Impact of internal and external shocks on Sri Lanka’s foreign exchange earnings

Sri Lanka, as a developing country, is highly sensitive to both internal and external shocks. Today, Sri Lanka is facing a big challenge of controlling the spread of COVID-19, which is a global pandemic. Even though Sri Lanka is far better than other developed countries in terms of controlling the spread of this decease, the Government Medical Officers’ Association (GMOA) warns that the situation will worsen in the month of April. 

If we fail to control this pandemic as a nation, not only a large number of people will be victimised but also it will create a huge negative impact on the economy. Exactly around one year ago, in April in 2019, the Sri Lankan economy faced a negative internal shock: the Easter attack on April 21, 2019, which created bad impacts on the economy. This internal shock led to create a negative impact on the foreign exchange earnings, mainly through adverse effect on the tourism sector. 

Irrespective of the fact that the shock is internal or external, the Sri Lankan foreign exchange sources are adversely affected.  Although it is too early to estimate the impact of COVID-19 at this stage, it is safer to be aware of the possible impact of external and internal shocks on foreign exchange earnings. 

Major foreign exchange sources in Sri Lanka are export of goods and services, tourism and remittances. In 2018, Sri Lanka’s export of goods and services as a percentage of GDP was 22.79 percent and import of goods and services as a percentage of GDP was 30.13 percent (World Bank, 2018). The direct contribution of tourism to GDP was 4.9 percent in 2018 (Sri Lanka Tourism Development Authority, 2018). Personal remittances received by Sri Lanka in 2018 was equal to 7.9 percent of GDP. 

The objective of this article is to show the impact of internal and external shocks on the foreign exchange earnings in Sri Lanka with special reference to imports, exports, tourism and international remittances. 

Export and import of goods and services
The external shocks affect the domestic economy in direct as well as indirect ways. Among many ways, the effect on the supply chain is important as it will lead to many other consequences. Any change in the supply change will affect both imports and exports. 

The Harvard Business Review predicts that the peak of the impact of COVID-19 will occur, “forcing thousands of companies to throttle down or temporarily shut assembly and manufacturing plants in the U.S. and Europe”. How does this affect the Sri Lankan economy? 

This will affect both Sri Lankan exports and imports. Even though the major focus of this article is only on the foreign exchange sources and earnings, the impact on imports is also considered, as it affects the demand for foreign exchange. 

According to the Central Bank annual report (2018), 77.9 percent of Sri Lankan exports was industrial products, while only around 21.7 percent was agricultural products. Out of the industrial exports, around 45 percent was from the apparel exports in 2018. In the case of the Easter attack in 2019, the export sector was not affected. 

The Central Bank (2020) highlights that the external sector remained resilient amidst the setback in the tourism sector following the Easter Sunday attacks. The trade deficit contracted significantly during the first eight months of 2019, in comparison to the corresponding period of 2018, with lower import expenditure and increased earnings from exports. 

However, the impact of COVID-19 might be different. COVID-19 will affect the export earnings in two different ways. First, foreign demand for Sri Lankan products will reduce. Second, production quantity will be adversely affected during this lockdown period. 

Therefore, even if the demand will not go down, it is questionable whether Sri Lanka will be able to cater to the demand. As such, the apparel sector, the largest export earner, will significantly be affected. The demand for Sri Lankan apparel products will decline as a result of COVID-19, due to few reasons. 

First, in 2018 also the demand for our garments declined from the UK, the largest European market and estimate it will further decline in 2020, as the UK too is affected by COVID-19. Second, export earnings increased mainly due to higher demand from Germany, Italy, the Netherland and Sweden in 2018, with the restoration of the European Union (EU) GSP Plus. However, in 2020, we cannot expect a higher demand from European countries like Italy and Germany, as they are at the top of the list of affected countries. 

Further, imports of the input for the apparel industry will be questionable. Out of the total imports of intermediate goods (56 percent), around 13 percent was textiles and textile articles in 2018. Considering these factors, we can expect that the apparel industry in Sri Lanka will face big challenges after COVID-19. However, the EU GSP Plus agreement will help to moderate the adverse impact  to some extent. 

There is a considerable number of people working in the textile and garment sector. Any negative effect on this sector will also badly affect the employees of this sector. This causes to increase the unemployment rate and economic and social vulnerability of workers.

Further, higher demand for some other agricultural products from Europe also contributed for higher export earnings in 2018. For example, Italian demand was significant for Sri Lankan seafood exports in 2018. Not only the demand for seafood but also the demand for Sri Lankan tea will also be affected negatively. Around 12 percent of the export earnings came from the tea exports. 

The major reason for decreasing the demand for our products is that the Sri Lankan export market is not diversified. Our major export destinations are the USA and Europe. In 2018, our major export destinations were the USA (25.9 percent), UK (8.2 percent) and EU (16 percent), which are the mostly affected countries.

