The economic crisis that has gripped Sri Lanka is becoming more acute. Last week, Sri Lankan Prime Minister Ranil Wickremasinghe noted that the country’s economy has “completely collapsed” while appealing for urgent help from the International Monetary Fund (IMF).
Finding fuel and food
Many believe that Sri Lanka is facing its worst economic crisis since it gained independence in 1948. Citizens are scrambling to purchase essential goods such as food and fuels, which are in short supply. The government has opted to ration essential supplies to deal with the situation and imposed caps on the prices of various goods in an attempt to rein in inflation. Many public officials have been asked to work from home to reduce the overall demand for fuel. This week a ban on private vehicles getting fuel came into effect. Sri Lankans have also had to endure power outages as power generators do not possess sufficient dollars to import raw materials necessary to generate more power.
The country has also run out of forex reserves required to import food supplies and has failed to make good on its foreign debt commitments. Its forex reserves have dropped below $2 billion from over $7.5 billion in 2019. Sri Lanka notably defaulted on its external debt of about $50 billion for the first time ever in May this year, and this has led to a rise in borrowing costs for the government. India has offered substantial help, totalling over $3.5 billion this year, to the struggling nation through credit lines while the Sri Lankan government is in negotiation with IMF officials for a larger bailout. China, too, as assured support.
Many troubled economies in the past have faced problems that Sri Lanka faces at the moment, such as high inflation, shortage of essential goods, depleting foreign exchange reserves, sovereign debt default, etc. And as bad as things look, a few simple reforms can help to stabilise Sri Lanka’s economy.
Currency reform is the most important step that the Sri Lankan government can carry out to put an end to the crisis. It should be remembered that money is what greases the wheels of commerce in any economy. And when there is very little trust in the value of a country’s currency, most people would be wary of selling their goods and services in exchange for the currency. They may instead opt to barter or use alternative currencies or gold. Sri Lanka’s central bank estimates that the country’s inflation rate was around 30% year-over-year in April, and projects it to reach 40% soon. Independent economists, however, estimate that prices across the economy have more than doubled over the last one year and that the situation could get far worse going forward.
It is unreasonable to expect an economy to function normally when its currency is losing value at such a rapid rate. When people cannot be reasonably certain about the future value of their currency, they would not be willing to produce and sell goods in exchange for the currency as its purchasing power is in serious doubt. This can cause the overall level of economic activity to plummet.
It should be noted that the Sri Lankan central bank was simply watching as inflation got out of control. In fact, it was more than willing to create fresh rupees out of thin air to fund the Sri Lankan government’s spending needs. This caused the money supply in the economy to rise rapidly, in turn causing prices of goods across the economy to shoot up. The task before the Sri Lankan central bank is to provide assurance that it will not inflate the economy’s money supply at will. To do this, it could peg the Sri Lankan rupee to a commodity like gold or at least to a stronger currency like the US dollar, thus limiting its supply. This would assure both ordinary citizens and investors that the value of the Sri Lankan rupee would remain stable, thus encouraging productive economic activity.
Meanwhile, many analysts have blamed the sweeping tax cuts in 2019 offered by the Gotabaya Rajapaksa government for the economic crisis and have demanded that taxes be raised to balance the government’s budget. But taxing an economy that is already in a severe crisis situation will only discourage economic activity and worsen the crisis.
Getting rid of price controls completely is another reform that will be crucial for Sri Lanka to escape the current economic crisis. The government has resorted to imposing price ceilings on essential goods such as food and fuel to control the rise in their prices. Price ceilings, however, discourage producers from producing goods particularly when high input costs make it unviable to produce them. Sri Lankan power generators, for instance, have demanded a hike in electricity prices of over 800% for it to be economically feasible to produce more power. It is encouraging that the government has allowed for fuel prices to be raised by as much as 22%, but what is required is greater decontrol of all prices. Price caps also create shortages, which is the natural outcome of a good being sold at below its market-clearing price.
It should be remembered that market prices act as signals that tell investors where they should be investing their limited capital. Deregulating prices will thus signal businessmen to produce more food and other essential goods which are now in short supply. And as the supply of essential goods in the market rises as businessmen respond to price signals, the prices of these goods will drop, thus making these goods more affordable to citizens.
Price reforms should also include allowing the Sri Lankan rupee to find its natural value against the U.S. dollar in the forex market. The Sri Lankan central bank has indeed allowed the rupee to depreciate against the U.S. dollar from where it was a few months ago. But many believe that the current peg of around 360 rupees to a dollar is still unsustainable and also harmful. For one, the Sri Lankan central bank has to shell out precious dollars to try to defend an overvalued rupee. Since it does not have the dollars required to prop up the rupee, it has resorted to bans and other restrictions to somehow maintain the peg. But by making it illegal to pay more than the official exchange rate to import goods, the central bank may actually be adversely affecting the supply of essential goods into Sri Lanka and worsening the economic crisis.
Germany’s miraculous economic recovery after World War II was due to currency reforms and the decontrolling of prices. There is no reason to believe that similar reforms will not help Sri Lanka recover from its present economic crisis.