inflation and debt burden aggravate economic crisis

People queue outside a supermarket in Colombo, following Sri Lanka’s declaration of a state of emergency due to food shortages as private banks ran out of foreign currency to finance imports. August 31, 2021

Ishara S. Kodikara | AFP | Getty Images

For Zahara Zain, current times in Sri Lanka are reminiscent of the early 1970s, as the country struggled for survival amid crippling food shortages.

“It almost feels like we’re reliving the 1970s when everything was rationed,” said Zain, owner of a small food business in the capital Colombo. She said daily life had become a struggle for most Sri Lankans as the price of many food staples had soared due to limited supplies.

Sri Lanka is facing the double whammy of rising prices and high debt levels, and its people are bearing the brunt as the domestic situation grows increasingly grim.

“Milk was rationed along with other food items, like rice and sugar,” said the mother of two young children. Before, she could buy 1 kg of milk powder, but now shops are only allowed to sell 400 g.

“How can that be enough? I have kids who need milk,” Zain told CNBC. Also, the price of milk has gone up by almost a dollar per kilogram, she said.

The shortage of U.S. dollars in the country has had a knock-on effect on the prices of most food items and raw materials that are essential for his food business, Zain said. “The situation is really bad and people are suffering.”

The economic crisis has further complicated the situation in Sri Lanka increasingly difficult external debt crisisanalysts said.

Policymakers grapple with “the twin challenges of managing overseas debt repayments while meeting domestic needs,” said Shahana Murkherjee, economist at Moody’s Analytics.

Spiral debt

Sri Lankan President Gotabaya Rajapaksa has declared a economic emergency in September. It allowed the government to take control of the supply of basic foodstuffs and set prices to control rising inflation, which climbed to 14.2% in January.

The South Asian country’s tourism dollars have dried up due to the pandemic. But even before that, Sri Lanka’s debt spiral was already on an unsustainable path, economists said.

Since 2007, successive governments have issued sovereign bonds “without thinking too much about how we will repay the loans“, said Dushni Weerakoon, executive director of the Institute of Policy Studies in Sri Lanka.

“The reserves have been built up by borrowing funds in foreign currency, rather than by increasing earnings from exports of goods and services. This has left Sri Lanka highly exposed to external shocks,” she said.

Moreover, the government spent the foreign currency to pay off the debt and the central bank depleted its foreign exchange reserves. support sri lankan rupeewhich has come under pressure, said Alex Holmes, Asia economist at Capital Economics.

As a result, “there’s not much foreign currency left in the economy to do things like importing food, which is one of the reasons we’ve seen inflation rise into double digits,” he added. Holmes.

Pandemic hits tourism

Covid-19 has dealt another blow to the island nation’s tourism-dependent economy, adding to the debt burden.

“The strain on finances induced by the pandemic has been significant, with government revenues coming under undue strain, as the important revenue-generating tourism sector has effectively been on pause since the start of 2020,” Murkherjee said. “Remittances from migrant workers have also suffered a major setback.”

The pressure on finances induced by the pandemic has been significant, with government revenues under excessive pressure.

Shahana Murkherjee

Economist, Moody’s Analytics

the tax cuts in 2019 worsened the situation by leading to a significant drop in tax revenues and further weakening the government’s hand to support the economy during the Covid crisis, analysts said.

The pandemic has cut off the usual channels of capital inflows as already weak fiscal and debt indicators have worsened,” Weerakoon said. “Sri Lanka’s sovereign rating has been downgraded, drying up access to capital market borrowing,” she added.

China and India offer relief

The country’s official reserves fell by $779 million to $2.36 billion in January from $3.1 billion in December, according to Citi Research. The government’s next big challenge is a $1 billion bond repayment due in July, said analysts.

Debt payments worth nearly $7 billion are also due this year, according to Moody’s.

To cope with the deteriorating financial situation, Sri Lanka has sought assistance from India and China.

In January, Rajapaksa met with Chinese Foreign Minister Wang Yi to ask China to restructure its debt repayments. Last year, the country’s central bank and the People’s Bank of China entered into a bilateral currency swap agreement for a swap facility in the amount of $1.5 billion this decision was intended to reduce the risk of exchange rate fluctuations in the event of financial volatility.

difficult balance

that of Sri Lanka public debt is expected to fall from 94% in 2019 to 119% of GDP in 2021.

“For the government, it’s all about balancing the positives and negatives of defaulting on debt,” Holmes said. “Certainly the cost of a default is probably less than the cost of [keep] go to Sri Lanka,” he said, adding that it was better for policymakers to “bite the bullet”.

Analysts said the country should either restructure the debt or go to the International Monetary Fund for a relief package.

“We believe the Sri Lankan government will eventually have to go to the IMF, although we cannot rule out the risk of a default before any agreement with the IMF is finalized,” Citi analysts said in a note. .

For the government, it’s all about balancing the positive and negative aspects of debt default

Alex Holmes

Asia Economist, Capital Economics

The government’s messages on pursuing the IMF option have been mixed. Finance Minister Basil Rajapaksa was quoted in the FinancialTimes as saying that all options were being explored, including IMF relief.

But central bank governor Ajith Cabraal told CNBC that Sri Lanka does not need IMF help because it has an alternative strategy. In an interview at the end of January, he claimed that Sri Lanka is able to finance its outstanding debt, especially international sovereign bonds, “without causing pain to our creditors”.

Avoid a deeper crisis

In February, the central bank said Sri Lanka had pledged to honor all future debts. He also denied media reports who asserted that the country was on the brink of sovereign default, and said that “such claims are totally unfounded.”

“Policymakers may prioritize stabilizing domestic conditions in the very near term by diverting a significant portion of any additional foreign aid to meet the country’s growing domestic needs and avert a deeper economic crisis,” he said. Moody’s Mukherjee.

For Sri Lankans, the country’s current debt crisis has become a cause of growing anxiety and frustration.

“People are worried and there is a lot of anger directed at the government,” said Zain, a small business owner from Colombo.. “The country is already in a hole, I hope they don’t dig a bigger hole – and just solve the debt problem.”

Saheli Roy Choudhury contributed to this report.

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