There is growing speculation that the Nepali economy will disintegrate like in Sri Lanka as the country's foreign exchange reserves have shrunk and inflation has soared with rising fuel prices. For the first time since the 2000s, foreign exchange reserves have dropped to around $9 billion, which is barely enough to fund imports for six months, down from 11 months. At the same time, inflation has hit an all-time high of 8.56 percent with the employment rate remaining as disappointing as usual. Therefore, there is no reason to disregard the suspicions outright.

Before delving into this phenomenon, it is relevant to understand how Sri Lanka landed in its worst economic disaster ever. Facts and figures made available by the World Economic Forum show that, like Nepal, Sri Lanka depends excessively on a handful of export products such as tea, rubber and readymade garments. Earnings from tourism and remittances contribute substantially towards the net income of foreign currency. But because the product base for exports is narrow and earnings from tourism and remittances often remain stagnant, the country frequently encounters balance of payments crises which strain its foreign exchange reserves.

Too many loans

Since Sri Lanka depended on limited sources of foreign currency to finance its import growth, and foreign debt-aided development activities took place aimlessly, the island nation was often at the mercy of International Monetary Fund loans to meet the foreign exchange gap resulting from a rapidly growing trade deficit and debt servicing. To date, Sri Lanka has received IMF loans 16 times, and all loans were based on conditions of tight fiscal and monetary policies, reduced domestic subsidies, and depreciation of the national currency to make its exports cheaper.

Unfortunately, Sri Lanka's latest IMF loan in 2016 coincided with the beginning of its economic meltdown. As a result, it affected not only growth but also added a debt burden denominated in foreign currency. Adding to this catastrophe, a series of incidents in the following years contributed to choking the economy. It all began with a steep decline in tourist arrivals due to the Colombo bomb blasts in 2019 which was followed by the coronavirus pandemic in 2020. The government's irrational decision to cut taxes in 2021 only worsened the crisis. And most surprisingly, the government banned the import of chemical fertilisers to conserve foreign currency and declared the country's farming to be 100 percent organic. The decision to ban chemical fertilisers and the shift to organic farming proved ill conceived as it reduced agriculture productivity and production, forcing the country to import more food. The move also adversely affected output and exports of tea and rubber, which served as an essential source of foreign currency.

Consequently, the country gradually faced increased pressure on foreign exchange reserves, forcing it to take import control measures, which led to supply shocks. Import controls caused inflation to spike to over 17 percent early this year, creating a shortage of foods, fuels, and medicines. Ultimately, for the first time since its independence from Britain, Sri Lanka defaulted on its external debt payment in May 2022, declaring South Asia's once prosperous economy bankrupt.

Having observed the Sri Lankan debacle, one can be convinced that there are early signs of the Sri Lankan syndrome in the Nepali economy. Like Sri Lanka, Nepal's trade imbalance problem is gradually getting severe. The country's trade deficit has surged to an all-time high of almost Rs1,600 billion since the beginning of the current fiscal year. At the same time, the balance of payments, which usually enjoyed a surplus, had faced a deficit of nearly Rs300 billion as of the end of the last fiscal year. As a result, the Nepali currency has depreciated constantly, leading to import shocks and soaring price levels. The steep increase in food and fuel prices is most striking.

But for a small and import-oriented economy like Nepal, which relies on limited and unreliable sources of foreign currency, it is difficult to absorb the shock from high imports. Nevertheless, given the country's external financial liabilities and the ratio of external debt to gross domestic product (GDP), Nepal is in a comfortable position to manage the crisis. Nepal's external debt to GDP ratio is around 21 percent, compared to over 40 percent in Sri Lanka, accumulating debt obligations of about $51 billion in 2022. And as there are signs of post-pandemic recovery, Nepal has ways to fend off economic contingencies.

However, despite the options available to address the structural weakness to prevent the economy from further deterioration, Nepal is wallowing in weird policies and squandering resources in politically motivated superfluous development projects. One of the reasons for Sri Lanka's crisis was investments in redundant development projects seeking foreign exchange dominated mainly by international sovereign bonds. The country also arbitrarily introduced piecemeal programmes targeting the problem of trade imbalance and foreign exchange shortages without success.

Thus, if the series of Sri Lankan economic incidents is any lesson for Nepal, it is essential to deal with the early signs of the financial hardships without delay. Since the root of the current economic problem lies in the country's acute trade deficit problem and dwindling foreign exchange reserves, intervention in external trade should be given priority. But there is no possibility of taking radical steps to curb imports due to the country's over-dependence on imports and poor domestic manufacturing. Nor can it expect to see a miracle in exports which are sluggish.

Policy options

But there is no paucity of policy options. Regarding imports, there is a possibility of optimum tariff, which maximises welfare instead of measures that illogically control imports and only help to raise inflation. The government can provide incentives that encourage innovation and entrepreneurship in exports instead of direct subsidies, which are mainly discriminatory and ineffective.

At the same time, Nepal needs to discourage development projects, particularly those that accumulate debts in foreign exchange with a very long gestation period. Whether dry ports or mega airports and fast tracks or railway tracks, any decision on investment in development projects must aim at balanced regional development that contributes to overall production. Political interests at the cost of economic rationality should be rejected by any means in this regard otherwise, Nepal will inevitably face an economic crash like in Sri Lanka.