The depleting foreign exchange reserves in Sri Lanka and the subsequent economic crisis has left many Nepalis feeling nervous about Nepal’s economic situation and what the future holds – is Nepal in a brink of an economic crisis like Sri Lanka?
The depleting foreign exchange reserves in Sri Lanka and the subsequent economic crisis has left many Nepalis feeling nervous about Nepal’s economic situation and what the future holds – is Nepal in a brink of an economic crisis like Sri Lanka?
Experts have long warned Nepal of a possible economic crisis owing to its economic history and political landscape. While the situation might not be as dire in Nepal as it is in Sri Lanka, it is important to acknowledge that Nepal is positioned at a critical juncture, where Sri Lanka was a few years ago. To put it simply, Sri Lanka is currently grappling with a spiraling economic crisis because the government failed to identify weak projections regarding its political and economic trajectory. The country failed to introduce effective regulations and policies that could have potentially mitigated the situation from escalating. Hence, it is important for Nepal to learn lessons from Sri Lanka’s situation and initiate relevant regulations to prevent the economy from becoming weaker and eventually crashing.
What is happening in Sri Lanka?
Sri Lanka is experiencing an economic crisis because of their exhausted foreign exchange (forex) reserves. The country’s forex reserves plummeted by almost 70% in two years. It fell to USD 3.1 billion, which is enough to pay for just two months of imports. In February 2022, the forex reserve fell to a precarious level of USD 2.31 billion. Given Sri Lanka is an import reliant country, and is unable to finance its imports, even essential goods, the country is facing shortages that have had an immense impact on the price of food. Sri Lanka’s overall inflation was at 17.5% in February 2022, with food inflation hitting 30.2% in March 2022, forcing 13 hour blackout and long waits for basic items such as food, fuel, and medicine.
What factors led to the crisis?
The current crisis in Sri Lanka was provoked mainly by a massive dip in the country’s forex reserves on account of interest payment on heavy debt, decrease in tourism and remittance revenues, and unsuccessful policies such as tax cuts and organic farming, among others.
Sri Lanka was in a brutal, long civil war, which lasted for about 26 years. The conflict arose between the government majority and the country’s minority Tamil citizens and came to an end only in 2009. Further to the internal war, the country’s economy was affected by the global financial crisis and the surge in world prices of oil and food during the 2007-2008 global food crisis. Despite these shocks, the country’s economy showed resilient growth rates in the first three years following the civil war, in fact the country’s growth rate was 8.7% during 2010-2012. However, the growth was driven mainly by massive infrastructure development projects funded by foreign borrowing. In 2010, the country’s total external debt stock was USD 21.684 billion, which grew by almost 160% in just 10 years, reaching USD 56.342 billion in 2020. Besides tourism and remittance, the country’s foreign reserves were built simply by borrowing foreign funds and not through export. Interest payment on debt took up 72% of the government revenue in 2020. Moreover, the country’s main sources of income, tourism, and remittance, were hit hard since the outbreak of the COVID-19 pandemic. On one hand, tourism revenue, which contributes to around 12% of the country’s GDP, reached a record low of USD 0.50 million in December 2020 – a sharp fall from an all-time high of USD 475.20 million in December 2018. On the other hand, remittances started to fall as people began to avoid converting USD to Sri Lankan rupees through formal channels, because of a fall in the black-market value of the currency. This, added with the country’s tax cuts introduced by the President Gotabaya’s Government, slashed the government’s revenue.
What is happening in Nepal?
Nepal is facing a liquidity crunch because of decrease in foreign currency reserves, increased credit, and low deposits. According to the country’s Current Macroeconomic and Financial Situation of Nepal based on seven months’ data of the current fiscal year, released by Nepal Rastra Bank (NRB), the gross foreign reserves stood at USD 9.75 billion. It fell by 17%, from 11.75 billion in mid-July 2021 to USD 9.75 billion in mid-February 2022. However, unlike Sri Lanka, Nepal’s dwindling forex reserves cannot be attributable to debt. Sri Lanka’s Government Debt to GDP ratio was 101% in 2020, whereas Nepal’s outstanding debt was NPR 1.41 trillion in 2020, which is 40.16% of the country’s GDP. Furthermore, while Nepal has taken long term loans only, Sri Lanka took multiple short-term loans from foreign countries, which has been one of the main causes of the current crisis in the country. According to experts, Nepal still has room for taking more loans and does not need to worry till the debt to GDP ratio remains 50-60%.
Nepal, however, still needs to monitor the country’s increasing imports and depleting remittances, causing a dip in forex reserves. During the seven months of 2021/22, merchandise imports increased 42.8% to NPR 1147.46 billion and remittance inflows decreased 5.8% to USD 4.53 billion. Based on the imports of seven months of 2021/22, the forex reserve of the banking sector is sufficient to cover the prospective merchandise imports of 7.4 months, and merchandise and services imports of 6.7 months. This is a steep decline as compared to a year ago, when the reserves could support the prospective merchandise imports of 13.1 months, and merchandise and services imports of 11.9 months.
The two major sources of foreign currency for both Nepal and Sri Lanka are tourism and remittance. In 2019, the contribution of tourism to GDP of Sri Lanka and Nepal were 12.6% and 7.9%, respectively. Similarly, in 2020, personal remittance as a percentage of GDP of Sri Lanka and Nepal were 8.85 and 24.09, respectively. For both countries, tourism and remittance have contributed heavily towards the country’s total forex reserve. In Nepal, while the tourism industry was hit by the COVID-19 pandemic, the revenue from tourism has slowly started picking up since the ease of travel restrictions. On the other hand, remittance has been depleting as foreign migrants continue to send back money through informal channels. To accelerate revenues, the Government of Nepal should work towards creating an ecosystem that attracts more tourists and at the same time work with BFIs to provide incentives to bring remittances through formal channels.
Lessons for Nepal
As Nepal’s foreign currency reserves continue to fall, the Government of Nepal is coming up with directives and regulations to balance its deficit. It is important to follow NRB’s directives and bring the imports of non-essential goods to a standstill to balance the trade deficit. It is also crucial that the Government of Nepal and the policy makers actively monitor the economic situation of the country and take timely actions. What is happening in Sri Lanka is a result of a delayed government response coupled with challenges posed by the rising fuel prices and COVID-19. While situations are similar in Nepal, there’s a lot that Nepal can learn from Sri Lanka to avoid the situation from escalating.
Although Sri Lanka and Nepal are geographically different countries with political and economic complexities unique to these countries, it is critical to understand that any kind of economic crisis would have similar and more devastating impacts on its people. It is the role of the government to introduce and implement policies and regulations that create a buffer between its citizens and the economic shocks. Economic crises hit the vulnerable and underserved the hardest, increase income inequality, and access to essential goods become difficult. Therefore, relevant policies need to be put in place to mitigate the irregularities caused by an economic crisis to absorb the shocks of the crisis.
Aarya Rijal is a recent graduate with a B.A. in Economics from Union College, USA. Her key interests are in corporate finance, macroeconomics, and international economics. Before joining NEF, Aarya worked as a student data analyst and a research assistant at Union College. She is currently working as a fellow at NEF.