Sri Lanka is facing its worst economic crisis since independence in 1948. It plunged into deep political crisis as protesters stormed Presidential palace after setting ablaze PM’s private home. Months of raging public anger against rising prices and shortages of food, fuel, medicines and other essentials culminated in these scary scenes of anarchy.

After Sri Lanka emerged from a 26-year long civil war in 2009, it showed healthy GDP growth of 8-9% pa till 2012 but then growth rate almost halved after 2013 as global commodity prices fell and trade deficits rose.

The island country of 2.2 crore people is heavily dependent on foreign exchange earnings by way of tourism, remittances from overseas workers and tea /rubber/apparel exports.

Country’s tourism-dependent economy was badly hit after Easter bomb blasts of April 2019 in churches in Colombo and later the Covid led to serious drop in tourist arrivals.

The problem was further compounded by build-up of huge government debt, rising oil prices and a ban on import of chemical fertilisers (due to shortage of foreign exchange to finance imports) last year that devastated agriculture.

President Gotabaya Rajapaksa had promised lower tax rates and subsidies for farmers during 2019 election campaign and quick implementation of these ill-advised promises exacerbated fiscal deficit. Big tax cuts introduced in 2019 led to government losing more than $1.4bn a year.

In 2021, all fertiliser imports were completely banned and it was declared that Sri Lanka would become a 100% organic farming nation overnight. This overnight shift to organic fertilisers heavily impacted food production. In part, the ban was imposed to save dollars needed for fertiliser imports ! and dollars were needed for servicing foreign debt, notably to China!

When Sri Lanka’s foreign currency shortages became a serious problem in early 2021, the government tried to limit them by banning imports of chemical fertiliser. The fertiliser ban (reversed in November 2021) also seriously hurt tea and rubber exports.
The government has incurred huge foreign debts to fund what critics call unviable infrastructure projects.

Sri Lanka’s total external debt is estimated to be about $51bn and annually needs over $6bn for debt servicing. In contrast, Sri Lanka had $7.6bn in foreign currency reserves by end of 2019. By March 2020, reserves fell to $1.93bn. Recently the government said it had just $50m left.

Sri Lanka earned about $4bn from tourism in 2019 which dropped by 90% due to the pandemic! Its foreign exchange reserves dropped to just about $1.6bn by the end of November, only enough to pay for just a few weeks of imports. The government was forced to restrict import of essential commodities including food in a desperate bid to save dollars.

High global oil / food prices and cost of shipping especially after Russia Ukraine conflict tripped Sri Lanka totally off balance.

Debt to GDP ratio rose from 94% in 2019 to 119% in 2021. Over 10% fiscal deficit in 2020-21 in covid-hit, import dependent and heavily indebted economy resulted in over 15% inflation and serious shortages of food and fuel. A few days’ petrol/diesel left, not enough to even run essential services.

Amidst depreciating currency and rapidly depleting forex reserves an economic emergency as declared to contain rising food prices.
After taking a $2.6 billion loan from the IMF in 2009, it again approached the IMF in 2016 for another US$1.5 billion loan.

Some ill-informed, rather irresponsible and politically motivated commentators have been (rather gleefully!) quick to suggest that India may also witness such scenes soon. Such fear mongering is absolutely baseless.

India had indeed landed in a somewhat precarious economic crisis in 1991 when at one point we had less than 1 billion US dollars in our reserves; just enough to pay for 15 days of imports!

We were on verge of default on international loans but we rose to the occasion. We were quick to rise on our feet. We pledged gold to raise emergency loan followed by IMF loans and have since travelled a lot of distance on the path to progress.

India’s foreign exchange reserves stood at $588 billion on July 1. No doubt all emerging economies are under pressure. Our forex reserve dipped by $5 billion in the week ending July 1 prompting RBI to launch fresh remedial measures. However, our granaries are overflowing and we are slowly switching energy mix and decarbonising economy to slowly reduce dependence on imported crude oil and foreign debt is less than 5% of total public debt.

