sri lanka street

The Russia–Ukraine war is exacerbating Sri Lanka’s economic woes, while island-wide power cuts and fuel shortages have crippled day-to-day activities. Duruthu Edirimuni Chandrasekera reports.

Strong public calls for better policy decisions are resounding in Sri Lanka amid the country’s swiftly diminishing foreign exchange (FX) reserves after losing access to international financial markets, the decade-high consumer price inflation and spiralling debt.

The country’s reserves have fallen to a record low. The debt to gross domestic product ratio has risen by 24% over the past two years and total public debt has increased to 119%. The interest cost to government revenue is 71% — the highest in Sri Lanka’s history.

On March 7, the Central Bank of Sri Lanka (CBSL) devalued the currency by 15%, to SLRs230 per US dollar. Economists say that floating the exchange rate is a welcome move, but it is still not sufficient as it must realistically catch up to the grey market rate, which is trading at SLRs270 per dollar.

As a result, the annual inflation in the country hit a 13-year peak at 15.1% in February 2022 in the midst of a record rise in the prices of food products.

Rehana Thowfeek, an economist and researcher based in the capital, Colombo, says: “The Sri Lankan rupee has depreciated significantly in comparison to last year, inducing inflation from the rising production costs and an excess demand stemming from the inadequate supply. The monetary expansion by CBSL to fund the government’s large fiscal deficits in the past two years added to the eroding rupee value. Without a commensurate increase in production, the inflationary pressure has driven prices upwards.”

The low official exchange rate drove as much as 60% of migrant worker remittances off formal channels last year, creating a black market in the process. These remittances are now at an all-time low – less than $300m per month. If the SLR is defended at current rates, there is very little incentive for people to send money back home through formal banking channels, according to industry experts.

Struggling importers are trying to maintain their businesses amid the FX shortage, while exporters say the low exchange rate is prohibiting competitiveness in the international marketplace.

Sri Lanka’s 10 leading private business chambers, whose members employ 50% of the country’s workforce, recently demanded the government’s immediate action to stem the economic crisis by reforming the energy sector with market-driven pricing formulas, starting a pre-emptive foreign debt restructuring process and a reform programme backed by the International Monetary Fund (IMF).

Tourism hope

Massive tax cuts in 2019 increased the country’s fiscal deficit and debt became unsustainable, leading to rating downgrades. This effectively isolated Sri Lanka from the international financial markets, putting a stop to its habit of rolling debt over. This is forcing the country to spend its FX reserves to repay its debts and to meet import needs.

The government’s hope for shoring up FX lies in regenerating the tourism industry. One step in this direction was the successful Covid-19 vaccination drive, which saw Sri Lanka start opening up for tourism. CBSL governor Ajith Nivard Cabraal has repeatedly expressed his faith in tourism being a catalyst in easing the FX shortage, pointing to the 100,000 international visitors in February. He expects a higher number from March onwards.

Despite seeing a 14% month-on-month increase in February, according to Ministry of Tourism data, tourism industry officials say March tourist arrivals do not look promising as top tourism source markets — Ukraine and Russia — are at war. Between January and mid-February 25% of the 130,000 tourists were from Ukraine and Russia, arriving in Sri Lanka on package deals through travel agents.

Swift’s banning of seven large Russian banks has impacted Russian tourists’ use of bank cards and bank transfer systems to pay for services including hotels — a major reason that cancellations from Russian tourists are high, according to hoteliers. Tourist inflows from Ukraine are also expected to dwindle due to the war.

“Barring another wave of Covid, Sri Lanka should be able to rely on its traditional tourism source markets like India, the UK and Germany to drive tourism recovery,” says Ms Thowfeek. “However, essential items shortages will impact arrivals as tourists would not want to travel around unable to meet basic needs. Thus, tourism recovery, which was expected to be fast, could slow down.”

Economist and Joint Apparel Association Forum secretary-general Yohan Lawrence says: “Even before the Ukraine crisis, the theory that tourism will save the country was flawed as it assumes that tourists will convert their foreign currency through the formal system. With the low exchange rate, tourists will go to the black market, thus shutting off those revenues from the official inflows.”

The war is also affecting Sri Lanka’s exports sector, as Russia and Ukraine are large markets for one of the country’s main exports, tea. In a statement, National Chamber of Exporters of Sri Lanka’s CEO Shiham Marikar said: “Sri Lankan exporters are concentrating on reducing their exposure or tentatively stopping exporting to these markets.”

Scarce fuel

Acute fuel shortages are further upsetting the tourism industry and other FX-earners, such as the apparel sector. “The power cuts, coupled with fuel shortages, will cripple the economy and bring it to a grinding halt,” Mr Lawrence says.

The dissension in government policy decisions came to a head when energy minister Udaya Gammanpila and industries minister Wimal Weerawansa were sacked in early March.

Sri Lanka managed to receive credit lines from India and the UAE to support its imports needs, and is requesting support from Australia, Pakistan and Russia. Economists warn that these ad hoc measures are insufficient to deal with the crisis the country is facing. “These measures will help in alleviating immediate trade needs, but they are not adequate in the longer term,” Ms Thowfeek says.

Rating agencies are sceptical about Sri Lanka’s economy, with Fitch Ratings forecasting growth to slow to 2% in 2022.

The opposition and certain sections of the public have called for the government to pursue debt restructuring. “At this juncture, Sri Lanka can only undertake debt restructuring if an external party supports it, so that can either be with a large and powerful country, like India or China, or with an international institution like the IMF. It is unlikely that any such country will come to rescue Sri Lanka, so our best bet right now is with the IMF,” Ms Thowfeek says.

CBSL is steadfast in refusing IMF aid, but finance minister Basil Rajapaksa* says that all options — including going to the IMF — will be explored.

Few options

If Sri Lanka prolongs starting discussions with the IMF, this will add more cost to the economy, says Nishan de Mel, executive director, Verité Research, a think tank based in Colombo.

Other economists say the perennial issue of financing the trade deficit in the country must be resolved. Kenneth De Zilwa, economist and managing director Econsult Asia, says: “The widening trade deficit is the main issue, and the current account doesn’t sufficiently meet the $10bn gap needed to be financed, forcing the country to go to the capital markets [for the first time] since 2009.”

However, calls for debt restructuring are gaining traction, with economists saying that it is Sri Lanka’s best bet — accompanied by a credible set of policy reforms, including fiscal consolidation. Mr de Mel says: “Debt restructuring will assist Sri Lanka to flatten impending debt outflows and allow a grace period to restructure and reform the economy, as well as be better equipped to face debt repayments in the future.”

On February 25, the IMF concluded its Article IV consultation with Sri Lanka, recommending the country raise income tax, reform state-owned assets and adopt cost-recovery energy pricing. It emphasised that the country should implement a reliable and clear strategy to restore macroeconomic stability. The IMF encouraged continued improvements to expenditure rationalisation, budget formulation and execution, and fiscal rule.

Murtaza Jafferjee, chair of think tank Advocata Institute, says: “If Sri Lanka decides to take the IMF route, the country will be able to secure up to the $800m annually for the next three years to bridge the external sector gap.”

*Basil Rajapaksa was removed from his post on April 4.


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