Analyzing the Root Causes of Sri Lanka's Economic Crisis: A Multi-faceted Examination Analyzing the Root Causes of Sri Lanka's Economic Crisis: A Multi-faceted Examination

Abstract

The Sri Lankan economic crisis of recent years has drawn signi icant attention from scholars, institutions, and policymakers alike, prompting an in-depth analysis of its root causes and implications. This paper employs a comprehensive approach to dissect the crisis, drawing from a myriad of sources, including academic works, governmental reports, and the insights of renowned experts in the ield. The analysis categorizes the indings into eight key dimensions that structure the understanding of the crisis. These dimensions encompass policy initiatives, debt composition, political factors, foreign exchange challenges, resistance to IMF assistance, monetary policies, crisis management, and governance-related issues, including corruption and human rights concerns. The paper underscores the critical lessons for the global economy that emerge from Sri Lanka's experience. It highlights the signi icance of maintaining robust central bank reserves as a buffer against tightening global inancial conditions. The crisis also raises concerns of a broader emerging market debt crisis, with a substantial proportion of emerging economies at risk of debt distress. Additionally, the paper examines the complexities of sovereign debt restructuring when a major creditor like China is involved, demonstrating the intricate negotiation dynamics in such scenarios. The analysis serves as a valuable resource for policymakers, economists, and scholars seeking to better understand the intricacies of economic crises in emerging markets and the lessons that can be drawn from Sri Lanka's experience.

Full text

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Analyzing the Root Causes of Sri Lanka's Economic Crisis:
A Multi-faceted Examination
Candauda Arachchige Saliya
Department of Business Management, SLIIT Business School,
Sri Lanka Institute of Information Technology, Malabe, Sri Lanka.
Telephone: +94 11 7544642; Mobile: +94701649443
Emil: saliya.a@sliit.lk; saliya.ca@gmail.com
ORCID: https://orcid.org/0000-0002-9239-1648
Abstract
The Sri Lankan economic crisis of recent years has drawn signiicant attention from scholars,
institutions, and policymakers alike, prompting an in-depth analysis of its root causes and
implications. This paper employs a comprehensive approach to dissect the crisis, drawing
from a myriad of sources, including academic works, governmental reports, and the insights
of renowned experts in the ield.
The analysis categorizes the indings into eight key dimensions that structure the
understanding of the crisis. These dimensions encompass policy initiatives, debt
composition, political factors, foreign exchange challenges, resistance to IMF assistance,
monetary policies, crisis management, and governance-related issues, including corruption
and human rights concerns.
The paper underscores the critical lessons for the global economy that emerge from Sri
Lanka's experience. It highlights the signiicance of maintaining robust central bank reserves
as a buffer against tightening global inancial conditions. The crisis also raises concerns of a
broader emerging market debt crisis, with a substantial proportion of emerging economies
at risk of debt distress. Additionally, the paper examines the complexities of sovereign debt
restructuring when a major creditor like China is involved, demonstrating the intricate
negotiation dynamics in such scenarios.
The analysis serves as a valuable resource for policymakers, economists, and scholars
seeking to better understand the intricacies of economic crises in emerging markets and the
lessons that can be drawn from Sri Lanka's experience.
Keywords: Corruption, Crisis, Debt stress, foreign reserves, Policy issues, Sri Lanka
GEL: D01, F45, F59, G10, G28, G38