When we discuss about the import performance, as we mentioned earlier, the Easter attack did not affect the import sector too. However, we can expect COVID-19 to make a significant impact on imports, as the entire world and their supply chains are affected. 

Around 40 percent of imports are from China and India. The EU’s import share was 12 percent in 2018. This will affect our production sector as we import a significant percentage of our intermediate commodities from other countries. 

Oil prices went down to the lowest price ever recorded. However, positive impacts of this lower oil price cannot be harvested at this moment, as the entire country is not working. The current government is using the benefit received from lower fuel prices to subsidise the consumption of poor people in the country. 

Remittances
Remittance inflows to Sri Lanka were playing a counteractive role in the Sri Lankan economy. Remittance inflows have played a countercyclical role when Sri Lanka has faced economic downturns. For example, remittance inflows increased significantly immediately after the Asian tsunami in 2004 and also after the civil war in 2009.  
However, in 2020, when Sri Lanka is affected by COVID-19, can remittances play the same role to support the country? The answer is very straightforward: “No”. Why? In the short run, remittance inflows will drop due to the fact that a large number of migrant workers returned to Sri Lanka during the COVID-19 outbreak. 

The long-run effect is twofold. First, the entire globe is in lockdown and it will negatively affect the remittance flows with the poor economic performance in the labour-demanding countries. Second, international labour movement will be slowed down for a longer period due to two reasons: 1) Lower demand led by slow growth in labour-demanding countries and 2) unwillingness of migrant workers to supply labour (go abroad for employment purpose) even after COVID-19. 

As we all know the impact of COVID-19 is high on the EU countries, the remittance inflows from the EU region will reduce. According to the Central Bank annual report (2018), around 19 percent of remittances were received from European countries. 

According to the brooking experts, the Middle Eastern countries are not that much affected, except Iran. However, they predict that the expected growth in this region in 2020, after the low and fluctuated oil prices, will not happen now. The region might be badly affected due to the lower oil prices, which is their major income source.
Jihad Azour (2020) also mentioned that the biggest challenge currently faced by the Middle East is COVID-19. If this is the case, remittance inflows to Sri Lanka will be badly affected, as around 51 percent of remittance inflows to Sri Lanka are from the Middle Eastern region. 

Further, a significant portion of remittance inflows comes from the temporary migrants but not from permanent migrants. Temporary migrants are the people who came back to Sri Lanka during the COVID-19 outbreak. 
On the other hand, even though some migrants do not come back to the home country, it is questionable whether they can send remittances to Sri Lanka like they did previously because if the destination economies are affected, it will lead to reduction of income and savings of the migrant workers. Therefore, their capacity of sending money back home will decrease. This reduction in remittance inflows will widen the balance of payments issue. 

Tourism
The travel and tourism industry in Sri Lanka is the third largest export earner in the economy, after remittances and textiles and garments. Sri Lanka is an increasingly popular destination for international travellers as well as for expatriates returning home to visit friends and relatives. 

In 2013, Lonely Planet nominated Sri Lanka as the number one destination in the world to visit. In 2015, Forbes Magazine ranked the island among the ‘Top Ten Coolest Countries’ to visit. 

According to the annual report of the Sri Lanka Tourism Development Authority (2018), the number of international tourists to Sri Lanka was 2,333,796 and the foreign exchange earnings were Rs.712,027.3 million (US $ 4380.6 million). The direct contribution of tourism to GDP is 4.9 percent. Total employment generated by the travel industry was 388,487. The direct employment created by travel and tourism was 169,003 while indirect employment generation was 219,484 in Sri Lanka.

Even though the tourism industry contributes to the national economy largely in various ways, such as increase foreign exchange, GDP, employment opportunities and development of small and medium-scale industries, this sector is highly sensitive to external shocks. 

For example, all the shocks such as civil war during 1983-2009, the Easter attack in 2019 and currently the COVID-19 decease, have badly affected the tourism industry by decreasing the tourist arrivals. The impact of COVID-19 will be higher as most of the tourists are from Europe, India and China. 

In 2018, the majority of tourists were from India, China, the United Kingdom, Germany and Australia. All these countries are affected by COVID-19. Nearly all the counties closed their airports and banned travel from country to country. Most of the countries banned travel even within the country. This condition influences badly on the tourism sector.  

On the other hand, the demand for tourism is seasonal. During the year 2018, the high season was spread over a period of six months.  A large number of tourists arrived in December, January, February, March, July, August and November. The highest number of arrivals were recorded in the month of December. The lowest number of arrivals were recorded in May. 

The COVID-19 pandemic has arisen in the high season of tourist arrivals and therefore, the negative effect will be higher. Thus, foreign exchange earning from tourism is highly vulnerable to these internal and external shocks and seasonal variations. 

Further, these shocks and seasonal variations badly affect all the direct and indirect income earners and small and medium enterprises (SMEs), which depend on tourism.  