India is trying to help Sri Lanka by extending credit lines, selling food and fuel on credit and also outright aid. India has signalled its willingness to go beyond the $4bn in loans, currency swaps and aid already provided to Sri Lanka when about $5bn are needed in the next six months to cover basic necessities for people struggling with long queues worsening shortages and power cuts.

So any suggestion that India is in the same boat as Sri Lanka is patently mischievous political propaganda. India is indeed part of the rescue team.

Since April last year, WPI has been above 10% every month.

This is not the first year when the country has faced double-digit inflation but sources and duration have been different.

Prices can rise due to multiple reasons. A drought, flood or pandemic affecting production/supply of goods can create demand-supply mismatch. An abundant supply of cheap credit can fuel demand-push inflation –too much money chasing too few goods. Emergence of monopoly producers with pricing power can push up prices. High taxation can push up prices. High cost of imported crude oil can push up prices.

While many of these factors were already at work, the Russia-Ukraine conflict, resultant food shortage and crude oil price hike has resulted in global inflation surge. There are dominant concerns on inflation despite some other short-term gains. Inflation is indeed causing worry now.

As the pandemic ebbs, there has been heavy demand surge while the production and logistics that got stalled during pandemic is yet to pick up fully creating a demand supply gap. Inflation on the inputs side is being passed on by manufacturers to the output prices.

As the margins of the manufacturers have been under pressure due to rising input costs, transportation, and logistics, they are passing on these into their output prices leading to higher inflation in manufactured products. The higher input costs, especially of raw materials, have aggravated due to the Russia-Ukraine conflict.

Who can remedy the situation and how?

The Reserve Bank of India controls the extent of supply of money/credit in the market keeping in mind several factors like the foreign currency exchange rate and inflation.

To some extent, the RBI can control demand push inflation if it is caused by excessive money supply.

However, if the production fails, if the logistics fails or if the monopoly producers dictate prices or if the prices go up due to taxation, there is little that the RBI can do.

This is a short comment on the ‘inflation targeting’ by the RBI.

In 2016, the Reserve Bank of India Act, 1934 was amended and a whole new chapter was added on ‘Monetary Policy’.

One of the newly inserted provision in the Act (Section 45ZA) introduced a system of Inflation target. It mandated that tThe Central Government shall, in consultation with the RBI, determine the inflation target in terms of the Consumer Price Index(CP)I), once in every five years. A Monetary Policy Committee and a mandatory Monetary Policy Report was introduced.

The Act stipulated that if the RBI fails to meet the inflation target, it shall set out in a report to the Central Government— (a) the reasons for failure to achieve the inflation target; (b) remedial actions proposed to be taken by the Bank; and (c) an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions.

For the five years 2016-21, the government notified consumer price inflation target of 4 percent with toleration deviation in the range of 2 percent to 6 percent. The same target has been extended for next 5 years.

The CPI has now breached 6%. As per the law, the RBI has to ‘explain’ to the government why it is so?

CPI has a large weight of food and fuel prices which are out of the control of RBI. RBI cannot control either international crude prices nor petrol products’ taxation nor food supply disruption due to bad weather. Food and fuel demand is not much influenced by cost and availability of bank credit! (Does one buy more food and fuel if more low-cost bank credit is available? No)

WPI pertains to only goods, not services. So, the WPI basically captures the average movement of wholesale prices of goods and is used for comparing changes in Gross Domestic Product (GDP) at current market prices.

GST collections have been growing in recent months sowing the success of government in cracking down on tax evasion. One fall out of this crackdown is that prices go up because what was being sold earlier without tax on kutcha bills is now being forced to be sold on pucca bills. So in a way tax evasion and inflation are inversely related.

Let us hope that increased tax collections, increased tax compliances nudges the government to lower tax rates. A beginning has been made by reduction in Central taxes on petroleum products. Rationalisation of GST rates is awaited.