Sri Lanka – Debt trap, economic crisis and bankruptcy, explained

Sri Lanka

Sri Lanka – Debt Trap- Prologue

On a sunny Sunday, I was enjoying my cup of coffee along with my newspaper. Suddenly, a loud voice came from the kitchen, “There’s no milk!” You might have been there, and you know exactly what is to be done – run to the nearest dairy and get the milk as soon as possible. Else you will have to deal with a boiling head in the kitchen, instead of boiling milk, and anybody would prefer the latter. So, I grabbed my keys and immediately rushed to the nearest dairy – picked up milk and came to the counter for billing. While the shopkeeper printed the bill, I realised I forgot my wallet. Now that’s an awkward situation – the shopkeeper is suspicious about you, and meanwhile, your head is thinking about the kind of mess you are in if you don’t get milk back home. This is ‘Momentary bankruptcy’ – a situation where you need something urgently, but you don’t have the money to buy it. We encounter such a situation many times and it is funny when we look back. When an individual goes bankrupt for real, the situation is quite similar except that it is way more grim, troubled and serious. You have to fight for and find ways to fulfil your necessities while your pockets can’t afford it, and meanwhile, lenders out there are hunting for you. It’s a terrible situation no one wants to be in, and wouldn’t wish for, even for enemies. Can you imagine the situation if an entire country goes bankrupt?

Debt Trap Background

Sri Lanka is in a deep financial crisis and as a result, in a humanitarian crisis as well. Inflation has reached record highs, food prices have zoomed to record highs, and pandemic-induced disruptions are driving its coffers dry. The island nation is feared to go bankrupt this year. The country has a debt repayment of estimated USD 7.3 billion due in domestic and foreign loans in the next 12 months which includes USD 500 million international sovereign bonds as well. As of November 2021, the available forex reserves with Sri Lanka were just a paltry USD 1.6 billion, against the USD 7.3 billion due to be paid, apart from the necessary imports of the country.

The COVID-19 pandemic has led the economy which is highly dependent on tourism into turmoil. High government spending and tax cuts have eroded state revenues. Meanwhile, the country also owes a big loan to China. The Government has been printing money to square off domestic loans and foreign bonds, however, it comes at a price – a price that is to be paid by the citizens vide inflation which has increased to 12.1% in December, from 9.9% a month before. Meanwhile, the food price inflation soared to 22.1% from 17.5% a month before. According to estimated by the World Bank approximately 5,00,000 people have fallen below the poverty line since the beginning of the pandemic. This is equivalent to five years’ progress in fighting poverty. The country has lost vital foreign revenue from tourism which contributes more than 10% to the GDP. International rating agencies have already downgraded Sri Lanka’s ratings as there is high suspicion on the ability of the country to service its debt of USD 26 billion.

Sri Lanka’s President Rajapaksa expressed his hope of reviving the economy in his New Year Message, however, did not announce any measures to address the crippling foreign exchange crisis, not surprising, as there isn’t much to say. The recent turn of events has led the country to a big mess, however, the seeds were sown way before the crisis emerged!

Declaration of economic emergency

Sri Lanka is a net importer of food and other commodities. With the surge in coronavirus cases and deaths tourism sector suffered and the economy shrank by a record 3.6%. The cost of basic foodstuffs such as sugar, onions and potatoes surged. There were long queues outside shops due to shortages of milk powder, kerosene and cooking gas. Month-on-month inflation had increased 6% in August, mainly due to high food prices. The Sri Lankan rupee had fallen by 7.5% against the US dollar. This increase in the foreign exchange rate had led to rising prices of many essential items. When the situation seemed to be going out of control, the government was forced to declare a ‘National Economic Emergency’ on August 31, 2021.

Emergency measures came into effect immediately. The former army general has been appointed by the government as the commissioner of essential services, as the government now has the power to seize stocks held by traders and retailers, after the declaration of emergency. Authorities took control of the supply of basic food items, including rice and sugar, and set prices to control rising inflation. These items were provided at government-guaranteed prices or based on the customs value of imported goods to prevent market irregularities. The presidential aide warned introducing fuel rationing if the consumption was not reduced.

Why does it seem Sri Lanka is at the brink of bankruptcy & Debt Trap?

