Sri Lanka's economic crisis - a stark warning to the developing world
Once labelled the number one tourist destination to visit by Trailfinders travel magazine, Sri Lanka's economic demise has been a culmination of political instability, failure of economic policy and the impact of Covid-19. This has led to inflation rates well over 65%, and the government defaulting on its sovereign bond holdings for the first time in its history. With foreign exchange reserves dwindling away to a mere $1.6 billion and shortages of food, medicine and vital essentials for life persisting, the next few months are crucial in order to steer the once ‘Pearl of the Indian Ocean’ back to economic stability.
As mentioned before, Sri Lanka was once a hotspot for tourists travelling from all corners of the world: visitors continued to pour in pre-pandemic to experience the world-class hospitality as well as the beaches and landscapes scattered around the island nation. However, Covid-19 struck at the wrong time for the Sri Lankan economy: the industry which contributed nearly 5% of the $74 billion GDP was instantly wiped away, causing vast levels of unemployment in regional areas as well as a reduction in foreign currency due to the lack of tourists spending their foreign incomes in the economy. According to the Sri Lankan Tourist Development Authority, foreign exchange earnings as a result of tourism plummeted from $3.6 billion to only $570million, which certainly has played a part in the lack of forex reserves. This means vital imports essential for life are scarce, leading to massive queues for fuel and vast shortages of medicine. Covid-19 and its vast economic consequences still linger today in Sri Lanka and are playing a part in the economic woes of the nation which was too reliant on an industry that completely collapsed during the pandemic.
One major cause of the economic issues that have permeated throughout the Sri Lankan Economy is the 2019 tax cuts implemented by the president, aimed at injecting money into the economy to boost growth and employment. Whilst being a noble objective, the expansionary fiscal policy pursued by the Sri Lankan government to boost development and investment backfired rapidly as it ran huge budget deficits which were completely unstable in the long-run: as a result, the country’s credit rating was downgraded. This meant borrowing from the financial markets had
become harder and more expensive for an already indebted government that was having to borrow extortionate amounts. According to economic theory, these tax cuts would spur growth, innovation and investment by firms on new capital, increasing the productivity of the economy and boosting the competitiveness of their exports. Unfortunately, the pandemic again wiped out all of the above, as business investment collapsed whilst GDP growth fell 6%. Hence, these untimely tax cuts left a gaping hole in government finances as billions of rupees were lost in foregone tax receipts, causing government debt to escalate to $80 billion whilst foreign exchange reserves simultaneously plummeted to $50 million.
Sri Lanka's economic woes stem from global factors (Covid-19, Russia-Ukraine War) which have pushed commodity prices to inconceivable levels and also a mismanagement of economic policy. For example, crude oil has elevated to $115 per barrel from lows of $50 per barrel, hurting emerging markets, coupled with a very strong dollar in the ascendancy as the FED continues to hike rates further. The prolonged crisis serves as a stark message to developing nations that counter-productive economic policies such as the vast tax cuts implemented can cause serious harm to an economy in the long-term, and totally erode a country’s credit rating which is vital when borrowing from financial markets to encourage business investment and growth.
Ashwin Aravinrhan is an A-Level student at St Dominic's Sixth Form College studying Maths, Further Maths, Economics and Physics. He first became interested in the Sri Lankan economy during a summer trip, where he saw first-hand the economic woes that were plaguing the nation, from fuel queues to medicine shortages.