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Around the World, Across the Political Spectrum

The Financial Crisis of Sri Lanka: History, Factors, Effects, and Global Consequences

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The small island nation of Sri Lanka made its first financial default since its formation in 1948 on May 18, 2022, sending a troubling portent for its future. A member of the Parliament was among the hundreds of people injured and scores of people killed during the months-long protests and violence that came before this. The nation dubbed the "Pearl of the Indian Ocean" and known for its miles of sandy beaches, mountainous tea plantations, and warm-hearted people, has now become a living hell for its citizens due to rolling power outages, shortages of essentials like food, medicine, and fuel, and rising political instability (Mehta, 2022).

How it all started

Ethnic tensions between the Tamil minority and the Buddhist majority Sinhalese, who make up about three-quarters of the population, began to flare soon after Sri Lanka (previously known as Ceylon) gained independence from Britain in 1948. These tensions had been simmering under colonial rule. The "Sinhala Only Act," which established Sinhala as the only official language of the country, was passed by Prime Minister S.W.R.D. Bandaranaike in 1956, which hastened the process. It sparked bloodshed throughout the nation, with extensive rioting between Tamil-speaking minorities and the Sinhalese who felt oppressed. After being assassinated by an extreme Buddhist monk, Bandaranaike's wife, Sirimavo Bandaranaike, took over as prime minister (Zhang, 2022).

In the city of Jaffna, which has a mainly Tamil population, the burning of the Jaffna Public Library in May 1981 marked a turning point in racial tensions that eventually led to the outbreak of a catastrophic civil war in 1983 under the control of the LTTE. More than 100,000 civilians, soldiers, and militants died throughout the conflict's two decade duration in Sri Lanka, while hundreds of thousands of people were displaced in the country's north. With huge costs in the form of decreased tourist arrivals and slowed foreign investment as a result of the turmoil, the economic cost was also enormous, estimated to be approximately $200 billion. In addition to running ongoing budgetary deficits and accumulating significant sums of unsustainable external debt as a result of this protracted and expensive battle, the government was also adversely affected by the 2008 global financial crisis (Mani, 2022).

The majority of the increase in unmanageable external debt, however, occurred during the decade that followed the end of the war, when the administration of the then-president Mahinda Rajapaksa launched massive, multibillion-dollar infrastructure and development projects all over the island to spur economic growth and investment. However, because they were deemed to be economically unviable "white elephants," the majority of those initiatives ended up being viewed purely politically. The Hambantota port in Hambantota, the political family's hometown, was one notable example. After the loan could not be repaid, the port was ultimately leased to a Chinese corporation for 99 years (Zhang, 2022).

Factors that led to crisis

Although prior governments' poor financial management and wasteful investments can be blamed for a large portion of Sri Lanka's current problem, external developments from 2019 onward have had a significant part in worsening the crisis and increasing pressure on an already unsustainable debt burden. The first of them was a coordinated sequence of terrorist assaults by Islamists against churches and five-star hotels on April 21, 2019, in Colombo, the country's commercial center. The over 300 fatalities and more than 500 injuries made it the bloodiest terrorist attack in Sri Lankan history. The critical tourist sector, which is a significant employer and provider of foreign currency, was also badly hit. Tourism earnings fell by about 20%, which had a detrimental effect on the country's balance of payments and tax receipts. After the attacks, Gotabaya Rajapaksa, Mahinda's brother, quickly won the presidency by appealing to nationalist and pro-security emotions, and appointed members of the Rajapaksa family to his cabinet (Salikuddin, 2022).

Shortly after, the new administration launched a fiscal expansionary agenda that resulted in tax cuts for individuals and corporations, a rise in budget deficits, and record-high money printing by the central bank to finance rising spending. This decreased tax revenue, which was already low, and increased pressure on the government to pay off the mounting debts. The beginning of the global COVID-19 outbreaks and the ensuing lockdowns made the situation even worse. The already troubled tourism industry suffered greatly as visitor numbers sharply declined, robbing the government of crucial foreign currency and creating thousands of jobless people. The government failed to maintain the currency linked to the USD as a result of the rapid money creation, which caused inflation to spiral out of control and the currency to depreciate to new lows. Foreign workers began to send money through unauthorized means as a result, which led Sri Lankan banks to run out of crucial foreign currency. In addition, the government's decision to outlaw the use of inorganic fertilizers in April 2021 had a significant negative impact on the nation's major export industry—tea cultivation (Bostock, 2022).

Last but not least, the pandemic-induced spike in food and fuel prices worldwide coincided with the start of the Russo-Ukrainian conflict in early 2022. Sri Lanka's vital foreign reserves fell precipitously during this time from $7.6 billion in 2019 to a pitiful amount of $50 million in May 2022. With obligations totaling $7 billion due this year, Sri Lanka eventually stopped making payments in May 2022 (Salikuddin, 2022).