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Analyzing the Root Causes of Sri Lanka's Economic Crisis:
A Multi-faceted Examination
Introduction
Many researchers emphasized the importance of asking the question "why" (or even "how")
multiple times, possibly up to ive times or more, until saturation is achieved (Saliya, 2021;
2022;2023). This approach encourages a thorough exploration of the root causes of a
problem (Saliya, 2017; 2020).
There have been extensive analyses and discussions regarding the root causes of Sri Lanka's
bankruptcy crisis. These investigations draw from a wide range of sources, including
scholarly articles Abeygoonasekara, 2022; 2023; Devapriya, 2022; Athukorala and Wagle,
2022; Saliya, 2022;2023), institutions such as UN, IMF, The World Bank, The Central Bank of
Sri Lanka (CBSL), and the Institution of Policy Studies. Additionally, research institutions like
Verite Research have contributed valuable insights, and newspaper articles from respected
individuals who have transitioned from high-ranking positions to academia and research,
such as Professors W.A. Wijewardene and Nikhil Sanghani, have added to the discourse
(Wijewardene, 2022;2023, Sanghani, 2022).
Literature review and discussion
The sources collectively offer a comprehensive understanding of the economic crisis in Sri
Lanka, covering its causes, policy implications, external debt concerns, management
strategies, and the involvement of international institutions like the IMF. The points
discussed in these publications and press releases can be categorized into eight broad
categories, helping to structure the analysis of the crisis.
1. Policy Initiatives (rather blunders) and Reversals: A consensus emerged among
many contributors to the discourse, highlighting that the crisis was exacerbated by
substantial policy initiatives undertaken by the government (Abeygoonasekara,
2022;2023). These initiatives were deemed misaligned with the essential reform
priorities necessary for a country burdened with high levels of public debt. The policy
shifts, which notably included a strategic shift towards a combination of import
substitution and export orientation, explicitly outlined in the CBSL annual report
under the new Gotabaya-Cabral administration, along with increased state
intervention in market guidance, were seen as inadequate in addressing the
fundamental issues at the core of the country's debt problem (Saliya, 2022; 2023).
The government's policy blunders included a ban on synthetic fertilizers, which led
to crop failures, and sudden changes in economic policies that eroded conidence in
the business community.
2. Debt Composition, interest cost and liquidity management:
Composition of External Debt: Sri Lanka's external debt composition shifted from
multilateral and bilateral loans to more costly private market debt, including

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International Sovereign Bonds (ISBs). This compositional shift increased the cost of
servicing external debt.
Expensive Debts: The mounting burden of costly commercial debts, notably the
International Sovereign Bonds (ISBs) and short-term, high-cost borrowings intended
to settle maturing long-term loans, and bilateral swap arrangements with regional
economies, imposed a substantial inancial strain on the nation. Consequently, it
became increasingly dificult to fulill debt servicing obligations. This predicament
resulted in a scenario where debt repayments and interest payments started to
consume a signiicant portion of the country's earnings derived from both exports of
goods and services and government revenue (Athukorala, 2022).
Banking sector: State-Owned Banks' Contribution to External Debt: Although there
was some decline in the share of government external debt with the increase in the
share of state-owned banks in the banking sector, this did not signiicantly alleviate
the external debt burden, as banking sector debt was effectively considered
government debt.
Chinese loans played a pivotal role in funding substantial infrastructure ventures in
Sri Lanka, encompassing the construction of highways, an airport, and a port. It's
worth noting that numerous of these projects, although critical for development, have
encountered inancial non-viability and economic infeasibility, as they do not
generate suficient revenue (cash) to service the loans that facilitated their
realization. Consequently, these undertakings have faced challenges in terms of
inancial sustainability (Saliya, 2019).
3. Political and Socio-Political Factors:
Political Instability and Socio-Political Factors: The crisis led to socio-political
instability, which complicated the process of debt restructuring and negotiating
stabilization and structural adjustment programs. Political decisions, such as large tax
cuts and policy reversals, affected the country's iscal situation The World Bank
2022).
COVID-19 Management: The government's response to the COVID-19 pandemic
included various measures such as loose monetary policy, stringent import controls,
and bilateral swap arrangements with regional economies. These actions, while
intended to address the economic impact of the pandemic, had limited effectiveness
in managing the debt crisis.
4. Foreign Exchange and Reserves: Foreign Currency Shortages: Sri Lanka's chronic
trade imbalance, where imports exceeded exports, contributed to a shortage of
foreign currency reserves. The ban on chemical fertilizers and reliance on organic
alternatives further strained the country's export income (crop failure) and food
supply and worsened the foreign currency shortage (IMF, 2022).
Sri Lanka’s usable foreign reserves fell from USD 7,642 MN in 2019 to USD 1,579 MN
by the end of 2021. When compared with Sri Lanka’s regional peers during the
pandemic, the decline in its reserves appears to only have happened to Sri Lanka,

