Sri Lanka's Slippery Slope to Stagflation
- Rohan Naval and Rishikesh Madhuvairy
- Jul 31, 2022
- 3 min read
Updated: Sep 5, 2022
Sri Lanka is currently facing severe economic and political turmoil. According to United Nations human rights experts, “Sri Lanka’s economic collapse needs immediate global attention, not just from humanitarian agencies, but from international financial institutions, private lenders and other countries who must come to the country’s aid.” The crisis is said to have begun due to a series of factors such as tax cuts, default on debt payments, inflation, the impact of COVID-19, and a nationwide shift in farming methods to organic or biological farming.
Figure 1: Sri Lanka's Inflation Measured in CPI
Inflation refers to an increase in the average price of goods and services in the entire economy. According to the Sri Lankan Government, the inflation rate of 14% in January 2022 rose to a staggering 54.6 percent in June. Inflation was so rapid due to a combination of three reasons: untimely tax cuts; the impact of COVID-19; and weak government finances. In 2019, The Sri Lankan government introduced tax cuts which consisted of a VAT reduction from 15 percent to 8 percent, leading to a loss in government revenue of more than 2 percent of the country’s GDP. The Easter Sunday bombing and COVID-19 pandemic caused the collapse of Sri Lanka’s tourism market, one of its most lucrative industries. Consequently, the contribution of the tourism industry to its GDP drastically declined from 5 percent in 2018 to only 0.8 percent in 2020. In 2021, the Sri Lankan Government decided to ban the import of fertilizers in order to combat the depletion of the country’s foreign currency reserves. However, this backfired since the dependence on local organic fertilizers led to crop failure and further reliance on food imports. The organic farming push led to a food shortage and impacted the country’s biggest export commodity, tea.
Figure 2: Sri Lanka's Total Imports Growth
Sri Lanka’s trade and foreign relations policies have also greatly contributed to its current economic downfall. Given that GDP is a summation of consumer expenditure, producer investment, government spending, and net exports, trade is a crucial part of any nation’s GDP. The above graph shows that over the last year, Sri Lanka experienced an increase in imports (a leakage) with a sharp decrease following the plunge into its current state. The decrease in imports has coincided with the depreciation of its currency; the Sri Lankan Rupee has gone from 200 to 230 Rupees against $1 USD. The larger story in relation to the foreign impact of Sri Lanka’s economic crisis is its reliance on foreign creditors. China’s actions in South Asia, such as the Belt and Road Initiative, have been accused of being predatory. Sri Lanka has “fallen victim” to one such program. Seemingly attractive investments into infrastructure such as the Colombo Port City Economic Commission Bill have been passed by the Sri Lankan Parliament but were precariously bound to an inevitable and immense cost to their national debt, as China now holds 10 percent ($3.4 billion) of Sri Lanka’s $51 billion debt. As the nation defaulted on its debt payments, there have been few creditors like the IMF and other such organizations who have been willing to lend to Sri Lanka. China has offered assistance in the form of primary goods and monetary support, however, there may be stipulations that make the deal much more short-handed than it seems.
Sri Lanka’s heavy-handed intervention into the economy, namely by banning and regulating goods, has also led to its economic collapse. For example, the previously mentioned policy of banning imported fertilizer has had an impact on its tea exports. Moreover, the nation’s oil policy also seems to face similar shortages. Schools and workplaces have closed owing to the unavailability of transport. Rationing has taken place to conserve oil resources, with only government vehicles and public transport permitted to use petrol and diesel. This has also instigated riots across the nation, with it being seen as an elitist and irrational policy. Fears of stagflation, or a decrease in aggregate supply, have risen as a result of the decline in production, as the limitation of transport and producing goods have decreased the production capacity of the nation.
To summarize, Sri Lanka’s economic woes are only the product of ignoring predictable economic outcomes to reckless fiscal policy. An example of this is how the over-regulation of industries such as agriculture and energy has led to a decrease in output, which can be solved by deregulating sectors to ease the burden on producers. Given that the nation is experiencing a depreciation in exchange rates, an economic recession, and decreasing trust in consumer and lender confidence, the nation should correct its economic policy before taking any loans in the future, or bailout packages, for the sake of long-term stability and the welfare of its creditors.
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