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Sri Lanka is facing economic crisis — and the U.S. dollar is partly to blame

ROB SCHMITZ, HOST:

Skyrocketing prices, shortages of medical supplies, power outages. Sri Lanka is facing a deep economic crisis. Poor policy decisions and the pandemic are partly to blame. Another reason has to do with the U.S. dollar. Wailin Wong and Adrian Ma from our daily economics podcast The Indicator explain.

WAILIN WONG, BYLINE: 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.

ADRIAN MA, BYLINE: 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.

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: 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: 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 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.

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

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.

CHAYU DAMSINGHE: 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: 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 like fuel and even medical supplies. In the meantime, the country is getting short-term credit lines from India and aid from the World Bank. It's also in talks with the International Monetary Fund about a loan package.

MA: Adrian Ma.

WONG: Wailin Wong, NPR News.

(SOUNDBITE OF SWEET OSCAR'S "DOWNTOWN") Transcript provided by NPR, Copyright NPR.