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while its other Asian countries have seen an increase in their reserve balances
(Publicinance, 2022).
Figure 1: Comparison of Foreign Reserves of selected South Asian Countries
Source: Publicinance, 2022
Exchange Rate Issues and Remittances: A ixed exchange rate policy, followed by a
sudden loat, resulted in the emergence of a thriving black market for foreign
exchange. This, in turn, led to a diversion of funds from the oficial market to the black
market. These exchange rate issues affected remittances from Sri Lankan workers
abroad.
5. Resistance to IMF Assistance: The government hesitated to seek assistance from the
International Monetary Fund (IMF) for an extended period, delaying potential
solutions. The resistance to entering an IMF-supported stabilization program was
partly ideological and fueled by concerns about the impact of IMF conditionality on
iscal reforms (Wickramasinghe, 2022).
6. Money Printing, tax-cuts and inlation: The Central Bank of Sri Lanka resorted to
money printing, leading to concerns about inlation (Figure 2). Ill-advised tax cuts
affecting government revenue and access to overseas markets Critics argued that
excessive money printing led to increased demand for goods and services,
contributing to inlationary pressures (Saliya 2022).

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Figure 2: Money printing and Net Foreign Assets
Source: Economynext
7. Crisis Management: Ineffective Crisis Management: The government's crisis
response was considered ad hoc and inadequate, focusing on short-term measures
like import controls and exchange rate policies rather than addressing the root causes
of the crisis (The CBSL).
8. Corruption, application of law and human rights issues: the UN report on Sri
Lanka highlights a "devastating" economic crisis in the country, attributing it to issues
like "impunity" for past and present human rights abuses, economic crimes, and
corruption. It also underscores the necessity of ending reliance on draconian security
laws, reducing militarization, and delivering security sector reform (UN, 2023).
Furthermore, governance factors, including the rule of law, institutional quality, and
transparency issues related to corruption, were also prominent aspects that came
under scrutiny (Saliya, 2022; 2023).
Nevertheless, as we continue to probe further by repeatedly asking "Why" and "How," we
eventually arrive at a critical juncture where the heart of the country's economic crisis lies,
rooted in the depletion of foreign exchange reserves and the initial reluctance to seek
assistance from the IMF. The IMF has emerged as the pivotal entity that has stepped into
salvage Sri Lanka and is now instrumental in guiding its economic recovery.
If we delve even deeper into the analysis and inquire further, the responsibility for this
situation ultimately falls upon the ruling party. The economic fallout includes inlation, food
and fuel shortages, public outrage, and ultimately the ousting of the president.

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Conclusions
The discussion highlights three key lessons for the global economy:
1. Central Bank Reserves: Central bank reserves play a crucial role in providing a buffer
for countries facing tightening global inancial conditions.
2. Debt Crisis: Sri Lanka's situation raises concerns that it may be the irst domino to fall
in a broader emerging market debt crisis. The IMF warns that nearly a third of
emerging market economies face debt distress due to the challenging global economic
environment.
3. Sovereign Debt Restructuring: Sri Lanka's crisis tests how sovereign debt
restructurings are resolved when a major creditor like China is involved. Past
instances, such as China taking control of Hambantota Port, demonstrate China's
tough stance in negotiations. This complicates the prospects of reaching a new IMF
deal and dealing with private.
Sri Lanka's crisis serves as a case study with broader implications, highlighting the
importance of central bank reserves, the potential risks of an emerging market debt crisis,
and the complexities of sovereign debt restructurings involving major creditors like China.
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