• Sri Lanka is in the throes of the worst economic crisis since its independence. Gaining awareness as a global topic, various ‘experts’ started expressing conflicting opinions on the causes and solutions.

• Among the most prominent was Prof. Steve Hanke’s claim that setting up a currency board would solve Sri Lanka’s problems. But it’s not that simple.

• Some have pointed fingers at the Russian invasion of Ukraine as the cause of the economic crisis in Sri Lanka. This is wrong.

• Sri Lanka’s economic crisis is the result of poor economic policies, pursued for decades - which resulted in low tax revenue and low export revenue - that forced governments to borrow from foreign sources.

• Sri Lanka has a history of borrowing from China as well, but Chinese loans aren’t the sole reason for the crisis either. Those only account for 20% of total foreign debt.

• Getting out from the economic crisis requires addressing domestic policy issues.

Sri Lanka’s economic crisis and its history of default

Sri Lanka is currently going through its worst economic crisis since gaining independence. Foregrounded by its unsettled political climate, Sri Lanka’s economic crisis has drawn international attention, becoming a frequently discussed topic in foreign media and policy circles. This has led to a number of ‘experts’ offering a myriad of interpretations on the root causes of the crisis along with their, often unasked for, solutions. These hypotheses are largely founded on their personal ideologies, biases and beliefs.

For this very reason, most of these interpretations do not tell the whole story. Nor do they clearly explain the reasons behind the economic downfall or the specifics as to why Sri Lanka ended up defaulting on its foreign debt.

Here are some in-depth analyses of a few popular claims and how true (and/or biased) they are.

Steve Hanke’s currency board obsession and money printing

Steve Hanke, Professor of Applied Economics at Johns Hopkins University has but one solution for all countries in a currency crisis - to install a currency board.

Hanke was famously the expert hired by Indonesian President Suharto in 1998 to install a currency board in Indonesia to extract the country out of the Asian Financial Crisis. The currency board idea was protested by many Indonesian economists, politicians and international leaders and Indonesia’s currency board never saw the light of day. If you like to read more about it, you can read it here.

The professor has a record of proposing currency boards for almost any country that is facing high inflation and a distressed currency. At present, he is pushing for the implementation of currency boards in Pakistan, Ghana, and Turkey among others. He is also pushing for dollarization, which he claims to be the equivalent of a currency board in practice, in Venezuela and Argentina.

Unsurprisingly, and at the risk of making Hanke sound like a one-trick pony, his solution to the Sri Lankan economic crisis is to “mothball the Central Bank and install a currency board”.

https://twitter.com/steve_hanke/status/1543628634090618887

Steve Hanke soon became a frequently cited name by several local media stations largely due to his inflation calculations. Hanke’s inflation numbers, which were calculated using a different methodology gave far more clickbait-worthy figures than the poor Census Department did.

So, what exactly is a currency board? And is it, as stated by Hanke, the solution?

A currency board arrangement is an extreme form of a pegged exchange rate. In its purest form, a currency board is a monetary regime based on an explicit legislative commitment to exchange the domestic currency for specified foreign currency (known as an anchor currency) at a fixed exchange rate (for example, Rs 1 = $ 1).

Under a currency board, an economy essentially relinquishes monetary policy. This means there won’t be an entity to control interest rates. Currently, central banks set interest rates which are used as a tool to control inflation. Under a currency board, there won’t be a central bank, and the complete focus will shift to maintaining the fixed exchange rate between the local currency and the anchor currency. Inflation will be controlled by maintaining this fixed exchange rate. The entirety of the money supply in circulation is backed 100% by reserves of the anchor currency (in the form of notes, gold, interest-bearing bonds, securities etc.) so that the exchange rate is maintained.

Why this would not work

The main purpose of the currency board is to prevent deficit financing aka money printing.