Our main foreign exchange sources: exports, tourism and remittances, are highly sensitive to both internal and external shocks. The dependency of high risky sources of foreign exchange relies on very few exports and concentrating on few export destinations make the country more economically vulnerable to external and internal shocks. These fluctuations in the foreign exchange market may create many economic consequences. 

Reduction of foreign exchange inflow causes balance of payments problems. Further, lessening of foreign currency influences on devaluation of Sri Lankan rupee. During the first week of April, the Sri Lankan rupee depreciated against the US dollar, where it now stands at Rs.199 against the US dollar. 

However, we have to be careful in the COVID-19 situation, since all supply, demand and financial shocks will affect the exchange rate determination. If the currency devaluation keeps continuing, Sri Lanka has to face some other economic issues, such as inflation. Further, the severity of the debt crisis will increase as Sri Lanka is liable to pay huge amounts of loans to other countries and financial institutes. 

As mentioned earlier, a large amount of remittances is sent by temporary migrants. When there is a massive external shock such as COVID-19, most of them will return to Sri Lanka without any compensation. Some of these temporary migrants may return willingly or some countries force them to go back to their home countries. Other than the reduction of the remittance inflows, these returnee migrants may create huge problems, such as unemployment and economic reintegration problems. 

How can we get ready to face future shocks? One important action we need to take is the reduction of the import dependency. Unfortunately, Sri Lanka imports many food items, which can be easily produced in Sri Lanka. If our food consumption depends on the imported food, external shocks will badly affect our food consumption and may lead to food crisis, foodflation and food insecurity for some persons.

It will further increase the inflation rate and create balance of payments problems. Therefore, self-sufficiency is important. Although there are huge benefits of an open economy and globalisation, it is necessary to create self-sufficiency in the economy to some extent, since it is difficult to survive when there is a huge global crisis. 
Therefore, as a country, we should think of how we can adjust our economy to depend less on other economies. This is the right time for a new beginning. At the moment, home gardening is promoted, so that we can overcome future food deficit in the country. As such, food production should be promoted.

 
The government can provide the necessary facilities for making the agriculture sector more attractive. Although Sri Lanka is a high-middle-income country, we should develop the agriculture sector since we have the necessary resources and a strong history about a good agriculture-based economy. Especially Sri Lanka is blessed with good weather and sufficient labour so that we can produce all the food items to cater to the domestic demand and extra production for export. 

The development of the agriculture sector may also be a solution to the unemployment problem. Youth unemployment is high in Sri Lanka. Moreover, many Sri Lankans are leaving the country for unskilled jobs in other countries since they cannot find employment opportunities with a good salary in Sri Lanka.  Therefore, this is the great time to make the agricultural sector more attractive by providing the necessary infrastructure facilities and marketing facilities. 

In case where it is essential to import, we need to diversify our import destinations. As mentioned earlier, around 40 percent of our imports are from India and China. Any adverse effect in the Indian and Chinese economies may badly affect Sri Lankan imports.  

As mentioned earlier, the textile and garment sector, the second largest foreign exchange source, is also vulnerable to external shocks highly. This highlights the need of diversification of foreign exchange earnings as well as export destinations. Development of a self-sufficient industrial sector, which could not disturb the supply chain is another possible solution to reduce dependency on the global economy for industrial commodities. 

Sri Lanka records a higher literacy rate compared to other countries in the same income group and there is more capacity to develop science and technologies through research and development. It is proven by the Sri Lankan community, who produced the most necessary health equipment in the country with lower cost, during the COVID-19 outbreak, which was otherwise limited to importing. These new products reflect our capacity to develop the industrial sector.  

Further, it is better to promote SMEs, which have many benefits to the economy. SMEs support the supply chain of industrial products and enhance the employment opportunities massively. Apart from that, there are traditional SMEs in Sri Lanka that can be promoted as a source of foreign exchange earnings and diversify our exports. Further, development of SMEs is a way of promoting inclusive growth and reducing poverty.  

Active labour market programmes should be promoted as a means of building economically strong households. Economically sound households may not be vulnerable to risks. As there are many people working in the informal sector with lower income, the government has to provide subsidies when the economy experiences negative shocks. It is evidenced during this COVID-19 pandemic; the government is spending a huge amount of money as subsidies, which may cause a huge financial problem in the short and long term. 

In summary, to face any internal or external shock, we need to be self-sufficient by reducing the imports from other countries. For that, the agriculture sector should be promoted. Not only the agriculture sector but also the industrial sector should be developed and the export destinations should be diversified. 

Further, we need to diversify import destinations. Active labour market programmes and SMEs should be promoted so that the supply chain is not disturbed during an external or internal shock and also for reducing the vulnerability in a recession. 

(Dr. Roshini Jayaweera and Dr. Dammika Padmakanthi are Senior Lecturers at the Economics Department of the University of Kelaniya)