Why Sri Lanka's foreign exchange reserves are being drained : Planet Money : The Indicator from Planet Money A series of policy missteps combined with a global pandemic is putting heavy economic pressure on Sri Lanka. Today, the events that led to surging prices, power outages and violent protests in the island nation.

Sri Lanka's foreign exchange problem

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SYLVIE DOUGLIS, BYLINE: NPR.

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ADRIAN MA, HOST:

This is THE INDICATOR FROM PLANET MONEY. I'm Adrian Ma.

WAILIN WONG, HOST:

And I'm Wailin Wong. The country of Sri Lanka is in a deep crisis. For the last two years, the island has been grappling with skyrocketing prices and a depreciating currency. More recently, they've been hit with medicine shortages and rolling power outages.

MA: And one big reason for Sri Lanka's economic crisis actually has to do with the U.S. dollar. And that is because the U.S. dollar is the world's reserve currency. It is what global economies use to conduct trade and hold their savings. And so if you crack open most countries' metaphorical piggy banks, you will likely find a big stash of U.S. bucks inside.

WONG: Sri Lanka's piggy bank of bucks - it's almost empty. And this is money the country needs to do business with the rest of the world and literally keep its lights on.

MA: Today on the show, why Sri Lanka has been running so low on dollars and what this country's crisis reveals about the importance of foreign exchange reserves for an economy.

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MA: The first domino to fall in Sri Lanka came in late 2019. At the time, the country had a new president, Gotabaya Rajapaksa, and he instituted some big tax cuts. The government's hope was that the people who got these tax breaks would use that money they save to, you know, stimulate the economy.

WONG: Instead, the tax cuts blew a hole in Sri Lanka's budget, which was already running a deficit. And then just months later, the pandemic hit. The country went into lockdown.

YUDHANJAYA WIJERATNE: Within a week, we were running out of food, as in like us, neighbors, people downstairs.

WONG: Yudhanjaya Wijeratne is a data scientist who lives in Colombo, Sri Lanka's largest city. He runs a fact-checking organization called A WatchDog (ph). Yudhanjaya remembers that in March 2020, with the curfew in place, one of his only options for buying groceries and other supplies was this one truck that would come around.

WIJERATNE: I recall having this moment where we were haggling over the price of carrots. And it felt very much like a black-market drug deal.

WONG: (Laughter).

WIJERATNE: And I was also trying to get cigarettes, so cigarettes, carrots and some cans of tinned fish. And I was sitting there going, OK, if it's this bad now, and if we have systems collapsing underneath, this is going to be a problem.

WONG: It was during the pandemic that Sri Lanka's problems really started to snowball. The economy shrank 3.6% in 2020. And a big part of that was the disappearance of tourism, which brings in billions of dollars every year.

MA: Sri Lanka's local currency is the rupee. And so when American tourists arrive on the island for vacation, they swap their U.S. dollars for rupees. And their dollars then flow through the Sri Lankan banking system and end up in that metaphorical piggy bank we talked about.

WONG: Now, a government needs foreign reserves for all kinds of transactions. We'll talk about two big ones. No. 1 - pay off foreign debt.

MA: To understand how that works, just imagine like I am, I don't know, the supreme economic chief of my very own country, right?

WONG: Oh, boy.

MA: Hey.

WONG: (Laughter).

MA: To all the fictional citizens of this country, I apologize in advance. Let's just say that I want to borrow money on the international market. Well, getting into the game really requires you to have U.S. dollars. So when I issue bonds to try to raise money, I issue those bonds in dollars. But that also means I have to make interest payments on those bonds in dollars.

WONG: Exactly. And Sri Lanka, like a lot of countries, was a regular issuer of foreign bonds. But the country had a problem. More dollars flow out of Sri Lanka than come in. And this perpetual shortfall meant the country was always going in search of more dollars, especially when it came to keeping up with debt payments.

MA: Yeah, basically having to get new debt to pay old debt.

WONG: And then this treadmill of taking on new debt to pay off older debt - it was mostly fine before the pandemic. But then credit ratings agencies downgraded Sri Lanka. They were concerned that between the tax cuts and the pandemic, the country was too risky to be a good borrower.

