Explained: Sri Lanka's Foreign Currency Crisis & How It Is Ruining the Economy

The collapse of tourism and the lack of FDI has battered those sectors of the economy that earned foreign currency.

Sri Lanka is going through an economic meltdown of a scale unseen since the country's financial crisis of 1948. 

(Photo: Deeksha Malhotra/The Quint)

(This story was originally published on 6 April and is being republished from The Quint's archives in light of fresh unrest being reported from the country with several MPs demanding President Gotabaya Rajapaksa's resignation and huge protests at his residence.)

Sri Lanka is going through an economic meltdown of a scale unseen since the country's financial crisis of 1948, right after it secured independence from the British Empire.

The government, on Tuesday, 22 March, ordered its troops to prevent violence from breaking out at petrol stations as spontaneous protests erupted among motorists lined up for fuel.

In a shocking incident over the weekend, the police stated that two men had collapsed and died while waiting in separate queues to buy fuel.

Amid this economic nightmare, the central government of Sri Lanka has turned to both India and China for aid, as it struggles to pull the country out of this crisis and calm public tempers.

The main cause of the country's crumbling economy is its shortage of foreign currency, which has led to a massive reduction in imports of essential items.

This explainer examines the details of the Sri Lankan government's foreign currency crunch.

The Extent of the Crisis 

Sri Lanka relies heavily on its imports. It imports petroleum, food, paper, sugar, lentils, medicines, and transportation equipment, among other essential items.

The lack of foreign currency means the country does not have the money to buy (import) these commodities.

Imports are so essential that the government had to cancel examinations for millions of school students because it ran out of printing paper.

"School principals cannot hold the tests as printers are unable to secure foreign exchange to import necessary paper and ink," the department of education of the Western Province stated on 20 March.

The situation in Sri Lanka is so critical that the government had to suspend operations at its only fuel refinery because it ran out of crude oil stocks, according to Ashoka Ranwala, the president of the Petroleum General Employees' Union, as reported by Reuters.

The economy is plagued by inflation, which hit 15.1 percent last month. Government data shows that food inflation has risen to 25.7 percent. For example, over the weekend, the price of milk increased by $0.90 for a pack of 400 gram.

Additionally, the second largest gas supplier in Sri Lanka, Laugfs Gas, bumped up prices on Sunday by 1,359 rupees ($4.94) for a 12.5 kg cylinder, according to a statement released by the company.

Angry crowds blockaded a busy street on Monday in the capital city Colombo, upset at the government for the short supply of kerosene oil.

A senior defence official, on the condition of anonymity, told AFP that "tempers are getting frayed as queues get longer."

"A decision was made last night to call out soldiers to reinforce the police. This is to discourage any unrest," the official added.

Drop in Tourism & FDI 

The economic turmoil that Sri Lanka is witnessing today is due to a shortage of foreign currency or a balance of payments (BOP) crisis.

In simple words, BOP is the difference between all the money that has entered the country during a particular period of time and all the money that has left the country during that same period.

In his address to the nation last week, Prime Minister Mahinda Rajapaksa had admitted that the country will have a trade deficit of $10 billion. This means that last year, Sri Lanka imported more than it has exported.

Therefore, the outflow of money is more than the inflow, which, over the years, has led to the foreign currency crunch.

One reason for this is the collapse of the tourism industry in the country, which contributes to around 10 percent of its Gross Domestic Product (GDP).

Tourism was anyway going down after the serial bomb blasts in Colombo in 2019. The COVID-19 pandemic made it worse.

Consequently, the sectors of the economy that earned foreign currency were devastated, leading to a reduction in the inflow of foreign currency, something that is used for making import transactions.

Even its major export destinations like China, and countries of the European Union, due to COVID-19, had issues with trade, thereby reducing Sri Lanka's foreign exchange earnings.

Another factor concerns Foreign Direct Investment (FDI). According to government data, the FDI into Sri Lanka has decreased to $548 million in 2020, compared to $793 million in 2019 and $1.6 billion in 2018.

If the FDI into a country plummets, so does the foreign currency in its reserves.

Additionally, Sri Lanka refuses to take a loan from the International Monetary Fund (IMF).

The governor of the central bank, Ajith Nivard Cabraal, told reporters in January that the "IMF is not a magic wand."

"At this point, the other alternatives are better than going to the IMF," he had added.

By other alternatives, he meant China. "They would assist us in making the repayments... the new loan coming from China is in order to cushion our debt repayments to China itself," Cabraal concluded, as quoted by Reuters.

In the last two decades, China has been the largest bilateral lender and FDI provider to Sri Lanka, but the latter's debt to the former has now become over $2 billion, and is to be paid in 2022.

Therefore, in summary, Sri Lanka is facing a foreign currency crunch, which is severely damaging its ability to import essential items.

The roots of that crunch lie in the recent failure of the tourism industry, the failure to procure enough FDI, and the refusal to take a loan from the IMF.

What Is Sri Lanka Doing About It?

Sri Lanka is turning to China and India for help.

China is reportedly considering a $2.5 billion loan request from Sri Lanka.

Within this, the loan will constitute $1 billion and a credit line will constitute $1.5 billion, as stated to the media by the Chinese Ambassador to Sri Lanka.

"This is in addition to the $2.8–billion assistance that China has extended to Sri Lanka since the outbreak of the pandemic," Qi Zhenhong said, AFP reported.

India has also stepped in to aid its neighbour.

The State Bank of India and the Government of Sri Lanka came to an agreement last week when Finance Minister Basil Rajapaksa visited New Delhi.

India agreed to extend a $1 billion credit facility to the government of Sri Lanka, which will ensure that it can procure food, medicines and other essential commodities for the people.

"Neighborhood first. India stands with Sri Lanka. US$ 1 billion credit line signed for supply of essential commodities. Key element of the package of support extended by India," External Affairs Minister S Jaishankar tweeted.

Sri Lanka is finally seeking aid from the IMF. Basil Rajapaksa will visit Washington next month to discuss bringing about a resolution to the crisis.

President Gotabaya Rajapaksa stated that he had given a green light for an IMF programme to aid Colombo.

IMF spokesman Gerry Rice said last week that it will "discuss with the authorities how best we can assist Sri Lanka going forward, including during the Minister of Finance’s visit in Washington in April," as reported by Reuters.

(With inputs from AFP and Reuters.)