What is happening in Sri Lanka and how did the economic crisis start?
But generally, during an economic downturn, good fiscal policy dictates that governments spend more to stimulate the economy. This becomes impossible under IMF conditions. Despite this situation, IMF loans continued to flow and a beleaguered economy fell deeper and deeper into debt.
The last IMF loan to Sri Lanka was in 2016. The country received US$1.5 billion over three years, from 2016 to 2019. Terms were familiar and the health of the economy plummeted over the course of this period. Growth, investment, savings and income have fallen, while the debt burden has increased.
A bad situation worsened with two economic shocks in 2019. First, there was a series of bombings in churches and luxury hotels in Colombo in April 2019. The explosions led to a sharp drop in tourist arrivals, with some reports indicating up to 80% decline and depletion of foreign exchange reserves. Second, the new government led by President Gotabaya Rajapaksa cut taxes irrationally.
Value added tax rates (similar to goods and services taxes in some countries) have been reduced from 15% to 8%. Other indirect taxes such as the nation-building tax, pay-as-you-go tax, and economic service charges were abolished. Corporate tax rates have been reduced from 28% to 24%. About 2% of gross domestic product was lost in revenue because of these tax cuts.
In March 2020, the COVID-19 pandemic hit. In April 2021, the Rajapaksa government made another fatal mistake. To avoid the depletion of foreign exchange reserves, all fertilizer imports were completely banned. Sri Lanka has been declared a 100% organic nation. This policy, which was withdrawn in November 2021, led to a drastic drop in agricultural production and more imports became necessary.
But foreign exchange reserves remained under pressure. A decline in tea and rubber productivity due to the fertilizer ban also led to a decline in export earnings. Due to declining export earnings, there was less money available to import food and food shortages arose.
Because there is less food and other items to buy, but no drop in demand, the prices of these goods rise. In February 2022, inflation rose to 17.5%.
In all likelihood, Sri Lanka will now get a 17th loan from the IMF to overcome the current crisis, which will come with new conditions.
A deflationary fiscal policy will be followed, which will further limit the prospects for economic recovery and exacerbate the suffering of the Sri Lankan people.
By R Ramakumar, Professor of Economics, Tata Institute of Social Sciences
The Island (Sri Lanka)
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