Deficit financing has been happening in Sri Lanka for many decades; however, it reached a new, accelerated phase in 2020. Under the governorship of Prof W.D. Lakshman and A.N. Cabraal, broad money supply expanded by 40% in the two years between 2020 and 2021. This is now contributing to rapid inflation in Sri Lanka, which recently hit a new record high of 70% in August 2022.

So, it may be logical to conclude that the Central Bank, which provides this new money to the government, ought to be done away with. However, it is not that simple as the duties of the Central Bank per se are not at fault. The Central Bank of Sri Lanka already has the mandate for maintaining price stability (low and stable inflation), which it clearly flouted in the past 2 years to over serve the needs of the profligate government.

Furthermore, there are fiscal rules in place for the government of Sri Lanka which specify a limit of 5% of GDP for the budget deficit. In addition, it also sets out a limit of 85% of GDP for central government debt and limits for sovereign guarantees on state-owned enterprise (SOE) debt. Both of which have been repeatedly flouted by the government of Sri Lanka.

So, none of these rules of mandates have prevented Sri Lanka from breaking the rules. So what is, ultimately, the guarantee that a currency board (which is essentially a legally defined exchange rate) will not be flouted?

From a non-political viewpoint

Let’s take a look at what a currency board would mean for Sri Lanka. Simply put, we would be replacing the Central Bank with a currency board. Here the currency board’s sole objective would be maintaining the exchange rate which is pegged to the anchor currency.

What would the anchor currency be? Some have suggested the Indian Rupee, but despite its proximity, Sri Lanka imports mostly from China, and exports mainly to the United States. India is Sri Lanka’s third largest export market. It follows that the Chinese Yuan and the US Dollar are both contenders for the position of anchor currency. Now, suppose Sri Lanka chooses an anchor currency without causing a diplomatic uproar, what would this change entail? Furthermore, what would this mean for Sri Lankan monetary policy?

In brief, we would not have any monetary policy of our own. Consequently, we would be at the absolute mercy of the Central Bank within the anchor currency country (the Reserve Bank of India, the US Federal Reserve or the People’s Bank of China), none of whom would be making monetary policy considering the economy or the people of Sri Lanka. The question this raises is whether Sri Lanka should relinquish its autonomy over its entire monetary policy to an outside nation?

Also, let’s not forget that the Central Bank performs a broader role than a mere currency board. In all fairness, while it has failed miserably to carry out its mandate of maintaining the stability of country’s financial system, a central bank can be instrumental in helping banks and revitalising a country’s economy.

So, while Hanke’s proposition may work for some countries, it is not an across-the-board solution for every country.

What is more doable in the current context is to bring forth the new monetary law which was gazetted in 2019 and abandoned in 2020 subsequent to the government change. This act was aimed at granting the Central Bank more independence in addition to reducing deficit financing which is often referred to as ‘money printing’.

What is money printing ? Money printing refers to central banks purchasing of Government Securities (Treasury bills or treasury bonds). Usually, government securities are purchased by banks and financial institutions from the money they have. When that happens, existing money in the economy moves from one place to another. For example, when a bank purchase government securities, the money moves from the bank to the government. However, when the central bank purchase government securities, new money is injected into the economy. This results in an increase in the overall money stock in the economy due to the additional money injected into the economy by the central bank.

Chinese debt trap recycled

Sri Lanka being a victim of the Chinese debt trap is not new misinformation. It is a myth that has been debunked many times by local as well as international experts.

Nevertheless, we continue to see misleading statements which claim that Chinese lending is the cause of Sri Lanka's economic crisis. This narrative, in summary, goes as follows.

Sri Lanka borrowed too much from China at very high-interest rates. These were for different projects with little to no returns. Now the island nation is struggling to pay these high-interest loans to China, thereby having to default on its debt.

As one can see, this is a very simple narrative. Simple narratives are often the most popular. When married with anti-Chinese sentiment, the narrative becomes simpler, and consequently, a lot more tantalising to believe.

So, how true is this?

