How is Sri Lanka's economic crisis affecting India?

Inflation has soared past 17%. People are dying while waiting in queues for fuel, and authorities are scrapping school exams after running out of dollars to import paper and ink. Sri Lanka is going through its worst economic crisis since its Independence.

And the ripples are now being felt in India too. Driven out by hunger and loss of jobs, people from the island nation are seeking refuge in India, which is doing its best to help the neighbouring country.

India has extended financial assistance to the tune of $2.4 billion in the last three months to Sri Lanka, which includes a $400 billion RBI currency swap, deferral of a $500 million loan and a $1.5-billion credit line for importing fuel, food and medicines.

In addition to an International Monetary Fund Bailout, the southern neighbour has sought credit support of $2.5 billion from China.

The island has been facing daily power cuts and double-digit inflation, which hit 17.5% in February. The Sri Lankan central bank allowed the local currency to devalue by 30% in a month.

The crisis has been mainly caused by a shortage of foreign exchange reserves. They have plummeted 70% in two years to just $2 billion at the end of February, which can barely cover two months of imports. Meanwhile, the country has foreign debt obligations of about $7 billion this year. The forex crisis is the result of several factors.

Tourism, which is the country’s third-largest foreign exchange earner, came to a virtual halt after the 2019 Easter Sunday suicide bombings which killed more than 250 people. Tourist arrivals dropped by as much as 70%.

And then the pandemic struck, dealing a severe blow to the tourism industry. And remittances from foreign workers, which is the nation’s biggest source of dollars, slumped 22.7% to $5.5 billion in 2021.

The country’s heavy dependence on imports for essential goods like sugar, pharmaceuticals, fuel, pulses and cereals worsened the crisis. The government’s ban on chemical fertilizers last April as it looked to become the first country to fully adopt organic farming backfired. A survey showed that 90% of Sri Lanka’s farmers used chemical fertilisers for cultivation. The move led to a drastic drop in domestic food production, pushing up food prices.

The decision was rolled back after months of mass protests by farmers but the damage was done. Food inflation soared to 25.7% in February. The crisis is now starting to impact Indian exporters.

Thousands of containers sent from India to Sri Lanka, including for its own consumption as well as trans-shipment cargo, have been lying uncleared at Colombo port as authorities can’t afford to transfer containers between terminals. This, in turn, has led to some build-up of cargo intended for Sri Lanka at Indian ports.

India also relies considerably on Colombo port for global trade given it is a transhipment hub. 60% of India’s trans-shipment cargo is handled by the port. India-linked cargo, in turn, accounts for 70% of the port’s total trans-shipment volume.

India has traditionally been among Sri Lanka’s largest trade partners. Prior to the pandemic, India was the top tourism source for Sri Lanka. More than one-fifth of Sri Lanka’s total imports come from India.

India is also one of the largest contributors to Foreign Direct Investment in Sri Lanka. FDI from India amounted to about $1.7 billion from 2005 to 2019. After China and the UK, India was the biggest source of FDI for Sri Lanka in 2019 at $139 million. The main investments from India are in the areas of petroleum retail, tourism and hotel, manufacturing, real estate, telecommunication, banking and financial services.

A number of leading companies from India have invested and established their presence in Sri Lanka. These include Indian Oil, Airtel, Taj Hotels, Dabur, Ashok Leyland, Tata Communications, Asian Paints, SBI and ICICI Bank.

Although Sri Lanka holds minor importance to India in terms of trade, it is a geopolitically important country and India needs to counter the growing Chinese influence on its economy.

At $4.8 billion, India’s annual exports to Sri Lanka accounted for just 1.3% of India's total exports. Sri Lanka’s share in India’s total imports was just 0.16%.

However, any disruption in Colombo port operations makes India vulnerable to an increase in costs and congestion issues.

While the work on building a transshipment hub in Kerala has begun, it is in India’s interest to help Sri Lanka come out of the economic crisis in the short-term.