As the crisis in Sri Lanka gets worse, its government and central bank need to take difficult but necessary steps to turn things around.
As the crisis in Sri Lanka gets worse, 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 getting worse. Last week, Sri Lankan Prime Minister Ranil Wickremesinghe Noted that the country’s economy has “completely collapsed”, appealing for immediate help from the International Monetary Fund (IMF).
finding fuel and food
Many believe that Sri Lanka is facing its worst economic crisis since gaining independence in 1948. Citizens are scrambling to buy essential items like food and fuel, which are in short supply. The government has opted for an essential supply of ration to tide over the situation and has imposed price restrictions on various items in an attempt to rein in inflation. Many government officials have been asked to work from home to reduce the overall demand for fuel. The ban on getting fuel to private vehicles came into force this week. Sri Lankans have also faced power cuts as power producers do not have enough dollars to import the raw materials needed to generate more electricity.
The country has also exhausted the foreign exchange reserves needed to import food supplies and has failed to meet its foreign debt commitments. Its foreign exchange reserves have fallen below $2 billion from $7.5 billion in 2019. Sri Lanka notably defaulted on its external debt of around $50 billion for the first time in May this year, and this has increased the cost of borrowing for the government. , India has offered substantial help totaling more than $3.5 billion to the struggling nation this year through credit lines, while the Sri Lankan government is in talks with IMF officials for a bigger bailout. China also gave assurances in the form of support.
Many troubled economies in the past have faced problems that Sri Lanka is currently facing, such as high inflation, shortage of essential commodities, dwindling foreign exchange reserves, sovereign debt defaults, etc. And as bad as things look, a few simple fixes can help stabilize Sri Lanka’s economy.
currency reform
Currency reform is the most important step that the Sri Lankan government can take to end the crisis. It must be remembered that money is what lubricates the wheels of commerce in any economy. And while there is little confidence 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 choose to barter or use alternative currencies or gold. Sri Lanka’s central bank estimated the country’s inflation rate at around 30% year-on-year in April, and is projected to reach 40% soon. However, independent economists estimate that prices in the economy have more than doubled in the past year and the situation could worsen 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 of the future value of their currency, they will be unwilling to produce and sell goods in exchange for the currency because its purchasing power is in serious doubt. This can lead to a fall in the overall level of economic activity.
It should be noted that the Sri Lankan central bank was simply watching as inflation spiraled out of control. in fact, it was More than willing to make fresh rupees out of thin air to meet the spending needs of the Sri Lankan government. This led to a rapid increase in the money supply in the economy, resulting in a rise in the prices of goods in the economy. Sri Lanka’s central bank has to give assurances that it will not increase the money supply of the economy at will. To do so, it may link the Sri Lankan rupee to a commodity like gold or at least a stronger currency like the US dollar, limiting its supply. This will reassure both ordinary citizens and investors that the value of the Sri Lankan rupee will remain stable, thereby encouraging productive economic activity.
Meanwhile, several analysts have blamed the Gobaya Rajapaksa government’s sweeping tax cuts in 2019 for the economic crisis and demanded that taxes be raised to balance the government’s budget. But taxing an economy that is already in a dire state of crisis will only discourage economic activity and make the crisis worse.
rate control
Completely getting rid of price controls is another reform that will be crucial for Sri Lanka to survive the current economic crisis. The government has resorted to imposing price limits on essential commodities such as food and fuel to control the rise in their prices. However, price ceilings discourage producers from producing goods, especially when high input costs make them impractical to produce. For example, Sri Lankan electricity producers have demanded a more than 800% increase in electricity prices to make it economically viable to produce more electricity. It is encouraging that the government has allowed a hike of up to 22% in fuel prices, but greater control of all prices is necessary. Price ceilings also create shortages, which are the natural result of an item selling for less than the market-clearing price.
It should be remembered that market prices act as signals that tell investors where they should invest their limited capital. Controlling prices thus would prompt traders to produce more food and other essential commodities that are now in short supply. And as the supply of essential goods in the market increases, traders respond to price signals, the prices of these commodities will fall, thus making these goods more affordable to citizens.
Value corrections should also include allowing Sri Lankan Rupee To find out its natural value against the US Dollar in the Forex market. The Sri Lankan central bank has actually allowed the rupee to depreciate against the US dollar from where it was a few months ago. But many believe that the current peg is around Rs 360. Still volatile for a dollar and also harmful. For one, Sri Lanka’s central bank has to pay precious dollars to try to protect an overvalued rupee. Since it does not have the necessary dollars to raise the rupee, it has resorted to sanctions and other sanctions to somehow maintain the peg. But by making it illegal to pay more than the official exchange rate to import goods, the central bank could actually adversely affect the supply of essential goods in Sri Lanka and exacerbate the economic crisis.
Germany’s miraculous economic recovery after World War II was due to currency reforms and the release of price controls. There is no reason to believe that similar reforms will not help Sri Lanka overcome its current economic crisis.