The reality regarding Sri Lanka’s foreign debt is a lot more complicated than this. We’ve tackled this issue previously in this long piece.

Sri Lanka’s debt problem extends far beyond China. At the time of the country defaulting on foreign debt repayments, only 20% of Sri Lanka’s foreign debt was owed to Chinese creditors. Furthermore, even in 2022-2023 and 2024, Sri Lanka’s foreign debt repayments to be paid to Chinese creditors would be only 20%.

The biggest foreign debt repayment to be settled, constitute the country’s International Sovereign Bonds (ISB) which amount to approximately 50% each year from 2020-2025 including a one-off payment of USD 1 billion or above each year.

Repaying these ISBs requires USD 2 billion each year. However, certain factors including the losing the ability to issue new ISBs due to the credit rating downgrades, the stagnation of export incomes and the drastic reduction of the dollar income from tourism meant that Sri Lanka had no way to continue repaying these ISBs. The country was inevitably compelled to declare sovereign default.

This doesn’t mean that Chinese loans aren’t problematic. It is true that some of them were obtained to construct white elephant projects such as the Mattala Airport. Furthermore, most of the loans obtained from the China EXIM Bank were made through unsolicited proposals. There was no competitive bidding, and contracts to carry out these projects were awarded to Chinese contractors. For example, four loans were obtained from the China EXIM Bank to construct Hambantota Port and the contract was awarded to China Harbor Corporation without competitive bidding.

However, Sri Lanka’s failure to service foreign loans stems from long-lasting structural weaknesses including a consistent reduction of the tax to GDP ratio, the downtrend of export performance, and the failure to attract sufficient Foreign Direct Investment (FDI). These weaknesses compelled the country to borrow heavily in foreign currency without increasing the debt repayment capacity. This eventually led to the country’s sovereign default.

Therefore, Chinese debt is only the tip of the iceberg when it comes to Sri Lanka’s debt problem. Blaming China for Sri Lanka’s economic crisis will only result in ignoring the elephant in the room, which is Sri Lanka’s over reliance on ISBs without addressing the tax problem, export problem, and the FDI Issue.

Did the Russian invasion of Ukraine catalyse Sri Lanka’s economic woes?

Another narrative that has taken hold in some quarters around the world is that Sri Lanka’s crisis is collateral damage springing from Russia’s invasion of Ukraine. While one of the most high-profile proponents of this narrative is Ukraine’s President, Volodymyr Zelenskyy, this story has also been repeated by varied others as well, both locally and internationally.

https://twitter.com/htTweets/status/1547408103880413184

In a global perspective, Russia’s invasion of Ukraine and the resulting hike in oil prices can easily be seen to tie into Sri Lanka’s crisis. After all, Sri Lanka’s crisis got worse a month after Russian troops moved into Ukraine, and the prices of oil and other commodities soared in tandem with the conflict. But while the rising price of oil definitely had a part in how bad the crisis got, it was far from being the primary reason or even the primary trigger of Sri Lanka's economic crisis.

How exactly did this affect us

The main impact of Russia's action in Ukraine for Sri Lanka was through the hike in the price of oil. Meeting our full oil consumption would have cost anywhere up to 600m USD a month compared to the bill of 430m USD for January 2022. Some food prices would also have been affected as wheat and maize exports from Russia and Ukraine were disrupted.

However, while these were contributing factors, they were proverbial twigs on the vast branches of Sri Lanka’s foreign liquidity crisis. Massive powercuts and long fuel queues didn’t happen unexpectedly because oil became expensive. Sri Lanka spent all its dollar reserves in paying debts and in attempt to try and control the exchange rate.

Consequently, we didn’t have any dollars left to buy oil with.

Oil could have been 50 USD a barrel rather than 100 USD, and Sri Lanka would still have struggled to find the dollars to pay for it. At the root of it all, even on the side of inflation, is the fact that the rupee depreciated massively.

