The crisis that Sri Lanka faces today is the result of macroeconomic disequilibrium.
Since 2019, Sri Lanka has run a massive fiscal deficit, financed through money creation by the Central Bank. The result has been an increase in levels of aggregate demand. Despite tight import restrictions, Sri Lanka is not a closed economy so the expansion in aggregate demand has lead to a corresponding increase in imports resulting in a current account deficit.
Current account deficits (along with fiscal deficits) have been the norm in Sri Lanka almost since the time of independence. Current account deficits are not in themselves problematic but they are unsustainable when symptomatic of macroeconomic imbalances which would eventually trigger disruptive adjustments, which is the case today.
Since 2007, a significant component of the financing of the current account deficit has been through borrowing on international capital markets. The sharp turn away from fiscal and monetary orthodoxy in 2019 lead to a series of debt downgrades that have effectively shut the country out of international capital markets. The government is therefore unable to refinance its maturing debts or finance the current deficit; hence the ongoing balance of payments (BoP) and sovereign debt crises.
Policymakers viewed the balance of payments as the problem, not the budget deficit. Having confused symptoms with causes, the policy focus has been import controls. The deficit widened with the tax cuts of December 2019 and is now at a three year high.
When there is a shortfall in the balance of payments, the usual adjustment mechanism is the exchange rate. If this normal mechanism is allowed to work, the depreciation in the exchange rate causes prices of imports to rise, consumers buy less and imports reduce. Exports may also benefit. When this happens normally it is a gradual process and the change in demand adjusts naturally, there are no shortages and since the adjustment is gradual, no shock to the system.
When policymakers suppress the normal market mechanism for extended period of time the divergence between the official rate and the real value of the currency expands. At one point the artificial official rate has to give way and when it does suddenly it causes a large shock to the economy.
Resources within the economy are allocated on the basis of prices and when prices are out of alignment it results in misallocation of resources which reduces the efficiency of the economy. When price distortions are high then the allocation is no longer optimum and the entire economy starts to malfunction.
To solve the problem requires understanding the causes and addressing the fundamental imbalances but if the imbalances have grown so large as to reach a crisis stage this is very difficult to do. To reduce some shortages in the goods market requires urgent foreign exchange bridging finances but no one will lend money if the public finances are unsustainable. Its a catch-22 situation but luckily since the governor has taken bold steps towards fixing the problem and establishing some credibility, some initial support from the World Bank has already been promised.
Because of the large quantum of government borrowing, interest rates will need to remain high. The high rates mean there will be some crowding out of private consumption and investment. Over time as private demand contracts the current account deficit will reduce.
Upward pressure on interest rates will remain as long as government borrowing is high so if the crowding out effect is to be reduced, the quantum of government borrowing must reduce. This means closing the fiscal deficit.
Increases in personal taxes will reduce the government deficit and therefore the government borrowing requirement reducing the pressure on interest rates. Higher taxes can help curtail private consumption (including import consumption) but may also impact savings and therefore investment. Increases in corporate taxes could curtail investment.
The most painless way to reduce the deficit is therefore to cut expenditure but the recurrent expenditure is very rigid (mainly salaries, interest and pensions) so reducing capital expenditure is more feasible politically. Some trimming of unnecessary current government expenditures can increase available fiscal space for social transfers.
While the reduction in government capital expenditure is also a reduction in net investment, public investment is likely to be less efficient than private investment therefore reducing the pressure on interest rates through cuts in government capital expenditure. Deregulation and PPP projects can permit the private sector to take up the slack of government capital expenditure.
The imbalance in the goods market is connected to the balance of payments and money market disequilibrium. In the long term this will be resolved due to a combination of factors: demand contraction due to higher interest rates and demand contraction due to higher prices which result from the adjustment of prices to the realistic exchange rate.
All this is very painful but will stabilise the economy, allowing the exchange rates, interest rates and the balance of payments to come into a new equilibrium. The price level will be much higher than before, unemployment will be higher, people will be poorer but things will not be getting any worse. To restore growth requires further reform, to increase productivity, the level of output that can be achieved from the available resources.