plan and monetary policy, taxes have to be hiked in order to repay debt, and interest rates and opening of imports will allow taxes to flow back to the Treasury.
While it is possible to raise rates and generate dollars to repay foreign debt by curtailing domestic credit, it is not practical to do it on an ongoing basis for many years. If investors see foreign reserves going up after debt repayments, confidence may come back but it is a painful affair, which may or may not work given the current ideology.
