In today's Finshots we see why a lot of people are worried about Sri Lanka's deteriorating economic condition


The Story

Sri Lanka’s problem seems to stem from the fact that the country is quickly running out of foreign exchange reserves — Things like gold, dollars, and other dollar-like assets. And while this prognosis may seem accurate at first, it’s simply a symptom of a problem that runs much deeper. So let’s take it from the top, shall we?

Sri Lanka is what you call a “Frontier Economy” — an economy that’s neither underdeveloped nor big enough to be branded an emerging economy. It’s somewhere in between. And countries like these are usually dependent on a few specialised sectors. It’s where they make most of their money. And in Sri Lanka’s case, they seem to be highly dependent on tourism, tea and a few other agricultural products. Tourism in fact contributes more than 10% to its GDP.

And so when the pandemic made landfall, it was inevitable that the country would have to deal with a lot of problems. Sri Lanka’s tourism industry took a beating and the economy nosedived, shrinking by 3.6% in 2020. Tourists were no longer thronging the beaches of the island nation and the country lost out on a lot of precious foreign income. According to data from Trading Economics, Sri Lanka earned revenues of $455 million a month during the heady pre-pandemic days. But it was down to a meagre $3 million this July. So, while large economies like Japan, China, the US, and India were easily able to muster resources to fight the pandemic, frontier economies like Sri Lanka were hit disproportionately hard.

But then there was something else.

As the country was reeling from an economic crisis, its government decided to go “100-per cent organic.” And in a bid to fully realize this vision, they banned fertilizers. Yes, like all chemical fertilizers.

This hurt tea plantations hard and since tea exports accounted for a bulk of the dollar earnings, foreign exchange reserves took a hit once again. As per a report in Al-Jazeera, Tea is Sri Lanka’s single biggest export, bringing in more than $1.25 billion a year, making up almost 10% of the country’s export income. And the ill-thought-out crusade not only cost tea plantations and farmers dearly but also related services and financial sectors that fed off from tea exports. The result — the tea industry capitulated as did many other plantations. By the time the government did relax a few restrictions, the damage was done and the country had already lost out on much-needed foreign income.

And now Sri Lanka is in a state of economic emergency. The country has nearly run out of its foreign exchange reserves. Their reserves plummeted to $2.8 billion by the end of July from $7.5 billion in November 2019. And it doesn't look like they’ll be earning more anytime soon either. So many experts believe that this may be the point of no return.

But why? What makes foreign exchange reserves so precious?

Well, think of it this way. Foreign exchange — generally dollars — is how countries pay for goods when they buy stuff from international markets. So if Sri Lanka wants to buy fuel or meat, they’ll have to pay for it with reserves they’ve earned. Unfortunately, they have been expending a lot of foreign currency while not earning as much. So if they need to buy stuff from the international markets anytime soon, they’ll be in a bit of a pickle.

Now some industrious readers may be tempted to find creative solutions — perhaps take a trip to the printing press. That is to say, if Sri Lanka can print a lot of local currency and exchange it for dollar-denominated assets, that would solve a lot of their problems. Unfortunately, this approach is also ill-conceived because, all things being equal, the local currency will eventually make its way into the economy and wreak havoc. There will be a lot of money floating around without much value and this is a sure-fire way of walking into an inflationary or a hyperinflationary environment where paper currency practically turns worthless.

But Sri Lanka’s troubles don't end there. The country in the past has relied heavily on foreign loans to pursue developmental and infrastructure activities. And many of these loans will be due anytime soon. In July alone, Sri Lanka repaid $1 billion worth of debt, depleting its reserves even further. And at the end of it all, they were left with just enough resources to cover 2 months' worth of imports. Also, with another $1.5 billion worth of foreign bond payments due in January and July next year, the country needs a miracle to walk out of this crisis unscathed.

So yeah Sri Lanka has to deal with a dangerous cocktail of economic mismanagement, pandemic woes and crippling debt obligations all at once. And in all honesty, nobody knows how the country will deal with all of this without some outside help.

Until then…

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