Sri Lanka: How a Nation Went Bankrupt

On 18 May 2022, the small island nation of Sri Lanka officially defaulted on its debt for
the first time since its founding in 1948, sending an ominous signal for its future. This
was preceded by months of protests and violence that left hundreds injured and scores
dead, including a member of the parliament. The country, popularly called the "Pearl of
the Indian Ocean" and famous for its mountainous tea plantations, miles of sandy
beaches, and the hospitality of its people, has now turned into a living hell for its
inhabitants with rolling power cuts, shortages of staple food, essential medicine, fuel,
and growing political instability. This article explores the causes that led to the current
crisis, its effects, and wider implications for similar countries globally.

The Civil War and the Origins of Public Debt Buildup

Soon after Sri Lanka’s (formerly called Ceylon) independence from Britain in 1948, ethnic
tensions between the Buddhist majority Sinhalese (who made up nearly three quarters of
the population) and the Hindu minority Tamils, which had been simmering during
colonial rule, began to reach a boiling point. It accelerated with Prime Minister S W R D
Bandaranaike’s passing of the "Sinhala Only Act" in 1956, which made Sinhala the only
official language of the nation. It plunged the country into violence with widespread riots
between Tamil-speaking minorities who felt discriminated against and the Sinhalese.
Bandaranaike himself was killed by an extremist Buddhist monk and was succeeded as
prime minister by his wife, Sirimavo Bandaranaike. Under her rule, discrimination against
Tamils was further intensified with the policy of standardization, which required Tamil
students to gain a higher qualifying mark than Sinhalese students to gain admission to
universities. During this period, political parties representing Tamil interests began to
lose ground to more radical militant groups seeking to create an independent Tamil state.
Prominent among them was the Liberation Tigers of Tamil Eelam (LTTE), led by V
Prabhakaran.

The burning of the Jaffna library in May 1981 in the Tamil majority city of Jaffna proved
to be a turning point in ethnic tensions, culminating in the start of a destructive civil war
in 1983 led by the LTTE. Over the ensuing two decades, till the end of the war in 2009,
Sri Lanka suffered the loss of more than 100,000 civilians, soldiers, and militants, with
hundreds of thousands displaced in the northern part. The economic cost was also
immense, estimated at around $200 billion, with large opportunity costs in the form of
lower tourist arrivals and dampened foreign investment due to the instability. This
prolonged and costly conflict also caused the government to build up large amounts of
unsustainable external debt and run continuous budgetary deficits, further negatively
impacted by the global financial crisis of 2008.

However, the bulk of the growth in unsustainable external debt took place in the decade
after the end of the war as the government of then president M. Rajapaksa embarked on
large-scale, multi-billion-dollar infrastructure and development projects across the island
with the goal of stimulating economic growth and investment. However, most of those
projects turned out to be taken on a political basis as they proved to be unviable
economically and came to be viewed as white elephants. One prominent example was
that of the Hambantota port in Hambantota, the home district of the Rajapaksa political
family, which ended up being leased to a Chinese company for 99 years after the loan
could not be repaid. These unproductive projects, coupled with large deficit spending,
caused Sri Lanka’s external debt to double between 2010-19.

Terrorism, Tax Cuts, and a Pandemic

Although most of the burden of Sri Lanka’s present-day crisis can be put on the financial
mismanagement and unproductive projects of past governments, external events from
2019 onwards also played a prominent role in accelerating the crisis and adding further
pressure to an already unsustainable debt burden. The first of these was the series of
coordinated Islamist terrorist attacks on churches and luxury hotels on April 21st, 2019
in the commercial capital, Colombo. It was the deadliest terrorist attack in Sri Lanka’s
history, killing nearly 300 people and injuring more than 500. It also negatively impacted
the vital tourism industry, a large source of foreign exchange and employment, with
tourism revenue falling by nearly 20%, negatively impacting the balance of payments
and tax revenue. Shortly following this, Gotabaya Rajapaksa, brother of Mahinda,
became president, riding on nationalist and pro-security sentiments following the
attacks, and placed members of the Rajapaksa family into his cabinet.

