August 4, 2022
  • August 4, 2022

Opinion: Sri Lankan syndrome and Nepa

By on July 16, 2022 0

There is growing speculation about the disintegration of the Nepalese economy like in Sri Lanka, as the country’s foreign exchange reserves have dwindled and inflation has soared with rising fuel prices.

For the first time since the 2000s, foreign exchange reserves fell to about $9 billion, barely enough to finance imports for six months, down from 11 months previously. At the same time, inflation reached a record high of 8.56%, with the employment rate remaining as disappointing as usual. Therefore, there is no reason to simply ignore the suspicions.

Before delving into this phenomenon, it is pertinent to understand how Sri Lanka landed in its worst economic disaster ever. Facts and figures made available by the World Economic Forum show that, like Nepal, Sri Lanka is overly dependent on a handful of export commodities such as tea, rubber and ready-to-wear. Tourism income and remittances contribute substantially to net foreign exchange income. But since the export commodity base is narrow and tourism and remittance revenues often stagnate, the country frequently experiences balance-of-payments crises that weigh on its foreign exchange reserves.

too many loans

Since Sri Lanka depended on limited sources of foreign exchange to finance its growing imports and development activities financed by foreign debt proceeded aimlessly, the island nation was often at the mercy of loans from the International Monetary Fund. to fill the foreign exchange gap resulting from a growing trade deficit and debt servicing. To date, Sri Lanka has received IMF loans 16 times, and all loans were based on conditions of tight fiscal and monetary policies, reduction of domestic subsidies and depreciation of the national currency to make its exports cheaper.

Unfortunately, the last IMF loan to Sri Lanka in 2016 coincided with the onset of its economic collapse. As a result, this not only affected growth, but also increased the burden of foreign currency denominated debt. Adding to this disaster, a series of incidents in the following years helped to stifle the economy. It all started with a sharp drop in tourist arrivals due to the Colombo bombings in 2019, followed by the coronavirus pandemic in 2020. The government’s irrational decision to cut taxes in 2021 has only worsened crisis. And most surprisingly, the government banned the import of chemical fertilizers to conserve foreign currency and declared the country’s agriculture to be 100% organic.

The decision to ban chemical fertilizers and the switch to organic farming proved ill-conceived as it reduced agricultural productivity and production, forcing the country to import more food. This decision also had a negative impact on the production and exports of tea and rubber, which were a key source of foreign exchange.

Consequently, the country gradually faced increased pressure on foreign exchange reserves, forcing it to take import control measures, which led to supply shocks. Import controls pushed inflation to over 17% earlier this year, creating a shortage of food, fuel and medicine. Ultimately, for the first time since its independence from Britain, Sri Lanka defaulted on payment of its external debt in May 2022, declaring South Asia’s once-thriving economy bankrupt.

After observing the Sri Lankan debacle, one can be convinced that there are warning signs of the Sri Lankan syndrome in the Nepalese economy. As in Sri Lanka, Nepal’s trade imbalance problem is gradually worsening. The country’s trade deficit has hit a record high of nearly Rs 1.6 trillion since the start of the current fiscal year. At the same time, the balance of payments, which was generally in surplus, had faced a deficit of nearly 300 billion rupees at the end of the last fiscal year. As a result, the Nepalese currency has steadily depreciated, leading to import shocks and soaring prices. The sharp increase in food and fuel prices is most striking.

But for a small import-driven economy like Nepal, which depends on limited and unreliable sources of foreign exchange, it is difficult to absorb the shock of high imports. Nevertheless, given the country’s external financial liabilities and the ratio of external debt to gross domestic product (GDP), Nepal is in a comfortable position to manage the crisis. Nepal’s external debt-to-GDP ratio is around 21%, compared to over 40% in Sri Lanka, accumulating debts of around $51 billion in 2022. And as there are signs of post- pandemic, Nepal has the means to deal with economic hazards.

However, despite the options available to address the structural weakness to prevent the economy from deteriorating further, Nepal wallows in strange policies and wastes resources on superfluous politically motivated development projects. One of the reasons for the Sri Lankan crisis was investments in redundant development projects in search of foreign currencies dominated mainly by international sovereign bonds. The country has also arbitrarily introduced piecemeal programs targeting the problem of trade imbalance and currency shortages, without success.

So, if the series of economic incidents in Sri Lanka is a lesson for Nepal, it is essential to deal with the first signs of financial difficulties without delay. Since the root of the current economic problem lies in the acute problem of the country’s trade deficit and dwindling foreign exchange reserves, intervention in foreign trade should be given priority. But there is no scope for taking drastic measures to curb imports due to the country’s overreliance on imports and poor domestic manufacturing. Nor can it expect to see a miracle in sluggish exports.

Policy options

But the political options are not lacking. With regard to imports, there is a possibility of an optimal tariff, which maximizes welfare instead of measures which illogically control imports and only increase inflation. The government can provide incentives that encourage innovation and entrepreneurship in exports instead of direct subsidies, which are mostly discriminatory and inefficient.

At the same time, Nepal should discourage development projects, especially those that accumulate foreign currency debts with a very long gestation period. Whether dry ports or mega-airports, expressways or railways, any decision to invest in development projects must aim for balanced regional development that contributes to overall production. Political interests at the expense of economic rationality must be rejected by all means in this regard, otherwise Nepal will inevitably face an economic crash like in Sri Lanka.

(Contributed by Kathmandu Post)