Sri Lanka is in a severe economic and political crisis, which began during the pandemic. The country faces a shortage of food, foreign currency, fuel, fertilizers, and medicine. Is political and financial collapse is possibly in the global future?
After months of protests, people’s patience had run out. They occupied both leaders’ compounds and set fire to the prime minister’s residence finally achieving their goal – the country’s president Gotabaya Rajapaksa and prime minister Ranil Wickremesinghe have promised to resign.
To learn more about the origins of the Sri Lankan crisis watch this documentary.
How can the island nation overcome the hard times?
It is a mistake to see Sri Lanka in a vacuum. This isn’t a Sri Lanken crisis—this is the aftermath of a global pandemic and Sri Lanka had the misfortune of being the first domino to fall.
The same situations that played out there are have potential to play out throughout the developing world. Two years of lost tourist revenue and revenue from expatriate labor. Which managed to perfectly coincide with a huge spike in food and fuel prices driven by the war in Ukraine. That managed to perfectly coincide with escalations in the effect of climate change damaging crop yields throughout the world.
Food Importance Sri Lanka
All together? Countries that aren’t net food exporters (and even some that are, because foreigners might pay more than locals), that rely on outside money and which struggled financially during the pandemic might start going the same route. They are lacking the ability possessed by developed nations to essentially sustain themselves indefinitely on debt. Creditors genuinely question their ability to pay. This cycle will self-reinforce. Refugees will worsen food insecurity and provide a catalyst for conflict in some regions. Which in turn will drain more government funds and undermine government credit. Got to love a feedback loop.
Will it Spread?
How this plays out depends how bad things get. We’re already seeing signs of similar issues arising in Pakistan. Ukrainian and Russian food heavily supplied the middle east, which itself is not exactly stable.
This type of crisis isn’t new its pretty much a textbook case of a emerging-market crisis.
Sri Lanka pegged their currency artificially too high and also unsustainably high. They also borrowed a ton of money in foreign denominations. Combined with being a net importer this made them very vulnerable to capital flight. Their own economic mismanagement then provided the spark for a crisis. In particular crashing their agriculture markets by banning foreign fertilizer and pesticides.
Speculation of Financial Collapse
Basically, Sri Lanka used their foreign currency reserves to keep their currency artificially inflated so imports would be cheaper. They did this even though this introduces a massive risk of the peg breaking. Essentially, them not having sufficient foreign currency reserves to keep their currency afloat and causing it to collapse very rapidly. Compounding this issue they were borrowing in foreign currency because it was cheaper. That is those loaning money saw that there was a risk of the Sri Lanken rupee to go down in value. So they charge more interest for loans that are paid back in the rupee. Loans where they have to repay in dollars have a lower interest rate because nobody expects the dollar to collapse.
But crucially, if the rupee does collapse that debt becomes much more expensive. In this case a rupee was pegged so that you got around ~200 rupees for a dollar. Since the peg broke in march it is now 360. So basically all of their dollar debt got 80% more expensive in 4 months.
By setting an artificially high peg and borrowing in foreign currency they made the short sighted decisions. That the groundwork for a shock to their economy causing their currency to explode lead to sovereign defaults and all kinds of economic mayhem. They 100% did not have to take those risks but they did.
And one of the biggest triggers was their stupid laws crashing their own agro sector. They did by banning foreign fertilizer and pesticides. Add that to mostly bad luck reasons for tourism to fall off. In addition to a bizarre upper income tax cut and its no wonder investors wanted to take their money elsewhere.