Sri Lanka is printing money to pay salaries, but it could cause another economic implosion

To manage the economic crisis in Sri Lanka, newly inducted Prime Minister Ranil Wickremesinghe said he was forced to print money to pay the salaries of government employees, continuing a vicious cycle that led the country to s get into debt in the first place.

Sri Lanka printed 1.2 trillion rupees in 2021 and in the first quarter of 2022 it printed 588 billion rupees. Between December 2019 and August 2021, Sri Lanka’s money supply increased by 42%.

This cash surplus was deliberately created to fill the deficit and keep tax rates low. Sri Lanka’s populist former regime justified its economic policies with so-called modern monetary theory, which mainstream economists dismiss as a “wacky idea” and suggest it is better in theory than in practice.

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EXPLAINED - What's happening in Sri Lanka is the biggest hotbed of massive upheaval in neighboring India

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Sri Lanka began massively printing money in February 2020. The Rajapaksa government cut taxes in December 2019 just before pandemic-induced lockdowns that stifled tourism, the country’s fifth largest foreign revenue earner.

The Rajapaksa government then promoted organic farming to cut dependence on imported chemical fertilizers which the country could no longer afford. This devastated the country’s crucial tea and rice crops. Captive of its own economic mismanagement, the Rajapaksa government also resisted IMF aid, pushing the country into deeper crisis.

The dangers of printing money

Modern Monetary Theory, which Sri Lanka experimented with and had catastrophic consequences, is a theory that suggests that governments can simply print money instead of generating revenue through taxes and borrowing .

Sri Lanka borrowed heavily for years but wasted the money on Chinese-funded infrastructure projects, many of which are now largely obsolete. Its deficit (the difference between borrowings and income) has become massive. Without raising taxes, the populist Rajapaksa regime stepped up currency printing to finance the deficit.

Sri Lankan central bank governor WD Lakshman and his successor Ajith Nivard Cabraal both allowed printing presses to operate 24/7 and denied the link between money printing and the inflation or currency depreciation.

The consequence

Sri Lanka headed into its worst economic crisis since independence with no one holding back.

Although printing money to avoid a short-term crisis may seem like an attractive idea, it is a trap. Printing more money does not increase economic output: it only increases the amount of cash circulating in the economy.

With more cash on hand, consumers can demand more goods. However, if the goods are in limited supply, it leads to inflation and, of course, scarcity. For example, Sri Lanka has run out of fuel (an import) and it has no foreign currency to buy it because its foreign exchange reserves have been severely depleted. Sri Lanka desperately needs credit lines from allies like India and China and an IMF bailout to survive.

Yet Sri Lanka prints money because not doing so would be “a bigger crisis” according to current central bank governor Nandalal Weerasinghe. Government employees are the first beneficiaries of printed money, but this later leads to higher prices as the currency depreciates and inflation rises.

“If money printing is stopped and wages are not paid, there will be a bigger crisis,” Weerasinghe said. “I can clearly say that there is no problem paying the salaries and pensions of state employees. Because we can give money which is paid in rupees. But we have to do it with a certain responsibility and we must not do as before and increase inflation to around 40%”.

Meanwhile, Sri Lanka appears to be heading for its first external debt default as it is unlikely to be able to pay interest to bondholders by Wednesday (May 18), when his grace period to do so will end.