Sri Lanka paid a USD 1 billion bond in July 2021, however, the alarming state of its finances suggests that it is a step away from its first sovereign default, as all the requisite checkboxes are ticked:

  1. Bonds at nearly half their face value
  2. Debt-to-GDP levels are above 100%
  3. Over 80% of government revenues are being spent on interest payments alone
  4. Reserves can barely cover a few months of spending
  5. Chances of the economy soldiering by itself look slim, especially with the tourism industry on its knees

Colombo’s dollar-denominated government bonds are currently the most distressed in the emerging markets. The country was the first in the region to raise interest rates after the pandemic, to shore up its currency and ease the inflationary pressure of imports. However, it won’t be enough to buy dollars for the food and medicines. Yes, the Government has paid off USD 1 billion July 2021 bonds, and USD 500 million January 2022 bonds, however, there’s a heftier USD 1 billion in July 2022 and another USD 1 billion before the end of 2023. The fiscal deficit is estimated to be around 11% and therefore, the country can easily run out of rope. If things do not change fast and drastically, the country will be defaulting in its sovereign bonds, within the next 12, 18 or 24 months.

How did COVID-19 affect Sri Lanka?

The country with a 21 million population had to face food shortages as it had to battle with fierce coronavirus waves that claimed more than 200 lives a day. COVID-19 deaths in Sri Lanka rapidly increased that it had to declare a nationwide lockdown on August 21, bowing to intense pressure from medical experts as coronavirus infections overwhelmed hospitals. President Gotabaya Rajapaksa had resisted calls for a lockdown for weeks, however, had to agree to a 10-day closure after hospitals could no longer cope with the inflow of COVID-19 patients. Meanwhile, his health minister publicly endorsed sorcery and magic potions to battle with the coronavirus as infections and deaths hit record highs.

As a result of several lockdowns and restricted activities, the state of the country’s economy drastically deteriorated. The tourism sector generated a huge quantum of revenue for the island nation, saw a steep fall and got steeper during the 2021 wave of coronavirus.

Who helped Sri Lanka and how?

In August 2021, Sri Lanka received its share of the global Special Drawing Rights (SDR) allocation from the International Monetary Fund (IMF). The SDR is an international reserve maintained by the IMF to supplement the official reserves of its members. It is not a currency, but a potential claim on the freely usable currencies of IMF members, to provide liquidity at times of need. Sri Lanka also entered into a bilateral currency swap arrangement with the Bangladesh Bank. Thus, Sri Lanka received USD 787 million SDR from IMF and USD 150 million under the Currency Swap Arrangement with the Bangladesh Bank. The Government also expects to receive the syndicated loan from China Development Bank, a total of USD 1.3 billion from China. However, this didn’t seem enough.

When the country was again on brink of defaulting in January 2022, it was undecided whether to use its forex reserves for buying the essential items or to pay off the debt due. This is when the Indian Government came forward and extended assistance by advancing USD 900 million loans by way of currency swap allowing the Government to pay off the USD 500 million debt repayment due. However, this did not solve the country’s food and fuel crisis. Thus, the Indian Government also extended USD 1.5 billion for two lines of credit to help Sri Lanka purchase food and fuel. A line of credit is a flexible loan drawing power that allows the borrower to borrow requisite funds up to the limit set at any time. When a country allows such facility to another country, it allows the borrowing country to buy goods and services to the tune of the facility offered, instead of money. This helps the lender to increase its export of goods and services, while the borrower receives the much-needed relief by way of necessities against loans. The billion-dollar loan credit facility given by India to Sri Lanka is to be used to avert a food crisis allowing for the import of items and medicines. The interest rate on the line of credit is a nominal 2%.

India has provided temporary relief. However, for complete resolution of the situation, Sri Lanka has sought the help of the International Monetary Fund (IMF) who has agreed to provide options to the country. The IMF oversees the stability of the global monetary system and helps the economy sustain through difficult times, as against the World Bank whose goal is to reduce poverty by offering assistance to middle-income and low-income countries. This is the reason why World Bank provides ultra long term loans to various countries while bailout packages are provided by IMF. The IMF also continuously monitors the economic activity of its member nations, offers policymaking tools and analysis, and short term loans when required. Notably, both organizations were established as part of the same ‘Bretton Woods Agreement’ in 1945.

What led Sri Lanka into an economic crisis?

Unlike individuals, a country is made of diverse constituents, and therefore, the good times and bad times are both a result of multiple factors converging at the same point.

Ambitious targets

In 2019, Sri Lanka faced several challenges including a slowing economy, a rising debt, and compromised national security resulting from a terrorist attack in April 2019. The new President Gotabaya Rajapaksa made ambitious promises. Parting away with the market-friendly economic policies from the past, the government shifted towards an inward-oriented approach with the government taking up a significant role in economic activities. Ambitious five-year targets set for the country’s economic transformation including economic growth of 6.5% or higher, per capita income of USD 6,500 or higher, and unemployment of less than 4% failed were too ambitious to be true and when the COVID-19 pandemic hit the world, all chips were down.

