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Sri Lanka is in the midst of one of the greatest economic crises it has ever experienced. It has just defaulted on its foreign loans for the first time since independence, and the country's 22 million inhabitants are facing debilitating 12-hour power outages as well as severe shortages of food, fuel, and other necessities like medications.
Inflation is at an all-time high of 17.5 percent, with food costs skyrocketing to 500 Sri Lankan rupees (A$2.10) for a kilogramme of rice, which would ordinarily cost roughly 80 rupees (A$0.34). Due to shortages, a 400g packet of milk powder is said to cost more than 250 rupees (A$1.05), compared to 60 rupees (A$0.25) normally.
President Gotabaya Rajpaksha declared a state of emergency on April 1. After widespread protests by outraged citizens over the government's handling of the problem, he withdrew it in less than a week.
Many important products, such as gasoline, food, and pharmaceuticals, are imported into the country. Most governments typically maintain foreign currencies on hand in order to trade for these commodities, but Sri Lanka's sky-high prices are being blamed on a foreign exchange shortage.
What is China doing in this debate?
Many people believe that Sri Lanka's economic ties with China are a major cause of the issue. The United States has coined the term "debt-trap diplomacy" to describe this occurrence. When a creditor country or institution advances debt to a borrowing nation in order to boost the lender's political leverage, the borrower is at the mercy of the creditor if they cannot repay the debt.
In 2020, however, Chinese loans represented for only around 10% of Sri Lanka's total foreign debt. International government bonds account for the majority of the money - roughly 30%. Japan is responsible for a bigger percentage of the country's foreign debt, at 11%.
These facts, however, do not add up. The Chinese Exim Bank supported the building of the Hambantota port. The port was losing money, therefore Sri Lanka leased it to the Chinese Merchant's Group for 99 years at a cost of US$1.12 billion.
So, rather than causing a balance of payments crisis (when more money or exports go out than come in), the Hambantota port disaster boosted Sri Lanka's foreign exchange reserves by US$1.12 billion.
Truth behind this crisis
Sri Lanka's agriculture was dominated by export-oriented products such as tea, coffee, rubber, and spices after the country gained independence from the British in 1948. The foreign exchange obtained from exporting these crops accounted for a considerable portion of the country's gross domestic product. The funds were used to import basic food products. Over time, the country began to export garments and gain foreign currency through tourism and remittances (money sent into Sri Lanka from abroad, perhaps by family members). Any drop in exports would be a shock to the economy and put pressure on foreign exchange reserves.
As a result, Sri Lanka frequently experienced balance-of-payments problems. It received 16 loans from the International Monetary Fund starting in 1965. (IMF). Each of these loans came with conditions, such as reducing the budget deficit, maintaining a restrictive monetary policy, reducing government food subsidies for the people of Sri Lanka, and depreciating the currency once it was received (so exports would become more viable). In times of economic slump, however, good fiscal policy dictates that governments spend more to stimulate the economy. With the IMF's criteria, this becomes impossible. Despite this, IMF loans continued to flow, and a struggling economy absorbed more and more debt.
The COVID-19 pandemic began in March 2020. The Rajapaksa regime committed yet another grave error in April 2021. All fertiliser imports were prohibited to prevent the depletion of foreign exchange reserves. Sri Lanka has been designated as a 100% organic farming country. This programme, which was ended in November 2021, resulted in a sharp drop in agricultural productivity, necessitating the use of more imports.
Sri Lanka is likely to receive a 17th IMF loan to help it get through the current crisis, which would come with new terms. A deflationary fiscal strategy will be pursued, severely limiting the possibilities for economic recovery and exacerbating the Sri Lankan people's suffering.