Effects of the economic crisis

The formerly rich nation has descended into anarchy as a result of an extraordinary economic and political disaster. The thin wallets of everyday people are being squeezed by inflation, which surged to a record 54.6% in July 2022, especially in the prices of staple foods. Infinite queues for fuel, food, and medicine are now commonplace as a result of ongoing currency devaluation and declining foreign reserves, which has led to shortages of electricity, fuel, and cooking gas due to a drop in imports. The education of millions of pupils has also been impeded by severe paper and ink shortages, which have forced school closures and postponed exams. Additionally, the healthcare industry is in turmoil, where vital medications are becoming harder to find and ongoing power outages make it difficult to perform key surgeries and procedures. As supplies continue to run out, the government has also instituted a four-day workweek for employees so they can take a day off to cultivate their food. Additionally, according to the UN, four out of every five people in the 22-million-person nation are being compelled to skip meals (Mani, 2022).

With the whole government quitting in unison along with the prime minister amid widespread riots and violent protests around the island, the economic crisis has further thrown the nation into political unrest. The protests haven't subsided, and his replacement, opposition member and six-time premier Ranil Wickremesinghe, hasn't been able to win over the population. Foreign purchasers have shifted their orders for tea and textiles to nearby nations like India, severely hurting the export industry, a crucial source of foreign cash. In South Asia, Sri Lanka currently has the second-highest rate of child malnutrition, only behind war-torn Afghanistan, according to UNICEF. This underscores the severity of the current situation, which shows no indications of abating (Salikuddin, 2022).

Global outcomes of the crisis

The current crisis in Sri Lanka could serve as a warning to other developing nations in the area and around the world. The pandemic's three-pronged challenges—rising food and energy costs owing to the conflict in Ukraine and heavier debt servicing obligations due to an increase in global interest rates—are having an impact on developing nations in Asia and Africa. According to the World Bank, up to a dozen developing nations could find themselves unable to pay their debts within the next year, marking the largest wave of a debt crisis in developing economies in a generation. Approximately 60% of low-income countries face the possibility of having to restructure their debts to avoid default (Bostock, 2022).

Due to the substantial sums of variable rate loans that developing nations have taken—amounts that are now rising as central banks throughout the world tighten monetary policies—these countries are particularly vulnerable. Pakistan, a nation in the South Asian region that is also experiencing a worsening economic and political crisis, is one of the most susceptible. Similar to Sri Lanka, it has pursued debt-driven populist policies by constructing massive projects, providing subsidies, and implementing welfare programs for the poor. Now, however, it faces tens of billions of dollars in debt repayment obligations over the following few years due to rising imports, depreciation, and shrinking foreign exchange reserves. Imran Khan, the country's recently ousted prime minister, has threatened agitation and protests over the holding of new elections, adding to the country's impending political crisis. Pakistan appears to be on the verge of defaulting and degenerating into turmoil right now (Bostock, 2022).

The current economic crisis and insolvency of Sri Lanka are the result of years of financial mismanagement, poorly planned and financially unsound projects, and outside events starting in 2019. Only time will tell whether Sri Lanka will recover and see the light at the end of the tunnel or if it is just the first domino to fall (Salikuddin, 2022).

 

Arisha Aslam is a Government and Public Policy student at the National Defence University in Islamabad, Pakistan. 

 

 

References

Athas, I., Liakos, C., & Mogul, R. (2022, July 6). Sri Lanka is 'bankrupt,' prime minister says. CNN. https://edition.cnn.com/2022/07/05/asia/sri-lanka-bankrupt-fuel-crisis-intl-hnk/index.html

Bostock, B. (2022, July 6). Sri Lanka says it is 'bankrupt' as financial crisis ravaging the country deepens. Business Insider. https://www.businessinsider.com/sri-lanka-says-bankrupt-financial-crisis-ravages-country-debts-default-2022-7

Mani, S. (2022, July 9). Sri Lanka declares bankruptcy, what happens next? CNBCTV18.com. https://www.cnbctv18.com/world/sri-lanka-declares-bankruptcy-what-happens-next-14081332.html

Mehta, S. (2022, July 5). The economic crisis in Sri Lanka: What led to bankruptcy? SAGE Business Cases. https://dx.doi.org/10.4135/9781529612226

Salikuddin, T. (2022, July 16). Five things to know about Sri Lanka's crisis. United States Institute of Peace. https://www.usip.org/publications/2022/07/five-things-know-about-sri-lankas-crisis

Zhang, T., Cheng, S., & Luo, A. (2022, October 11). The Last Resorts' to Destroy the Democratic Socialist Republic of Sri Lanka. Frontiers in Business, Economics and Management, 5.3: 89-93. https://doi.org/10.54097/fbem.v5i3.1916

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