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Approach:

  1. Introduction.
  2. Analyse the reasons elaborately.
  3. Conclusion – implications for the S. Asian region.

Sri Lanka is facing its worst economic crisis yet since the country’s independence from British colonial rule in 1948, and new dynamics continue to unfold in the island nation.

  • The 26-year-long civil war that ended in 2009 had a massive impact on the fundamentals of Sri Lanka’s domestic economy. The global financial crisis of 2008 drained the country’s forex reserves, and economic mismanagement by a succession of governments caused the twin challenges of budget shortfall and Balance of Payments (BOP) deficits. The country’s soaring external debts, coupled with the increase in government spending for COVID-19 relief measures, have further weakened the domestic economy structurally. The country’s GDP growth rate had plummeted from 8.01% in 2010 to (–) 3.56 % in 2020.
  • Towards the end of 2019, and in early 2020, the government enacted deep tax cuts in fulfilment of election promise. This led to the loss of approximately one million taxpayers between 2020 and 2022— a massive challenge for an economy that was already suffering from widespread tax evasion.
  • Prior to these tax cuts, Sri Lanka already had one of the lowest tax revenue-to-GDP ratios in the region; these cuts created further burden on the exchequer.
  • Frictions on resource mobilisation had widened the budgetary deficit and increased the external debts for the Lankan economy.
  • The budget deficits rose significantly from 9.6% of GDP in 2019, to 11.1% and 2% of GDP in 2020 and 2021, respectively. The government’s total debt-to-GDP ratio had also escalated from 86.9% in 2019 to 100.6% in 2020, and 105.6% in 2021.
  • For Sri Lanka, the twin deficits on the current and fiscal accounts have moved together consistently since 1970 (with an exception in 1977 when current account surplus had occurred).
  • The economy’s national savings have been consistently lower than its national investment, but the gap has reduced over the years after a peak difference of 19.8 percent of GDP in 1980, when the country had undertaken large-scale public investment schemes.
  • The twin deficits phenomenon increased Sri Lanka’s reliance on foreign debt, leaving the economy more susceptible to exogenous shocks.
  • The relatively slower capital account, combined with the strongly deteriorating current account, have led to a massive BOP crisis in Sri Lanka in recent times, and it is finding it extremely difficult to pay even for its essential commodities.
  • The surging imports of wheat, sugar, and milk powder and other essential items from foreign countries increased the demand for forex.
  • Sri Lanka’s tourism sector accounts for 12% of the country’s GDP and is the fifth largest source of foreign currency in the economy. The industry has been severely damaged by the nation’s deepening economic crisis, out-of-control gasoline costs, and power outages.
  • The country had started to actively print money since the end of the devastating civil war in 2009, to mitigate the BOP crises. Sri Lanka has printed its domestic currency to the tune of LKR 588 billion only in the first quarter of 2022. However, the steady currency printing over the years made it extremely difficult to control inflation or bring stability to the exchange rates.
  • The ill-advised and sudden switch to organic farming could be considered the final nail in the coffin for Sri Lanka’s economy.
  • Sri Lanka has fallen victim to China’s ‘debt-trap diplomacy’.

The current wave of economic and political crises in the South Asian neighbourhood has three crucial implications. First, there must be a minimum level of insulation among countries in times of crises that will prevent an economic collapse of the entire region. Second, structural changes on the domestic front must enable economies to sustain short-run emergencies and supply chain disruptions without falling apart. And third, resilient and timely policies should absolve countries of extreme external dependence by increasing the efficacy of their domestic production and consumption processes.

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