Once again, this depreciation didn’t happen as a result of the conflict between Russia and Ukraine. Sri Lanka’s crises is a decades long problem driven by low taxes, low exports, low investment, and high debt. Sri Lankans are perfectly capable of messing up on our own.

Green elites and Sri Lanka’s push towards organic agriculture

Sri Lanka’s decision to turn organic overnight is another story that proved to be fertile ground for a number of incorrect narratives. The most common of these is the idea that Sri Lanka moved towards green agriculture on the whim of a global pro-environment group - who range from being US Democrats from California, global businesses elites from Davos, ESG investors and even Bill Gates.

https://twitter.com/ShellenbergerMD/status/1545936747174825984

https://twitter.com/berninger71/status/1546021236580368385

The type of people spoken about here indicates a very clear anti-progressive tilt to this story, and looking at varied sources, it seems that most of these stories stem from the US. Making no comment on whether a global push towards more sustainable agriculture is realistic or not, the fact remains that Sri Lanka’s choice wasn’t driven by climate concerns nor any form of environmentalism.

The most common argument locally arose from health concerns revolving around the use of chemical fertilizer in Sri Lanka, most notably kidney disease. Additionally, nationalistic arguments around Sri Lanka’s desire towards self sufficiency added fuel to the fire. This stemmed from a nostalgic view of a non-existent past - in which Sri Lanka supposedly saw the world’s best rice yields (never seen before or hence) magically popping up, untended, due to the inherent goodness of its people.

Next to this, the kidney disease claim seemed more likely, especially with the main doctors’ union, the GMOA, and senior medical officers backing up this theory. In contradiction, it was observed that people from both medical and farmer communities had pushback on that idea. However, in neither case was this claimed to be environmental guilt from the West.

Not see the wood for the trees

The more problematic element of this story however, is that it makes people view Sri Lanka’s crisis purely from the push towards organic agriculture. Yes, there was definite harm done to the country’s food security and many, many farming communities across the country were left helpless. However, this shift wasn’t the sole reason for Sri Lanka’s crisis.

In fact, the loss of food security and the instability of farmer livelihoods seems to have more to do with the overnight nature of the shift. There are many global examples of organic agriculture working well for crops, as long as the transition was structured and well guided over a calculated period of time. At the very least, it would have been something to explore, just not overnight.

The country’s overall crisis however, as mentioned before, had more to do with the overconsumption of imports, catastrophically low tax revenue, and an unbearable debt burden. The fact that this crisis had been building momentum since 2021 was also a likely factor that supported the ban in fertilizer imports. The reduction in food production definitely added to this crisis (higher prices for local crops and greater need to import food being immediate costs, while the country’s main export crop, tea, also saw negative effects). But with the ban being reversed (though with fertilizer no longer subsidised to the extent it had been before), these effects are slowly turning back.

Sri Lanka’s disastrous plunge into organics was definitely a terrible step, and had the potential to be catastrophic as well. But there’s no evidence to suggest that there were any “Green Elites” involved in this push. Local nationalism and the beginnings of the current foreign exchange crisis was likely far more important contributors.

In conclusion

The story of Sri Lanka’s economic crisis was a complicated one which we have explained in detail here. Many global ‘experts’ have attempted to link their favourite topic as the root cause of the Sri Lankan economic crisis.

The reality, however, is that this crisis was the consequence of poor domestic policies pursued by successive governments over the last few decades. Sure, Chinese loans and the Russian-Ukraine war contributed to the crisis, but the genesis of the problem stems from the country’s poor economic policies that led to a stagnation of export performances, the decline of tax revenue as a share of the GDP, etc.

Therefore, the blame game isn’t going to help Sri Lanka overcome the crisis. Merely focusing on setting up a currency board, blaming China or Russia or green elites will only divert attention from the real causes behind this. Sri Lanka needs to fix structural weaknesses in the economy (weaknesses such as low government revenue and low export revenue). That requires a focus on overall policy-making and implementation.