Getting Sri Lanka out of the economic mess

As the crisis in Sri Lanka gets more acute, its government and central bank need to take difficult but necessary steps to turn things around.

The economic crisis that has gripped Sri Lanka is becoming more acute. Last week, Sri Lankan Prime Minister Ranil Wickremasinghe noted that the country’s economy has “completely collapsed” while appealing for urgent help from the International Monetary Fund (IMF).  

Many believe that Sri Lanka is facing its worst economic crisis since it gained independence in 1948. Citizens are scrambling to purchase essential goods such as food and fuels, which are in short supply. The government has opted to ration essential supplies to deal with the situation and imposed caps on the prices of various goods in an attempt to rein in inflation. Many public officials have been asked to work from home to reduce the overall demand for fuel. This week a ban on private vehicles getting fuel came into effect. Sri Lankans have also had to endure power outages as power generators do not possess sufficient dollars to import raw materials necessary to generate more power. 

The country has also run out of forex reserves required to import food supplies and has failed to make good on its foreign debt commitments. Its forex reserves have dropped below $2 billion from over $7.5 billion in 2019. Sri Lanka notably defaulted on its external debt of about $50 billion for the first time ever in May this year, and this has led to a rise in borrowing costs for the government. India has offered substantial help, totalling over $3.5 billion this year, to the struggling nation through credit lines while the Sri Lankan government is in negotiation with IMF officials for a larger bailout. China, too, as assured support. 

Many troubled economies in the past have faced problems that Sri Lanka faces at the moment, such as high inflation, shortage of essential goods, depleting foreign exchange reserves, sovereign debt default, etc. And as bad as things look, a few simple reforms can help to stabilise Sri Lanka’s economy. 

Currency reform is the most important step that the Sri Lankan government can carry out to put an end to the crisis. It should be remembered that money is what greases the wheels of commerce in any economy. And when there is very little trust in the value of a country’s currency, most people would be wary of selling their goods and services in exchange for the currency. They may instead opt to barter or use alternative currencies or gold. Sri Lanka’s central bank estimates that the country’s inflation rate was around 30% year-over-year in April, and projects it to reach 40% soon. Independent economists, however, estimate that prices across the economy have more than doubled over the last one year and that the situation could get far worse going forward.  

It is unreasonable to expect an economy to function normally when its currency is losing value at such a rapid rate. When people cannot be reasonably certain about the future value of their currency, they would not be willing to produce and sell goods in exchange for the currency as its purchasing power is in serious doubt. This can cause the overall level of economic activity to plummet.  

It should be noted that the Sri Lankan central bank was simply watching as inflation got out of control. In fact, it was  more than willing to create fresh rupees out of thin air to fund the Sri Lankan government’s spending needs. This caused the money supply in the economy to rise rapidly, in turn causing prices of goods across the economy to shoot up. The task before the Sri Lankan central bank is to provide assurance that it will not inflate the economy’s money supply at will. To do this, it could peg the Sri Lankan rupee to a commodity like gold or at least to a stronger currency like the US dollar, thus limiting its supply. This would assure both ordinary citizens and investors that the value of the Sri Lankan rupee would remain stable, thus encouraging productive economic activity.