Sri Lanka’s Macroeconomic Crises: The Tale of Twin Deficits

In May 2022, Sri Lanka faced its worst economic crisis since its 1948 independence from Britain. The crisis led to skyrocketing prices, double-digit inflation, a more than 100 per cent increase in fuel prices, multi-hour power cuts, depleting foreign exchange reserves, an acute shortage of food and medicines, a dramatic collapse in incomes, mounting government deficits, devastating government policies, record debt defaults, and a downgraded currency rating. This was a dramatic shift, since Sri Lanka had once been the fastest-growing nation in the South Asian region with the second-highest per capita income in terms of purchasing power parity. It had the highest Human Capital Index among countries in South Asia. After the end of the civil war in 2009, Sri Lanka had accessed borrowings from the international market for infrastructure investments and earned the reputation of being a disciplined borrower that had never defaulted. By 2019, the World Bank had classified Sri Lanka as an upper-income country. The country’s economic crisis of 2022 resulted from politically motivated inefficiencies in government finances caused by unproductive spending. An unsustainable current account deficit, along with a large fiscal deficit, led to high and unsustainable government debt. Two black swan events—the emergence of the COVID-19 pandemic in 2020 and the 2022 intensification of the Russo-Ukrainian War—sparked the crisis. Though the International Monetary Fund (IMF), G7 countries, and India and China facilitated Sri Lanka’s bailout and prevented the country from defaulting on its loan repayments, an action plan to bring about structural changes was the only real remedy that could bring the country out of crisis and allow it to sustain itself over the longer term. This case highlights the factors that led to the crisis and the dilemmas faced by Sri Lanka’s new prime minister, Ranil Wickremesinghe, as he worked to draw up a restructuring plan and bring Sri Lanka’s economy back from crisis.

The target students for this case are graduate and post-graduate students of management programs and post-graduate students of economics programs. This case is also suitable for courses on macroeconomics and public policy, applied macroeconomics, public finance, and international economics. The case can be taught in a 70–90 minute session and can be used in the middle or at the end of the course. Students are expected to have a prior understanding of concepts such as circular flow of income, national income accounting and GDP, inflation, aggregate demand, government deficit indicators, fiscal multiplier, and balance of payment. After working through the case and its assignment questions, students will be able to achieve the following objectives:<br><br><ul><li>Analyze the significance of saving and investment in an economy.</li><li>Describe the role of government in stimulating the economy.</li><li>Explain government debt sustainability and its importance.</li><li>Analyze the relationship between budget deficit and current account deficit.</li><li>Investigate the twin deficits problem and suggest remedial measures.</li></ul>

• Fiscal Policy
• Current Account Deficit
• Fiscal Deficit
• Debt Default
• Crowding Out
• Public Debt Sustainability