The Tropical Island Being Hammered by War in Ukraine

Russia’s war in Ukraine, which has caused a humanitarian crisis and convulsed global financial markets, is now threatening to crush an $81 billion economy more than 4,000 miles away in the Indian Ocean.

Sri Lanka’s high oil import prices and drop in tourist revenue have caused a panic. The country is trying to avoid default with dwindling foreign exchange holdings. With inflation already at 15% —the worst in Asia—the conflict is only making it harder for the tropical island located off the southern tip of India. Blackouts that last up to seven hours and fuel shortages have been a daily occurrence. Meanwhile, gas station lines are getting longer as prices rise almost 50% each month.

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Authorities struggle to control the crisis. They’ve raised interest rates, devalued the local currency and placed curbs on non-essential imports. The battle against the odds is getting harder with only $2 billion worth of forex reserves, and $7 billion due in debt payments this year. The government this week finally abandoned its reluctance to seek help from the International Monetary Fund and President Gotabaya Rajapaksa pledged to fulfill Sri Lanka’s obligations.

“Seeking help from the IMF is the most feasible way to get out of the crisis,” said Ankur Shukla, a Mumbai-based economist with Bloomberg Economics. “The Russia-Ukraine war has worsened the already weak external balances situation, increasing the gap between external financial requirements and financing sources available.”

One of Europe’s worst conflicts since World War II couldn’t have come at a worse time for Sri Lanka, which is still recovering from a brutal 30-year ethnic strife that ended in 2009. South Asia’s country tried to boost its growth ever since. It spent millions of dollars on tourist infrastructure before the epidemic halted it. The crisis also shows how Russia’s war is putting some of the fragile developing economies at risk and imperiling decades of efforts to lift millions out of poverty.

Shukla indicated that South Asia has other countries, including Pakistan, Maldives (Nepal), Nepal, and Bangladesh. Though direct trade and financial linkages with Russia and Ukraine are limited, the “price and supply shocks are powerful,” he wrote in a note on March 9.

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Sri Lanka has a population around 22 million and is a net importer. Petroleum products made up about 20% of all inbound shipment, and their cost rose 88% compared to a year ago. This year’s increase in oil prices is adding to the problem.

The country has also been paying off external debt it piled on to help rebuild an economy scarred by the bloody civil war between the majority Buddhist Sinhalese and a Tamil minority that’s predominantly Hindu. It has also been depleting its forex reserves.

The loss of tourism revenue is another issue. A little over 30% of this year’s visitors were from Russia and Ukraine. According to official data, Sri Lanka’s tourism earnings were $3.6Billion in 2019. However, the outbreak of pandemic led to a drop in that figure to less than one-fifth two years later.

The central government’s foreign-owned debt stood at $32 billion as of November. Optimism that the government will soon manage to reach a deal with the IMF has already spurred a rally in the country’s dollar bonds. According to Bloomberg data, the offshore bond due 2030 rose to 49c to the dollar after falling to 38.9cs on March 9 from a record low. The one-year default probability has fallen to 18.2%, from 31.3% as late December.

The nation’s international bonds need to be restructured by July as Sri Lanka doesn’t have the necessary resources to pay the $1 billion due that month, Citigroup Inc. said in a February note.

Ajith Nivard Cabraal (Central Bank of Sri Lanka Governor) urged the restriction of non-essential imported goods of approximately 300 items, including electronics and apple.

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“The government seems to be reacting positively and that would help steer the economy to calmer waters in this time of unprecedented global challenges,” Cabraal said by phone last week.

But for everyday Sri Lankans the pain is very real. While civic groups held protests to highlight rising costs, the main opposition party organised a massive rally in Colombo demanding that President Rajapaksa resign. Protests against his government aren’t a concern as it commands almost two thirds of the parliamentarians.

Sugath Chaminda (44), said that it took him about 10 hours just to refill his car’s gas tank after getting turned down by several pumps running out. Then he spent even more time looking for cooking gas, which was in limited supply.

“I don’t know what the government is doing to have brought us to this situation,” he said in Colombo.

A portion of the inflation rise is self-inflicted. The government had an ambitious goal to increase organic farming and banned the import of chemical fertilizers last year. The government reversed the decision in November after protests and crop failure caused by a lack of nutrients.

Sri Lanka also approached China, India and Japan for bilateral credit lines in order to avoid the IMF bailout. However, negotiations were complicated by war in Ukraine. In the past, policymakers have generally considered some of the IMF’s conditions as burdensome, leading to reluctance to engage with the agency.

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Rajapaksa said Wednesday his government has weighed the advantages and disadvantages of working with the IMF, which has urged a “credible and coherent strategy” to restore macroeconomic stability and debt sustainability.

Restructuring is needed because the debt levels have risen too much, according to Kenneth Akintewe (head of Asian sovereign debt, Abrdn, Singapore).

“The country doesn’t have a history of defaults but that also means they don’t have experience with going through the restructuring process,” he said. “Added to that, the relationship with the IMF has been a fractured one. This leaves room for missteps along the way.”

Asantha Sirimanne and Lilian Karunungan with assistance of Ronojoy Mazumdar

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