Heavy reliance on the tourism industry

The country heavily relies on its tourism industry. When the pandemic forced the country to shut its door, the GDP, employment and economic activities took a hard hit. This has been the same for countries and states who rely heavily on one sector, something like tourism which cannot survive in a pandemic and cannot be controlled or scaled by simple policymaking.

No self-sufficiency in food and other necessities

Ever since India achieved self-sufficiency in necessities through the Green revolution and the white revolution, India has never had to look back for necessities. ‘One needs to cook their own food’ – if a country is reliant on imports for its necessities, it is obvious to fail in times of wars, pandemics and other similar crises.

Heavy unfavourable debt trap dynamics

Sri Lanka’s debt dynamics were unfavourable amid compound economic uncertainties. In December 2020, the government’s debt to GDP had increased to 101% while external debt reached USD 49.2 billion. Debts do not arise overnight. Sri Lanka’s high debt levels reflect its persistent fiscal and current account deficits, depreciation in currency and the costs of a 30-year civil war with the Tamil Tigers that ended in 2009. Had the country kept its debt in check, it wouldn’t have accumulated such huge debt levels, as it reached post-pandemic, as the pandemic further increased its debt.

The Chinese Debt Trap

Apart from the fallacies of its own, there’s another major political reason why Sri Lanka paved its way towards the debt trap – its foreign policy.

Sri Lanka’s relations with the powerful United States have always been tense since the end of the civil conflict in May 2009. The United States, along with other Western countries, argued that human rights were violated by the Sri Lankan troops during the final stage of the fighting. However, Mahinda Rajapaksa’s government accused the West of overly intervening and intrusive policies. With the election of Gotabaya Rajapaksa, a former US citizen, it was expected that a less fraught, more business-like working relationship would be established with the United States. However, lacklustre and disinterested response to a Millennium Challenge Corporation (MCC) Compact grant worth USD 480 million to reduce bottlenecks in transport and commercial land administration, led to the MCC Board withdrawing the grant in December 2020. The United States support for a new human rights resolution against Sri Lanka and occasional criticism of policies have intensified the bilateral tensions.

When it comes to India, the government showed positive signs in 2019 when it said it would prioritize India’s security sensitivities and hinted new era of relations with India. However, the country moved away from a neutral foreign policy stance and difficulties arose due to different approaches of the two countries. While India insisted on the full implementation of the 13th Amendment of Sri Lanka’s Constitution to resolve the long-standing ethnic issues, the Sri Lankan government didn’t follow the same. Sri Lanka’s breaking off the agreement with India and Japan to develop the ‘East Container Terminal’ in the Colombo Port due to mounting domestic protest, further deteriorated the bilateral relations.

Growing tension with India and the West, Sri Lanka was pushed to embrace China. More importantly, China was interested in embracing Sri Lanka, as the country is located strategically for China to gain dominance in the Indian Ocean region. It is an open secret that China has always been looking to increase its presence in the Indian Ocean Region which India has traditionally considered its backyard and natural sphere of influence.

Links between Sri Lanka and China, in particular, the economic relations have grown significantly over the past decade. And there’s more to the story than it appears. China’s ambitious Belt and Road Initiative (BRI) to connect China to South Asia and Europe through belt and road respectively, to re-open the so-called silk route, has made China deeply interested in Sri Lanka, as the same is a key junction on the route. China has therefore invested large sums of money to develop mega ports and other infrastructures and trade routes in Sri Lanka. Sri Lanka, in turn, receives key infrastructure, capital and skills that can put it well ahead in connectivity and trade facilitation. However, as much win-win it may appear, it has led Sri Lanka into a debt trap as the cost of infrastructure has been a huge debt for the country and there hasn’t been much recovery against the same. When the country couldn’t repay the debt on time, China used the situation to its advantage. When the country’s forex reserves were a concern, China infused a billion dollars in foreign direct investment in exchange for strategic Hambantota Port. In brief, Sri Lanka was forced to cough up the port of Hambantota to China after it could not repay its earlier loans.

The bottom line for Sri Lanka Debt Trap

The Sri Lanka government continues to see a friend in China who brings much needed foreign exchange to Sri Lanka. Since the pandemic struck in 2020, China has provided crucial and timely economic and health aid support including USD 2 billion in loans and currency swaps. Emergency anti-epidemic medical supplies, a million Sinopharm vaccines as donations and about six million as procurements are some other friendly gestures, according to the Sri Lankan Government. However, the government has failed to recognise how it has been led into a debt trap. While Sri Lanka is in the middle of one trap, this would be a key lesson to quote to the other South Asian nations who are probably being tamed similarly. Meanwhile, for Sri Lanka, it is time to unwind the past and learn from the same, as a sovereign default which seems just around the corner, will deteriorate its progress and economic state for years, besides bringing global disrepute.

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