The Lankan Economic Crisis Explained
There is so much to learn from the ongoing Sri Lankan financial crisis.
The COVID-19 pandemic drove the world to an economic recession. Layoffs, cutbacks, the shutdown of several brick-and-mortar stores were the pandemic's highlights from a financial standpoint. The Sri Lankan economic crisis is no different. The ongoing Sri Lankan balance-of-payments crisis is painted on the canvas of the early 1970s economic downfall, as Al Jazeera reports:
"A bullock cart carrying a barrel of Kerosene, a symbol of life in Sri Lanka in the 1970s, is once again a common sight on the streets of Sri Lanka's commercial capital as dwindling foreign currency reserves have hampered the imports of everyday essentials including cooking gas."
Let us understand the balance of payments in light of the Sri Lankan economic crisis. The crisis continues to gravely impact the Sri Lankan economy to the extent of the paper shortage.
Balance of Payments (BOP)
Each financial market comprises three parties, namely:
The BOP aids in recording the dollar value and volume of such transactions when these parties of one country engage in international transactions with another country. BOP can either be surplus or deficit.
A BOP surplus implies more inflow of money than the outflow. Transactions that create BOP surplus include increased exports, foreign remittances, tourism, etc.
A BOP deficit implies more outflow of money than the inflow. Transactions that include the BOP deficit include increased imports, outsourced labor, etc.
What When Wrong with Sri Lanka?
Quoting Shahana Mukherjee, an economist at Moody's:
"The pandemic-induced strain on finances has been significant, with government revenues coming under excessive pressure as the important revenue-generating tourism sector has effectively been on pause since early 2020. Migrant worker remittances have also suffered a major setback."
Hence, it is clear that a sharp decline in tourism activities and foreign remittances can cause a BOP deficit. It holds for the Sri Lankan crisis. Sri Lankan president urges foreign ex-pats to send remittances. He said, "Sri Lankans abroad who sent foreign currency back home are a major resource." Al Jazeera reported that:
"Data shows that overseas remittances — the nation’s main foreign exchange earner — have fallen by nearly 60 percent to $812m in December from a year earlier. For the whole year, remittances declined 22 percent to $5.4bn."
Accounts in BOP
There exist two kinds of accounts in BOP:
The capital account involves recording the value and volume of international transactions of assets. These assets include stocks, bonds, and real estate. Since the recording of the transactions of long-term securities takes place, it is called a capital account. Long-term securities mature on or after a year's completion.
Financing of development projects is made possible through capital account reserves. As per the Asian Development Bank (ADB), "Sri Lanka has invested substantially in physical capital such as in road infrastructure connecting cities or townships distributed evenly across the country."
The current account involves recording the value and volume of transactions, such as imports and exports, remittances, revenue generated from tourism, the outflow of money due to outsourced labor, purchase of foreign currency, etc.
Ideally, the sum of capital account balance and current account balance must be zero. It implies that a current account surplus can make for the capital account deficit, or a capital account surplus can make for the current account deficit.
Capital account balance + Current account balance = 0.
Official Settlements Balance
However, due to the presence of the nation's central bank, there arises no need to make for one's deficit with the other's surplus. The sum of both account balances is called the official settlements balance. Instead, the central bank tries to curb the deficit through official reserve transactions. Official reserve transactions include but are not limited to IMF's special drawing rights (SDRs) and borrowing from foreign nations. Sri Lanka did the same.
In the case of Sri Lanka, according to Citi Research, "the country's official reserves fell by $779 million to $2.36 billion in January  compared with $3.1 billion in December ."
"Reserves were built by borrowing foreign currency funds, rather than through higher earnings from exports of goods and services. This left Sri Lanka highly exposed to external shocks."
Moreover, Al Jazeera reports that "Sri Lanka has borrowed heavily and faces repayments on $15bn in international sovereign bonds.”
From Fixed to Floating Exchange Rate Regime
Apart from the official settlements balance deficit, the central bank transitioned from a fixed to a floating exchange rate regime. As Alex Holmes, Asia economist at Capital Economics, said:
"The central bank has been running down foreign exchange reserves to prop up the Sri Lankan rupee, which came under pressure."
However, in early March 2022, the central bank moved toward a floating exchange rate system. In such a system, the market forces of demand and supply determine the price of domestic currency in terms of foreign currency.
As The Guardian reports:
"Inflation has meanwhile been spurred by the government printing money to pay off domestic loans and foreign bonds."
As per the author's previous blog on Understanding Monetary Policy, too much money causes inflation.
The Role of Fiscal Policy
The Government directly issues a fiscal policy, unlike a monetary policy. A fiscal policy aims at regulating taxation and government expenditure. The issue of an expansionary fiscal policy takes place when the goal is to spend more and tax less. Sri Lanka did the same. According to The Guardian:
"The meltdown faced by the government ... is compounded by high government spending and tax cuts eroding state revenues, vast debt repayments to China and foreign exchange reserves at their lowest levels in a decade."
The Sri Lankan economic crisis arose due to several factors. These factors include:
the overall balance of payments deficit
the central bank printing excess money to offset loans
issuance of an expansionary fiscal policy
a downward trend in tourism and remittances
huge capital spending
excessive borrowing of foreign currencies.