Why has Sri Lanka’s economy collapsed and what’s next for the island nation?

Sri Lankan Prime Minister Ranil Wickremesinghe, who took office in Maysaid late last month that the island nation’s debt-ridden economy had “collapsed” and was heading for “bottom”.

Short of cash to pay for imports of these basic necessities and already defaulting on its debt, Sri Lanka has sought help from neighboring India and China and from the International Monetary Fund.

Saturday, Prime Minister Wickremesinghe and President Gotabaya Rajapaksa have agreed to resign amid growing pressure from demonstrators who stormed their two residences and set fire to one of them.

Sri Lankans skip meals as they face shortages and queue for hours trying to buy scarce fuel. This is a harsh reality for a country whose economy had grown rapidly, with a growing and comfortable middle class, until the last crisis deepened.

How serious is this crisis?

The government owes $51 billion and is unable to pay the interest on its loans, let alone reduce the amount borrowed. Tourism, an important engine of economic growth, has collapsed due to the pandemic and security concerns after the 2019 terrorist attacks. And its currency has collapsed by 80%, making imports more expensive and aggravating inflation already out of control, with food prices rising 57%, according to official data.

The result is a country hurtling towards bankruptcy, with very little money to import petrol, milk, cooking gas and toilet paper.

Political corruption is also a problem; not only has this played a role in wasting the country’s wealth, but it also complicates any financial rescue of Sri Lanka.

Anit Mukherjee, a policy researcher and economist at the Center for Global Development in Washington, said any aid from the IMF or World Bank should come with stringent conditions attached to ensure the aid is not mismanaged.

Still, Mukherjee noted that Sri Lanka sits in one of the busiest shipping lanes in the world, so letting a country of such strategic importance collapse is not an option.

How does this affect real people?

Tropical Sri Lanka normally has no shortage of food, but people are hungry. The United Nations World Food Program says nearly nine in 10 families are skipping meals or skimping to stretch their food, while 3 million are receiving emergency humanitarian aid.

Doctors have taken to social media in an attempt to secure critical supplies of equipment and medicine. More and more Sri Lankans are applying for passports to go abroad in search of employment. Government workers were given an extra day off for three months to allow them time to grow their own food.

In short, people are suffering and desperate for things to get better.

Why is the economy in such bad shape?

Economists say the crisis stems from domestic factors such as years of mismanagement and corruption.

Much of the public anger has centered on President Rajapaksa and his brother, former Prime Minister Mahinda Rajapaksa. The latter resigned in May after weeks of anti-government protests that eventually turned violent.

Conditions have been deteriorating for several years. In 2019, Easter suicide bombings in churches and hotels killed more than 260 people. It devastated tourism, a key source of foreign currency.

The government needed to raise revenue as external debt for major infrastructure projects soared, but instead Rajapaksa imposed the biggest tax cuts in Sri Lanka’s history. The tax cuts were recently reversed, but only after creditors downgraded Sri Lanka’s ratings, preventing it from borrowing more money as its foreign exchange reserves plummeted. Then tourism stagnated again during the pandemic.

In April 2021, Rajapaksa suddenly banned chemical fertilizer imports. The push for organic farming has taken farmers by surprise and decimated staple rice crops, driving up prices. To save on foreign currency, imports of other items considered luxury goods were also banned. Meanwhile, the war in Ukraine has driven up food and oil prices. Inflation was close to 40% and food prices rose almost 60% in May.

Why did the Prime Minister say the economy had collapsed?

The stark statement made in June by Wickremesinghe, who is in his sixth term as prime minister, threatened to undermine any confidence in the state of the economy and did not reflect any specific new developments. The Prime Minister appeared to highlight the challenges facing his government as it seeks IMF assistance and faces criticism over the lack of improvement since taking office weeks earlier. The comment may have been intended to try to buy more time and support as he tries to get the economy back on track.

The finance ministry said Sri Lanka had only $25 million in usable foreign exchange reserves. This left him without the means to pay for imports, let alone repay billions in debt.

Meanwhile, the Sri Lankan Rupee weakened to around 360 to the US dollar. This makes import costs even more prohibitive. Sri Lanka has suspended repayment of about $7 billion in foreign loans due this year out of the $25 billion to be repaid by 2026.

What is the government doing in the face of the crisis?

So far, Sri Lanka has gotten by, mainly backed by $4 billion in credit lines from India. An Indian delegation visited the capital, Colombo, in June for talks on additional aid, but Wickremesinghe warned against expecting India to keep Sri Lanka afloat for long .

“Sri Lanka places its last hopes in the IMF”, one reads in June in the Colombo Times. The government is in talks with the IMF over a bailout, and Wickremesinghe said he expected to have a preliminary agreement later this summer.

Sri Lanka has also asked for more help from China. Other governments such as the United States, Japan and Australia have contributed hundreds of millions of dollars in aid.

Earlier in June, the United Nations launched a global public appeal for help. So far, the planned funding barely scratches the surface of the $6 billion the country needs to stay afloat over the next six months.

To counter the fuel shortage in Sri Lanka, Wickremesinghe told The Associated Press in a recent interview that he would consider buying higher priced Russian oil.

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