Soon afterwards, the new government embarked on an expansionary fiscal program,

cutting personal and corporate taxes, causing budget deficits to soar and the central
bank to print record amounts of money to fund increasing spending. This lowered
already low tax revenue and put pressure on the government to service the ever-
increasing debts. This situation was further compounded by the start of the global
COVID-19 pandemic and resulting lockdowns. The already dampened tourism sector
took a big hit as tourist arrivals stalled significantly, depriving the government of valuable
foreign currency and making thousands jobless. As a result of rapid money creation,
inflation spiraled out of control and the government failed to keep the currency pegged
to the USD, with the currency depreciating to new lows. As a result, foreign workers
started to remit money through unofficial channels, causing Sri Lankan banks to run out
of vital foreign currency. Furthermore, the government’s decision in April 2021 to ban
the use of inorganic fertilizers caused a large drop in tea production, one of its largest
export sectors. Lastly, the outbreak of the Russo-Ukrainian war in early 2022 caused a
significant rise in food and fuel prices worldwide, already heightened by the pandemic.
During this period, Sri Lanka’s crucial foreign reserves plummeted from $7.6 billion in
2019 to a paltry sum of $50 million in May 2022, and with debts worth $7 billion coming
due this year, Sri Lanka finally defaulted on payments in May 2022.

The effects of the economic crisis

An unprecedented economic and political crisis has plunged the once prosperous
country into chaos. Inflation, especially in staple food prices, has skyrocketed to a record
54.6% in July 2022, stretching the thin wallets of ordinary citizens. Continuous currency
depreciation combined with dwindling foreign reserves has resulted in shortages in
electricity, fuel, and cooking gas due to a fall in imports and endless lines for fuel, food,
and medicine are now a common sight. Furthermore, the education of millions of
students has also been hampered due to acute shortages of paper and ink, resulting in
school shutdowns and the postponement of examinations. The vital healthcare sector
has also been put into disarray, with increasingly scarce essential medicines and rolling
power cuts hampering crucial surgeries and operations. The government, in a desperate
move, has also introduced a four-day workweek for government employees to have a
day off to grow their own food as supplies continue to run out. In addition, the United
Nations estimates four out of five people in the country of 22 million are currently
forced to skip meals.

The economic crisis has also plunged the country into political uncertainty, with the
entire cabinet resigning en masse along with Prime Minister Mahinda Rajapaksa, amidst
mass rioting and violent protests across the island. His replacement, Ranil
Wickremesinghe, an opposition member and six-time premier, has been unable to win
public confidence with protests remaining unabated. The export industry, a vital source
of foreign currency, has also been badly affected, with foreign buyers shifting textile and
tea orders to neighboring countries such as India. According to UNICEF, Sri Lanka now
has South Asia’s second highest child malnutrition rate, only behind war-torn
Afghanistan, underpinning the severity of the current crisis with no signs of receding.

Ramifications of the crisis globally

The ongoing crisis in Sri Lanka may serve as a wake-up call to other similar developing
countries across the region and globally. Developing countries across Asia and Africa are
facing the consequences of the three-pronged challenges of the pandemic: rising food
and energy costs due to the war in Ukraine and higher debt servicing burdens due to the
rise in global interest rates. According to the World Bank, about 60% of all low-income
countries are at risk of needing to restructure their debts in order to avoid default and,
furthermore, as many as a dozen developing countries could prove unable to service
their debts within the next year, representing the largest spate of debt crisis in
developing economies in a generation.

Developing countries are especially vulnerable due to the large amounts of variable
interest loans they have taken, which are now increasing as central banks around the
world tighten monetary policies. A particularly vulnerable country in the South Asian
region is Pakistan, which is also facing a deteriorating economic and political crisis. Like
Sri Lanka, it has also pursued debt-driven populist policies by building large-scale
projects, subsidies, and welfare schemes for the poor and is now facing tens of billions of
dollars of debt repayment over the next few years amidst rising imports, depreciation
and dwindling foreign currency reserves. It is also facing a looming political crisis, with its
recently ousted prime minister, Imran Khan, threatening agitation and protests over
holding fresh elections. Pakistan now seems to be hanging by a thread and may very well
default and descend into chaos.

Thus, the present economic crisis and bankruptcy of Sri Lanka were the culmination of
decades of financial mismanagement, ill-conceived debt-driven unviable projects, and
external events from 2019 onwards. Only time will tell whether Sri Lanka will see the
light at the end of the tunnel and recover, or whether it is only the first domino to fall.