Explained | What caused the Sri Lankan economic crisis?

Among other factors, the tourism industry has been hit hard by the COVID-19 pandemic, leading to a dip in foreign exchange.

People queue outside a state-run supermarket to buy essential food items in Colombo on September 3, 2021 as Sri Lanka began imposing price controls on essential food from September 3 after using a state of emergency to seize allegedly hoarded stocks of sugar and rice.

The story so far: Sri Lanka’s government declared an economic emergency last week amid rising food prices, a depreciating currency, and rapidly depleting forex reserves. President Gotabaya Rajapaksa has called in the army to manage the crisis by rationing the supply of various essential goods.

Why is Sri Lanka’s economy in trouble?

A number of factors have led to the current economic crisis in Sri Lanka.

The tourism industry, which represents over 10% of the country’s Gross Domestic Product and brings in foreign exchange, has been hit hard by the coronavirus pandemic. As a result, forex reserves have dropped from over $7.5 billion in 2019 to around $2.8 billion in July this year. With the supply of foreign exchange drying up, the amount of money that Sri Lankans have had to shell out to purchase the foreign exchange necessary to import goods has risen. So the value of the Sri Lankan rupee has depreciated by around 8% so far this year. It has to be noted that the country depends heavily on imports to meet even its basic food supplies. So the price of food items has risen in tandem with the depreciating rupee.

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The government’s ban on the use of chemical fertilisers in farming has further aggravated the crisis by dampening agricultural production. Earlier this year, Mr. Rajapaksa made public his plan to make Sri Lanka the first country in the world with an agriculture sector that is 100% organic. Many, such as Sri Lankan tea expert Herman Gunaratne, believe that the forced push towards organic farming could halve the production of tea and other crops and lead to a food crisis that is even worse than the current one.

What has been the government’s response to the crisis?

The Sri Lankan government has blamed speculators for causing the rise in food prices by hoarding essential supplies and has declared an economic emergency under the Public Security Ordinance. The army has been tasked with the duty of seizing food supplies from traders and supplying them to consumers at fair prices. It has also been given the powers to ensure that forex reserves are used only for the purchase of essential goods. The government has refused to end its aggressive push for complete organic farming claiming that the short-term pain of going organic will be compensated by its long-term benefits. It has also promised to supply farmers with organic fertilisers as an alternative. Further, Sri Lanka’s central bank earlier this year prohibited traders from exchanging more than 200 Sri Lankan rupees for an American dollar and stopped traders from entering into forward currency contracts.

Will the government’s response help the economy?

Mr. Rajapaksa’s drive to make Sri Lankan agriculture fully organic is likely to lead to a significant drop in domestic food production and cause a further rise in prices. Also, the various steps taken by the government to tackle the crisis may actually make things worse. The capping of food prices, for instance, can lead to severe shortages as demand exceeds supply at the price fixed by the government. People have already had to queue up to buy essential goods due to rising shortages.

The strong-arm tactics of the army can also have unintended consequences. When supplies are seized from traders, there is lesser incentive for them to bring in fresh supplies to the market. This can lead to a further drop in supplies and even higher prices for essential goods. It is also worth noting that speculative traders help contain price volatility by allocating scarce supplies rationally across time. So, to the extent the army’s actions discourage speculation, it can lead to greater volatility in food prices.

Further, the decision of the Sri Lankan central bank to ban forward contracts and the spot trading of rupees at above 200 rupees to an American dollar may affect essential supplies. For example, a rice trader who wants to pay more than 200 rupees for an American dollar to import rice may no longer be able to carry out the trade. In fact, trading of currency in the spot market has dried up since the central bank’s order. Also, without forward contracts, which help traders offload the risk of currency volatility onto professional speculators, many traders may be unwilling to import essential supplies.