Read the following articles

Read the following articles and answer the questions below, using only the concepts you have learned in this course.

Do not discuss this with anyone, and do not do any additional “research” i.e. your answers should be analytical and not empirical. In particular, do not include any specific information about individual companies or economies that you may have acquired from other sources.

Use the Answer Sheet provided on Canvas, and check that your exam has been properly submitted within the time limit.

Make sure your name is on EACH sheet.

Number your answers clearly (e.g., 1, 2, 3a, 3b etc.) and leave a one-line space between each answer. Do not reproduce the questions on your answer sheet.

You should not simply reproduce exact wording from the article, but rather explain in your own words your answer to each question.

State your conclusion and explain your logic clearly to receive full credit, offering correct conclusions without providing logically consistent reasoning would only result in partial credit.

Points assigned to each answer are noted in parentheses, for a total of 100. Note that the number of points reflects the weight given to each answer (based e.g. on difficulty and completeness), not the number of reasons/items your answer must give.

You should not give more reasons/explanations/effects than the number requested in the question. If you give more, only the first few numbers will be graded.

Your answers in total (combined) should fit within THREE single-sided pages of 11-point Times New Roman font text, single-spaced with 1-inch margins. Answers that go beyond three pages will not be graded.

Sri Lanka is “bankrupt”

Extracted from CNN, BBC, The Economist, Reuters, New York Times, and many other sources

In early July tens of thousands of angry Sri Lankans poured into Colombo, the capital of Sri Lanka, to chase President Gotabaya Rajapaksa and his government from office. Mr Rajapaksa went into hiding for several days and at last resigned. His departure marks the end of his family’s two decades of political domination. His prime minister, Ranil Wickremesinghe, was elected as the President by parliament.

Sri Lanka was a popular tourist destination due to its pristine beaches and rich local culture. But now protests on the streets are casting a shadow over its image as a safe place to go on holiday. The US State Department has raised its threat level and issued a level 3 travel advisory for American citizens against travel to Sri Lanka. India’s largest airline Air India has reduced the number of flights to Sri Lanka due to lower demand.

The immediate reason for the political crisis is the disastrous economic situation facing the island’s 22m people. Sri Lanka, the first country in South Asia to open its economy, is in the midst of its worst financial crisis in seven decades. The Sri Lankan rupee has declined by 45% against the dollar since the central bank abandoned its peg in March. Tourism and remittances were Sri Lanka’s main sources of foreign currency.

The government had spent months frittering away its dwindling foreign-exchange reserves on propping up the currency and servicing foreign debt, which had long become unaffordable. In April, it said it would stop paying its foreign-denominated dues; in May, it officially defaulted, losing access to capital markets. Because Sri Lanka has all but run out of foreign currency, it cannot afford to pay for imports, from fuel, food, medicines, to auto parts. Fuel shortages means doctors cannot get to work, hospitals can barely run ambulances and homegrown food cannot reach cities. The government has resorted to importing limits, restricting their purchases to just necessities.

The economy contracted by an annual 1.6% in the first quarter and is forecast to have shrunk more in the second. The annual inflation rate accelerated for the 11th straight month to reach a fresh record high of 64.3% in August of 2022. Biggest upward contribution came from food costs which jumped at an all-time high of 93.7%, after a 90.9% surge in July.

External shocks have played a part in the crisis. But the main culprit, and the main reason for the protesters’ anger, is government mismanagement. For decades, Sri Lankan political leaders have used populist promises like subsidized rice, low-priced bread, public sector salary increases, free fertilizer, and tax cuts to ride to power. An earlier Rajapaksa government led by Mahinda, Gotabaya’s brother, borrowed heavily to finance infrastructure projects, such as a fancy port development, that have yet to generate returns. The most recently disgraced government, led by Gotabaya, slashed taxes, which bashed treasury revenue. The nation’s government budget deficit for 2022 is projected to be 9.8% of its GDP.

Sri Lanka is pushing for a possible $3 billion extended financing programme from the International Monetary Fund (IMF) which would help it unlock other bridge financing options to pay for essential imports. The IMF indicated the need for stronger fiscal measures to put public finances back on track and boost debt sustainability following a ten-day visit to the country in June.

The central bank increased its standing lending facility rate to 15.50% while the standing deposit facility rate to 14.50%, the highest since August, 2001.

India is Sri Lanka’s third-largest trade partner, and one of the largest contributors to foreign direct investment (FDI). The main exports to Sri Lanka include engineering items, skimmed milk powder, sugar, onions, and grapes. 90% of Sri Lanka’s sugar consumption comes from India. India also relies considerably on the Port of Colombo for global trade, given the port’s function as a hub for transferring shipments. Nearly 60% of India’s total transshipment cargo and 30% of container traffic is handled by the port. Leading Indian companies in Sri Lanka include Indian Oil, Airtel, Taj Hotels, Dabur, Ashok Leyland, Tata Communications, Asian Paints, SBI and ICICI Bank.



