The IMF has allowed Sri Lanka to use the funds provided by it for managing the fiscal deficit. Photo: AFP / Mandel Ngan

After the economic collapse of Sri Lanka, efforts are under way to pull the country out of its unprecedented condition.

Sri Lanka’s foreign-exchange reserves dipped to US$1.716 billion in August 2022 compared with $1.817 billion in the previous month. The governor of the Central Bank of Sri Lanka (CBSL), Nandalal Weerasinghe, said the nation must begin utilizing its limited foreign exchange in a guarded manner.

To help achieve this, the Finance Ministry banned the import of 300 types of consumer items such as chocolates, perfumes and shampoos to reduce the outflow of foreign exchange.

Weerasinghe said the priority should be on purchasing basic items such as fuel instead of purchases that could be postponed, such as a TV or a car.

The CBSL has been trying to stabilize the market using borrowed reserves from the deferred payments to India under the Asian Clearing Union. Along with this, the bank has been sourcing US dollars through a forced sale requirement.

The bank has also maintained a high interest rate to reduce credit in the domestic sector and to balance the outflows and inflows.

These efforts seem to be resulting in positive changes, as the International Monetary Fund (IMF) has allowed Sri Lanka to use the funds provided by it for managing the fiscal deficit.

Sri Lanka’s balance-of-payments (BOP) problem is a recurring trend that is part of its systemic issues.

The twin deficits hypothesis

The twin deficits hypothesis states that the movements of a country’s fiscal deficit and current-account deficit (CAD) tend to be in the same direction. This is a common feature in developing nations that are consumption-driven. The twin deficits create a cycle in which the deficits widen more, and the currency becomes weaker, and the commodities produced in the country become less valuable in the global export market as well.

Trends in Sri Lanka’s current account balance and fiscal balance (1970-2016); Source: Asian Development Bank, data from Central Bank of Sri Lanka

Looking at the reasons behind this, the Mundell-Fleming model suggests that as budget deficits widen, interest rates are pushed upward, and vice versa. Increased interest rates make the nation attractive for international investors, resulting in more capital inflows. This flow results in an appreciation of the national currency, which in turn leads to an increase in the current account deficits.

Alternatively, the appreciation of the domestic currency will make imports cheaper and exports costlier. The exports thus fall in value, which again increases the current-account deficit.

Again, the Keynesian theory suggests that an increase in budget deficits leads to an increase in imports due to the demand for commodities not being met by domestic production alone, leading to more imports as well as increasing inflation, which further widens the CADs and vice versa.

Balance of payment gaps

The current-account balance of Sri Lanka has historically been in negative figures. On the other hand, Sri Lanka has seen capital-account surpluses, which had previously added some relief to the BOP situation.

The government sought to bring in foreign investment by employing measures such as providing tax holidays for investors who were putting money into projects inside the Colombo Port City built by China. The government had to resort to such measures because investors were not confident when the economic situation was not promising, as evident by the CAD widening inducing the BOP precarities.

The surging BOP deficits resulted in the nation being unable to pay for basic supplies such as fuel, food, and educational materials. India provided a credit line to ensure that Sri Lanka could import the raw materials required print books for its school students.

The import ban on 300 items mentioned above was aimed at correcting the BOP deficit, though it has led to private credit and investments reducing and firms having to stop operations in Sri Lanka.

Sri Lanka is exploring avenues of debt restructuring. The provisionally accepted $2.9 billion bailout plan from the IMF is a crucial juncture in the economic situation. Estimates put the external debt of Sri Lanka between $85 billion and $100 billion. Various multilateral agencies, India, China, Japan, and global asset management firms must tolerate losses for the restructuring to be a reality.

The IMF has also asked Sri Lanka to obtain debt-relief measures as well as new loans from China (which accounts for 12% of its external debt), India and Japan, failing which the Fund will not provide relief.

Sri Lanka’s status as a middle-income country made it ineligible to be a part of the G20 Common Framework plan, which would have provided it automatic debt relief. China’s participation in the restructuring is crucial since its absence would deter others such as global asset management firms (which hold $20 billion worth of Sri Lanka’s external bonds) from participating.

While it is true that the Covid-19 pandemic resulted in pressures on the Sri Lankan economy that were unprecedented, the policies adopted by successive governments also had a major role in its current situation. The BOP crises were left unchecked for decades and the government aggravated the problems by pursuing ill-advised policies such as the sudden shift to organic farming.

To climb out of the hole Sri Lanka has dug itself into, and to ensure that this crisis does not repeat, the government needs to formulate structural changes for its macroeconomic policies to address the BOP problems, without solely relying on bilateral and multilateral creditors.

The author acknowledges Aravind J Nampoothiry at the National Law School of India University in Bangalore for his research assistance on this article.

Soumya Bhowmick is an associate fellow at the Centre for New Economic Diplomacy, Observer Research Foundation, India. His research focuses on globalization economics, Indian economy and governance, and sustainable development.