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Why Sri Lanka Imploded

When Sri Lanka’s Rajapaksa family returned to power in 2019, it was riding a wave of support that it sought to sustain with popular but ill-advised economic handouts. By definition, unsustainable policies eventually run into a wall.

HAMBURG – As Sri Lanka’s economy unravels before our eyes, one must ask how this could happen in a country that is historically known for its high standard of living and stable economy. Sri Lanka’s achievements go back decades, giving it a per capita GDP that is 70% higher than India’s, and a life expectancy at birth of 77 years, compared to 73, 70, and 67, in Bangladesh, India, and Pakistan, respectively.

But now, Sri Lanka’s economy is in free fall. The proximate causes of the crisis are clear enough. Problems stemming from international factors such as COVID-19 and Russia’s war in Ukraine were exacerbated by Sri Lanka’s own policy mistakes. In 2019, President Gotabaya Rajapaksa (who has now fled the country) announced a round of mindless tax cuts, depriving the state of sorely needed revenue. Then, in 2021, his government abruptly banned imports of chemical fertilizer and pesticides. While the aim of the policy was to stall foreign-exchange outflows, the main result was a dramatic reduction in domestic food production, leading to acute food shortages this year.

The coup de grâce was the government’s ongoing effort to keep the Sri Lankan rupee artificially strong. Technically, Sri Lanka uses a “soft peg”: Rather than being fixed by government diktat, the rupee-to-dollar exchange rate is allowed to float, albeit with occasional interventions by the central bank (buying and selling dollars) to prevent excessive fluctuations.

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