How did Sri Lankan economy collapse in 2022? Causes & Economic Reforms
The Sri Lankan government is heavily burdened by external debt payments and a current account deficit that is putting pressure on the local currency, the rupee.
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Where is Sri Lanka? What are its demographics?
Sri Lanka is an island country in the Indian Ocean off the southeast coast of the Indian subcontinent. It covers an area of about 25,000 square miles (slightly larger than West Virginia), and its main export sources of income are textiles, garments, and tea leaves.
Of a population of 21 million, around 8.2 million are employed, a quarter of them in agriculture. The country’s population is aging rapidly, with the number of elderly (65 and older) projected to reach 25.7 percent of the population by 2050, compared to 13.4 percent in 2015.
An overview of the economy of Sri Lanka
The economy of Sri Lanka was valued at US$85.2 billion in 2021, remaining stable from previous years despite the impact of the COVID-19 pandemic on tourism, one of the biggest contributors to earnings.
Broken down by sector, services accounted for more than half of gross domestic product at 58.3%, followed by industry (25.9%); agriculture, forestry and fisheries (6.9%); and taxes less product subsidies (8.9%). In 2021, foreign debt was around $35 billion.
Services make up a large part of Sri Lanka’s economy.
Central Bank of Sri Lanka, Canva
Economic background
In the 1970s, Sri Lanka began to liberalize its economic policies, and the government pushed for an open economy in which goods and services would be traded freely and entry barriers such as tariffs would be removed. It was only after the end of the civil war in 2009, when the government defeated the Tamil Tigers – a separatist group seeking an autonomous state in Sri Lanka – that the economy picked up.
In the post-war period (after 2009), economic growth accelerated briefly and per capita income doubled. But not every aspect of the economy moved strongly. Sri Lanka is a resource-poor country and its reliance on agriculture contributes little to the economy. For decades, the government has run budget and current account deficits, meaning it has relied heavily on borrowing to fund government spending, and has at times borrowed at particularly high interest rates.
These twin deficits have long plagued the government’s ability to pull itself out of debt. For years, the government has mismanaged tax collection and made few meaningful attempts at diversification and revenue generation.
Remittances from abroad have helped prevent the current account, the broadest measure of trade in goods and services, from expanding. This secondary income accounts for a large part of GDP. The nation imports more than it exports, and the central bank has had to use up its precious foreign exchange reserves to make payments on imported goods and debt.
political background
In the post-conflict period, Sri Lanka had many opportunities to build on the momentum of the end of the civil war and focus on economic development. The head of state, President Mahinda Rajapaksa, ruled from 2005 to 2015 and has been blamed for ending decades of internal conflict, but his administration has been plagued by allegations of bribery, corruption and economic mismanagement.
For example, in peacetime, his government increased its defense budget instead of channeling spending into infrastructure projects. His family’s businesses have been accused of profiting from favorable government projects that could have gone to other contractors who had no ties to the president.
Following Mahindra’s tenure, a new president helped briefly put the budget in surplus, but Mahinda’s older brother, Gotabaya Rajapaksa, who was elected and took office in November 2019, implemented tax reform that lowered income tax rates on top earners and lifted the household budget further into deficit.
What caused the economic crisis in Sri Lanka?
Many factors contributed to Sri Lanka’s economic collapse in 2022. Foreign exchange reserves are particularly important when considering a developing country’s ability to protect itself from shocks to the financial system. A nation’s current account balance is also a leading indicator of economic growth and its currency. An examination of Sri Lanka’s current account and foreign exchange reserves can help explain what led to the country’s economic decline.
current account deficits
Sri Lanka has faced current account deficits for decades, partly due to the government’s inability to diversify revenue sources. Its main exports are textiles, garments and tea leaves, and the nation has little manufacturing output.
Services remain the largest contributor to GDP, but a quarter of Sri Lankans are disproportionately employed in agriculture. The government has relied on importing more goods than it can export, leaving the country’s current account in deficit.
As shown in the chart below, from 2012 to the second quarter of 2022, Sri Lanka has had few quarters in surplus. Funding this type of deficit usually means borrowing from abroad to cover the shortfall.
Sri Lanka has a persistent current account deficit.
Central Bank of Sri Lanka, Canva
foreign exchange reserves
With the current account in deficit, foreign investors had little reason to hold onto Sri Lankan rupees. The country has had to convert much of its own currency into dollars to pay for imported goods, and this has caused the rupee to depreciate.
Billions of dollars flow into the economy annually through remittances from Sri Lankans working abroad. Still, maintaining foreign exchange reserves is a challenge due to pressures to repay foreign debt (usually in dollars) and payments for imports such as gasoline, other crude oil fuel products, and fertilizers.
In the chart below, monthly reserves from November 2013 to November 2022 peaked at $9 billion in April 2018 before gradually falling to a low of $1 billion in November 2021.
Foreign exchange reserves began to fall in mid-2020 as nationwide lockdowns and a halt to global trade prompted the central bank to draw on reserves for payments.
Central Bank of Sri Lanka, Canva
COVID-19: A turning point in the economy
The COVID-19 pandemic has turned Sri Lanka’s economy upside down, further complicating the country’s finances and solvency. Inflation started to creep in 2021 due to supply chain disruptions, and maintaining foreign exchange reserves became difficult due to the decline in tourism and remittances.
The consumer price index, a measure of inflation, rose by more than 10% annually from December 2021 (eventually reaching almost 70% in September 2022). In early 2022, to curb runaway inflation, the central bank began aggressively tightening monetary policy, and the resulting rise in interest rates was detrimental to lending – forcing companies out of their ability to borrow to fund their operations, and in turn curbing the economy economic growth.
Annualized inflation accelerated rapidly from late 2021, highlighting the impact of the COVID-19 pandemic a full year later.
Central Bank of Sri Lanka, Canva
Accelerating into economic collapse in 2022
In early 2022, social unrest began to emerge in the form of public protests. The government tried to quell the protests by banning social media, declaring a state of emergency and imposing curfews, but these efforts were unsuccessful.
With foreign exchange reserves at their lowest level in years, the government had few funds to pay for goods from abroad, especially fuel. Long lines formed at gas stations and power outages became commonplace, affecting businesses and their production.
In March 2022, the central bank gave up hope of protecting the rupee from further depreciation and sent the currency into free fall. In April, the government – with foreign exchange reserves of just over 1 billion
By May, a dollar was fetching about 365 rupees, compared to about 200 rupees two months earlier.
After the sharp devaluation of the rupee, the IMF began to intervene to save Sri Lanka’s economy from another collapse.
Screenshot of the Central Bank of Sri Lanka
The public urged Gotabaya Rajapaksa to step down as president, which he did in July 2022. A new president came to power, but financial problems persisted and the government was too broke to deal with them.
The International Monetary Fund stepped in and served as lender of last resort, providing Sri Lanka with a $2.9 billion loan in September to help the country make its payments. However, the emergency aid came with certain conditions for economic reforms, including changing the country’s tax structures to generate more income and improving tax transparency.
Can Sri Lanka recover from its economic crisis?
With the IMF bailout package and austerity measures, Sri Lanka can embark on its path to economic recovery. Many other countries faced similar difficulties, and in most cases it took years to get their economies back on track.
One of the benefits of a devalued currency is that Sri Lanka’s goods and services are cheaper to buy in terms of foreign money, which could help push the current account into surplus. Diversifying its economy to include other forms of income generation may become a priority under the IMF’s economic reform plan.
Still, challenges remain on the political front, and much depends on political leadership’s willingness to change. Whether the new government will deviate from previous policies under previous governments remains to be seen.