MA: Sri Lanka lost its access to international markets and couldn't sell any more bonds. A key source of foreign exchange, which it needed for debt payments, was now gone.

CHAYU DAMSINGHE: We had absolutely no way to continue, you know, repaying our debt.

WONG: Chayu Damsinghe is an economist at a research firm in Colombo.

DAMSINGHE: The only way we could continue to pay debt would be to draw down forex reserves and really pay that off.

WONG: Sri Lanka started draining its reserves. And this created another problem because the second big way that governments use their foreign exchange is to pay for imports - all the stuff they buy from the rest of the world.

MA: To try and keep its foreign reserves from getting so depleted, the Sri Lankan government started restricting imports of certain goods like wine, mobile phones and furniture.

WONG: The president also made good on a campaign promise to ban chemical fertilizer. He cited health and environmental concerns for the policy change, but the ban happened so abruptly that there was a huge outcry from farmers and food prices spiked. The government later reverse the decision.

MA: Chayu says before the crisis, Sri Lanka would have enough reserves to cover maybe six months of imports. Now, it's around a month or less. The decline in reserves has been basically a vertical drop.

DAMSINGHE: From about 8 to 9 billion by the time the new government came in - we are currently at a usable reserves number that is, well, closer to 100 million, which is extremely low. It's unthinkably low. There was a cooking gas shipment that required a $5 million payment that couldn't be cleared, and the ship had to be sent back, so which is a ridiculously small amount not to be able to pay. Sri Lanka is - I mean, we should not have come to this level.

WONG: Diesel imports are also running short, which has affected public transit and the electricity grid. Today, there are daily power outages of 4 to 5 hours at a time. There was even a period when the electricity was out for more than half the day.

MA: The head of the WatchDog fact-checking group, Yudhanjaya, he says Sri Lankans have lived through a lot of turmoil - civil war, terrorist attacks. The economic crisis also feels existential.

WIJERATNE: Sri Lankan public has lived through years and years of people putting all manner of remorseless pieces of metal into each other's bodies while screaming slogans. So on the surface of things, sure, I mean, it's getting harder to eat, but OK, we're not dying. And then the electricity started failing. People looked around and went, I can't put food on the table, and I can't even see the table anymore because we are having 13-hour power cuts during the day.

WONG: Around the country, protesters are demanding that the president resign. Some of the demonstrations have turned violent, and there's been at least one death reported. As of today, Yudhanjaya's WatchDog group has counted 350 protests in Sri Lanka just in the last few weeks.

WIJERATNE: This has turned into, like, a proper island-wide protest movement, this massive people's protest, people coordinating and putting each other on telegram groups and saying, we're going to go there. We're going to stand there until that guy is sent home.

MA: Sri Lanka's health care system is now running out of crucial supplies - catheters, anesthesia, painkillers, antibiotics. The government is turning to India and China and also organizations like the World Bank and the International Monetary Fund, trying to get aid and loan packages.

WONG: Earlier this month, Sri Lanka stopped foreign debt payments. This is the first time in the country's history as an independent nation that it's done that. The pause is helping free up scarce foreign reserves to pay for critical imports.

MA: And in the meantime, to try and help the situation, economist Chayu Damsinghe says there is one thing that could help put more dollars in the country's piggy bank. He says Sri Lankans living overseas - or really anyone with the ability to open an account in the country - should just deposit dollars.

DAMSINGHE: Maybe even a few dollars coming into the banking system can really help because those dollars now become dollars that the banking system can have access to, to allocate foreign essential good import.

WONG: That's so interesting because what you're describing is basically like crowdfunded foreign exchange reserves.

DAMSINGHE: Very much, very much. If things really get - you know, don't really work out or don't work out fast enough critically, then really, Sri Lanka's only option to survive - or if it's just immediate medicine requirements - it will be to crowdfund a foreign exchange, yeah, very much.

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WONG: This episode was produced by Jess Kung with engineering from James Willetts. It was fact-checked by Corey Bridges. Our senior producer is Viet Le. Kate Concannon edits the show. And THE INDICATOR is a production of NPR.

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