Decoding Sri Lanka’s Financial Crisis

The Pearl of the Indian Ocean has lately run its economy into peril. Over the better part of the last two years, Sri Lanka has been facing a deep economic crisis which is now threatening to lead the country into bankruptcy.

This is what’s happening: record-high inflation, unprecedented rise in poverty, mounting debt, draining foreign reserves and food shortages, ALL of which have unfortunately led the country down the path of a possible sovereign default.

Consequently, Sri Lanka declared an economic emergency in September 2021.

The situation is now so dire that Colombo has asked China, one of its biggest lenders, to restructure its debt payments. The country has also sought $1bn in loans from India to import essential commodities.

How did things get so bad for the island nation? And how could this affect India?

State of the Lankan Union

At the core of the crisis lies the usual suspect — the pandemic. Sri Lanka’s economy contracted by 3.6% in 2020, its worst in 73 years. Widespread loss of jobs (>200,000) and foreign revenue from tourism, a sector which contributes more than 10% to the Sri Lankan economy, exacerbated the deficiencies of an economy which was already underperforming. The World Bank estimated that 500,000 Sri Lankans have fallen below the poverty line since the beginning of the pandemic.

Forex reserves have plunged from $7.5bn in 2019 to $1.6bn in November 2021 (which is only enough to pay for a month’s worth of imports). For a country which relies heavily on imports to meet even its basic food supplies, this has meant rising food prices in tandem with a depreciating currency.

No Debt Riddance

However, the most imminent and existential threat for the economy is its massive debt book. The country needs to repay an estimated $7.3bn in domestic and foreign loans over the next 12 months. This also includes a $500m international sovereign bond which matures on January 18th.

Unlike popular commentary, Sri Lanka is not strictly engulfed in a Chinese “debt trap”. External debt owed to China amounts to a little over 10% of its total borrowings. The chunk of Sri Lanka’s debts is owed to international capital markets (47%) followed by multilateral development banks (22%) and Japan (10%). However, China does have a significant bearing on the Sri Lankan economy due to its overarching investments in the country and Sri Lanka’s heavy import reliance on China.

Moreover, China is the largest bilateral creditor to the country. Unlike other debts, the Chinese ones have been ubiquitous, long-standing and embedded in the Sri Lankan economy. In addition to soft loans, Chinese debts have also, in a way, institutionalised themselves in the form of debt-for-equity swaps through long-term infrastructural leases (like the Hambantota and Colombo ports).

On top of it, the Sri Lankan government has relied on temporary relief measures to tackle this crisis by seeking additional credit via currency swaps from China, among other nations, thus adding to its Chinese debt load.

So, the current crisis seems to have been borne out of 1) a spectacularly bungled debt regime which was worsened by 2) the pandemic. However, it’s not quite two dimensional but rather a mix of other factors which had started brewing even before the pandemic.

Economic Miscalculations

The new President Gotabaya Rajapaksa decided to take the economy for a spin soon after coming to power in 2019. Breaking with the outwardly-oriented market-friendly economic policies of the past, he shifted to an inward-oriented approach.

This is what it looked like. Ambitious five-year economic targets were set, the PAYE (Pay As You Earn) taxes along with corporate and value added services taxes were greatly reduced, one lakh new employment opportunities were announced in the public sector and barriers were placed in trading on a broad range of items.

Reduction in revenues through reduced taxes and rise in government spending was definitely a bad gamble while grappling with a pandemic months later, especially so given the fact that Sri Lanka is a twin-deficit economy. Trade restrictions also slashed exports which could have been used as a leverage against the depreciating currency.

But the most glaring gamble of the Sri Lankan government was through the announcement to ban fertilizers in farming in an effort to make the country the “first in the world with a 100% organic agricultural sector”. Although a push towards organic farming is cool, it also drastically cuts down food production thereby leading to a food crisis and shortage of important crops like tea, one of the country’s biggest exports.

FYI: Sri Lanka plans to settle oil dues with Iran by paying it off in tea — $5m worth of tea each month to clear a $252m debt!

Tackling the Crisis

Considering that the bulk of Sri Lanka’s external debt is by way of market borrowings, experts insist on negotiating a program with the International Monetary Fund (IMF) to restructure its debt and mobilise bridge finance for the interim.

But here’s the thing about IMF bailouts — it comes with riders which could pummel a country’s financial autonomy. Plus, they demand austerity and transparency on how the money is spent. Unfortunately, transparency has never been a strong suit of the Rajapaksa regime. Add to the fact that Sri Lanka has already received $787m from the IMF last year through special drawing rights (SDR) allocations so any further monetary dependence on the organisation may not be ideal.

What About India?

In terms of extending a helping hand, India already has, through debt freeze, currency swaps and extending emergency credit lines. But over the years, New Delhi has grown particularly wary of Sri Lanka’s political and economic alliances with China.

This has become increasingly true with India essentially cleaning up “Chinese mistakes” in the island nation like the fertilizer bailout of last year. Bilateral relations have also deteriorated with Sri Lanka pulling out of a tripartite agreement with India and Japan for the development of the Colombo Port.

But with huge FDI interests of India in the nation ($1.7bn during 2005–2019) and large dependence on the Colombo Port which handles 60% of India’s trans-shipment cargo, India’s demand-driven interest in the Sri Lankan economy is likely to continue. After almost a decade of diplomatic schmoozing with China which has clearly led to precarious consequences, Sri Lanka’s pivot towards an “India First” foreign and security policy in 2020 shows great promise.

With the clock ticking on Sri Lanka’s debt payments, it remains to be seen whether it begrudgingly opts for a bailout or waits out on more Chinese assistance (and hence piles on more Chinese debt) to tide over this financial storm.

(Originally published January 16th 2022 in transfin.in)