Economic crisis | foreign exchange reserve | import dependency | policy failure | debt

Sri Lankans in London Protests against their President Gotabaya Rajapaksa and Prime Minster, Mahinda Rajapaksa during Mayday, demanding them to step down from power |Photo by Ehimetalor Akhere Unuabona on Unsplash
Sri Lankans in London Protests against their President Gotabaya Rajapaksa and Prime Minster, Mahinda Rajapaksa during Mayday, demanding them to step down from power |Photo by Ehimetalor Akhere Unuabona on Unsplash

Economy

Nepal has the Sri Lankan experience to learn from

The country’s current economic situation looks concerning but not yet dire. But the economy may go south if the present complacency persists.

By Karan Poudel |

In 2011, when Sri Lanka was at the peak of its economic and financial success, the notion the country might one day face its worst-ever economic crisis seemed far-fetched. Nepal’s GDP growth was less than half of Sri Lanka’s. Between 2009 and 2015, Sri Lanka’s economic growth averaged at around 6%. But by 2016, the country's debt had soared so much (around 78% of its GDP) it nearly defaulted. The IMF came to the rescue. 

From 2016, Nepal’s economic growth started catching up with Sri Lanka’s heyday rate, at an average of 5.9%, until the sudden arrival of the covid-19 pandemic in 2020.

Besides similar economic growth, the two economies share plenty of identical characteristics. After the country of 22 million people declared a major economic crisis in September 2021, similarities between the two are being scrutinised harshly. Sri Lanka’s crisis erupted due to unsustainable debt, low revenue collection, and declining remittances and tourism. 

Both rely heavily on remittances, agriculture and the service sector. Most troubling are parallels between the macroeconomic challenges which culminated in Sri Lanka last year and those appearing in Nepal today. They could spell enormous trouble and put the himalayan nation on the verge of a “lost decade”.

Declining foreign-exchange reserves has become a major issue in Nepal. In April the country had $9.61 billion in foreign-exchange reserves, compared with $11.75 billion in July of the previous year–down by 18.2%. The reserves can only foot the bill for less than seven months worth of imports, whereas 12 months of imports could be sustained in 2020.

That is worrisome because insufficient reserves for imports could lead to shortages of essentials, such as fuel and fertilisers, and give rise to stinging inflation. Just ask Sri Lankans, who are facing severe food and fuel shortages. Sri Lanka now has foreign reserves of just $50m (down from $9 billion in 2019), and it is not enough to pay for even a day’s imports.

The government’s effort to save the dollar reserves through banning imports of vehicles, electronics, and liquor products until July 2022 will have little effect in the long run. Soaring import bills and dwindling remittances have proved stronger forces. After steadily rising as a share of GDP from 2011 to 2015, the remittances are going downhill ever since and in turn weighing on foreign reserves, too. In April imports rose by 32% , up from 13.1% a year earlier, thanks to high global commodity prices. 

And in the same month, the balance of payments (BOP) hit a record deficit of $2.25 billion, compared with a surplus of $348.1 million in the same month last year. It’s expected to increase yet again due to higher fuel prices. Sri Lanka’s was $3.9 billion in 2021.

Suggesting beyond which level the BOP or debt of a country relative to the size of its economy spells trouble is hard. Nepal’s BOP now runs at roughly 5% of its GDP, five times Sri Lanka’s. At the peak of Sri Lanka’s BOP deficit last year, its economy suffered massive damage and defaulted on its foreign debt. 

Nepal’s increasing external imbalances would be of less concern had growing credit growth risen alongside economic growth. Nepalis and firms have been borrowing wildly. Instead of economic growth, credit expansion has rather pricked import rise, asset values (especially real estate), inflation, and even liquidity crisis as the majority of loans make their way to the informal economy. The economy has become more dependent on imports and less competitive. 

Revenue collection has not kept pace with burgeoning expenditure. Since 2014, the country’s public debt has more than tripled. In January of this year, the total debt-to-GDP ratio was 40.53%; external debt accounted for 18.28% of GDP. The external debt pressure is expected to rise as America’s Fed is on a campaign of interest-rate increases to quell rising inflation at home, in turn strengthening the dollar. Its value is up by more than 10% over the last year. 

In Sri Lanka’s case, its external debt ballooned from 44% of GDP in late 2019 to more than 60% in 2021, against the backdrop of rapidly diminishing foreign reserves, declining revenue following tax cuts in 2019 and collapsing tourism. Its debt levels reached several times the country’s reserves, creating a recipe for an economic crisis that ultimately burst. 

Swarnim Wagle, chief economic advisor at the UNDP Asia-Pacific, warns of an accidental crisis if policy failures (the likes of import ban or undermining the central bank’s independence) continue–a flavour of Sri Lanka. Bringing remittances through formal channels, reducing current populist-motivated expenditure, reviving exports and managing imports remain key areas to focus on, notes Mr Wagle. 

The parallel between the two South Asian nations has limits. Sri Lanka’s fiscal and BOP deficits were high. It loaded up on debt, including sovereign loans, it could not pay back. It failed to address the challenges it was facing. On the numbers, Nepal’s BOP deficit looks concerning but not yet dire to the point of economic collapse. Debt of upto 60% of GDP is safe for developing countries, says Prakash Kumar Shrestha, chief of the economic research department of the central bank. The country’s external debt distress remains low and sustainable. 

Yet according to the World Bank, the country’s debt burden indicators are vulnerable to exports shocks and natural disasters. To safeguard economic stability and expand foreign-exchange income streams, improving the business climate, high-quality public investment and structural reforms are necessary. Tighter monetary policy by increasing interest rates coupled with unwinding the current Covid-19 support measures would help tackle inflationary pressures that are hurting the economy. 

As both the government and the central bank scramble to avoid the fate of Sri Lanka, the similarities will likely continue to surface. But understanding the Sri Lankan experience looks more easier than engineering a way out of the current mess. 

Karan Poudel is an Investment Writer/Editor at Ansu Group. He was a former writer-analyst at the_farsight.

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