Explain how the government budget situation in Sri Lanka contributed to its currency crisis. (5 points)

Budget deficit-= tax was reduced> in addition to spending increases through subsides> debt increase for internal infrastructure development> Large foreign debt: (CI – CO) is negative BOP is negative depreciation



Beside your answers to Question 1 above, give five more reasons why Sri Lanka is in a currency crisis. (20 points)

1.Cumulative large Current Account deficit: CA deficit means (X-M) is negative, which means BOP is

negative, so currency depreciation,resulting

2-Large foreign debt: (CI – CO) is negative  BOP is negative  depreciation

3- `Risk of running out of foreign reserves: If government does not have a big foreign reserve, it will

be limited in its ability to buy back its own currency to limit depreciation

4- Currency depreciation -Domestic products become more attractive than foreign products. –

More exports – Less domestic products are left for domestic consumption-

inflation (-

5- covid in 2020> reduction in tourism> revenue> Reduced GDP> Currency crisis

6- ban on foreign fertilizers and reliance on domestic fertilizers> increased import cost for foreign food due to crop failures>increased /depletion of foreign reserves>currency crisis


Give two reasons why a currency devaluation might cause inflation. (10 points)

1-Currency devalution> IR increases> Import cost increase> Cheaper for foreign countries to buy local prodcts>increased inflation since the value of srilankan rupee to 1usd dollar has decreased

Currency devaluation causes cost of imports to go up(90% of srilanka’s sugar consumption comes from india)>exports increase> not buying as , causing X-M to go down, causing more currency depreciation

Imports more expensive – expensive imports – Cost of domestic production increases. -inflation

2- Currency depreciation -Imports cost more expensive – Cost of living for workers increases. –

Wage increases. – Cost of domestic production increases.-inflation

(a) Explain one benefit of the central bank’s high interest rate policy. (5 points) (b) Explain one cost of the central bank’s high interest rate policy. (5 points)

 Raising rates makes borrowing more expensive and slows down economic growth

Higher interest rate low consumption/ less likely to buy less demand for bank money inflation goes down

Cost: High IR

Higher interest rate reduces consumption reduces GDP

One recommendation in the IMF programme is to support the poor and vulnerable as high inflation will have the most impact on them. Accordingly, the government is considering alternative measures to manage inflation such as cash transfers to the poor. (a) Explain one advantage of cash transfers compared to the high interest rate policy. (5 points) (b) Explain one disadvantage of cash transfers compared to the high interest rate policy. (5 points)

Higher intrest rates> loss of employement, > Cash transfers>mitigate the loss of unemployement.


Disadvantage: budget deficit is increased. When money from cash transfers are spent on staples> demand increases> Inflation increases

(a) Give one reason why local bus transportation business could benefit from the Rupee crisis. (5 points) (b) Give one reason why local bus transportation businesses could be hurt from the Rupee crisis. (5 points)

Fuel prices go up> people can not afford cars/bikes> take bus/location transportations> Increase in the

Transportation revenue

Disadvantage: Fuel price goes up> cost of bus fare increases

Describe five ways the economic crisis will affect India. (10 points)

Srilankan rupee depriates> india’s cost to import from srilanka is cheaper

Cost more for india to export to srilanka > reduces the available import to srilanka>

Supply is low> demand is high> inflation in srilanka.

Economic crisis> high IR> Making it more attractive for india to invest in srilanka..

Increase in inflation> consumption goes up>firms want to produce more>firm borrow more money> more demand for bank money> ir goes us

Higher Inflation higher demand in indian currency weaker srilankan currency

Baur & Co. (Pvt.) Ltd. was the first Sri Lanka fertilizer company, exclusively involved in both organic manures and chemical fertilizers, founded in 1897 by Alfred Baur from Switzerland. Whilst the trade in fertilizers was always the company’s mainstay, it has become one of the major conglomerates importing and distributing in Sri Lanka of agro-chemicals, pharmaceutical specialties, industrial chemicals and textile dyes made by foreign firms. It also owns Baurs Airservices, a General Sales Agent for SWISS WorldCargo, SWISStours and does the Ground Handling Operations in Sri Lanka for Edelweiss Air, a Swiss leisure airline. (a) Give two reasons why Baur & Co. (Pvt.) Ltd. could benefit from a fall in Rupee. (10 points) (b) Give two reasons why Baur & Co. (Pvt.) Ltd. could be hurt from a fall in Rupee. (10 points)

Fall in rupee> foreignes invest in srilanka> tourism increase>tourists spend money> increase in swiss tour flights> increase in country’s tourist revenue and Baur & Co’s (SWISS Tours)revenue

Fall in rupee


1-Imports of agro chemicals/pharma will be expensive

2- Cargo cost (from swiss) would be high too.


Explain how the Sri Lanka crisis will affect the following companies: (a) MEIR Commodities India Pvt. Ltd., an agri commodity trading house exporting sugar, molasses, organics etc. (2 points) (b) Victoria’s Secret, Puma and Levi’s, who have dozens of clothing factories in Sri Lanka. (1.5 points) (c) Clothing factories in neighboring countries like Indonesia, Bangladesh and Vietnam. (1.5 points)

Fall in rupee> Imports from MEIR is expensive> company is lose export money.

Fall in rupee> cheaper for Puma, levi> more products for less money.

Will hurt neighboring countries, more expensive than srilanka.