Sri Lanka’s step towards debt repudiation
Sri Lanka temporarily suspended repayment of all external debts on April 12, 2022, marring its balance sheet with external debt service for the first time since independence in 1948. The country is struggling with declining foreign exchange reserves and an external debt of $25 billion to be repaid over the next five years.
Nearly $7 billion is due this year. The suspension comes ahead of negotiations for an International Monetary Fund bailout aimed at preventing a default that would see Sri Lanka repudiate all or part of its debts.
Sri Lanka has declared its inability to meet its obligations under existing external debt contracts in which repayments are due. Creditors are free to capitalize the interest owed to them or opt for repayment in Sri Lankan rupees. Credit rating agencies have not yet classified this decision as a default, although it qualifies as such under rating agency and credit default swap definitions.
The making of the crisis
Sri Lanka’s economic snowball crisis began to surface after the coronavirus pandemic as exports, tourism and remittances contracted sharply. The Russian invasion of Ukraine has added fuel to the fire by disrupting the return of tourists, an industry that generates around 20% of Sri Lanka’s goods and services export revenue.
Sri Lanka was highly vulnerable to external shocks due to insufficient external reserves. It lost access to the international sovereign bond market at the start of the pandemic. Ironically, the World Bank elevated Sri Lanka from a lower-middle-income country to an upper-middle-income country in 2019. That reversed exactly one year later.
In the early 1990s, the majority of Sri Lanka’s external debt consisted of concessional loans mainly from multilateral and bilateral agencies such as the World Bank, Asian Development Bank and Japan International Cooperation Agency. These loan repayments were spread over 25 to 40 years with an interest rate of 1% or less. In 2007, Sri Lanka issued its first International Sovereign Bond (ISB) worth $500 million and began raising funds in international capital markets. The share of commercial loans increased from 2.5% of Sri Lanka’s foreign loans in 2004 to 56% at the end of 2019.
Debt dynamics have shifted to a new paradigm. ISBs have a payback period of 5 to 10 years with an annual interest rate above 6% paid semi-annually in addition to principal repayments. The total amount borrowed from an ISB is paid all at once on the bond’s maturity date rather than being spread over the years through annual repayments. Thus, when an ISB matures, repayments of external debt skyrocket, leading to a large outflow of foreign currency.
The growing mismatch between foreign exchange inflows and outflows has dried up Sri Lanka’s foreign exchange reserves, forcing the government to issue even more ISBs to settle massive debt repayments. The government has imposed a broad import ban to conserve dwindling foreign currency reserves. The resulting shortages have fueled public anger, compounded by government mismanagement, years of piled up borrowing and misguided tax cuts. The shortage of foreign currency has prevented banks from providing lines of credit to importers, causing long queues for essential items like gasoline and powdered milk.
While the government oversaw a relatively successful vaccination program, some arrogant and fanciful decisions did serious damage. The government has borrowed heavily from China since 2005 for infrastructure projects, many of which have become white elephants – the so-called “bling infrastructure” that is non-revenue-generating, non-concessional, non-transparent and non- solicited. The hastily imposed decision to ban chemical fertilizers eliminated $400 million a year in government fertilizer subsidies. But a reduction in harvests of around 25-30% this harvest season could lead to a rice shortage that will likely cost the government $450 million in rice imports annually.
Tax debauchery has made the law. Sri Lanka seems to have borrowed as much as it could whenever it could. Annual budget deficits exceeded 10% of GDP in 2020 and 2021, due to pre-pandemic tax cuts, weak revenue performance following the pandemic and spending measures in response to the pandemic . Public debt has fallen from 94% of GDP in 2019 to 119% in 2021. The limited availability of external financing has led to significant direct financing of the budget by the central bank. The official exchange rate has been effectively pegged to the US dollar since April 2021 despite larger current account deficits and large external debt service payments.
Policy makers have suffered from the ostrich syndrome. The payment default occurred despite numerous warnings. Until 2021, several rating agencies have downgraded Sri Lanka’s sovereign credit ratings, including Standard and Poor’s, Moody’s and Fitch. These measures revealed concerns about Sri Lanka’s ability to meet its external debt repayments. The government dismissed concerns saying the rating agencies’ “premature” analysis was based on “ill-informed” models. As recently as January 2022, the government announced a $1.2 billion economic relief package claiming the country would not default on its international debt.
The recourse of creditors
What can foreign creditors really do to a sovereign country that does not repay its debts? The very nature of sovereignty, after all, is precisely that creditors cannot easily seize assets, as they might with a bankrupt private company, even if the assets are insufficient to cover the entire debt. Creditor rights are not as strong in the case of sovereign debt. The legal remedy available to creditors has limited applicability and uncertain effectiveness. It is often impossible to enforce a favorable court decision.
Sovereign debt markets remain viable because defaults are costly to the borrowing country, regardless of the effectiveness of legal remedies. Reputational costs, at the extreme, could lead to absolute exclusion from financial markets. Direct property and international trade sanctions imposed by creditor country governments and multilateral institutions can add direct costs to final defaults.
Certainly, Sri Lanka appreciates access to international capital markets. They don’t want to lose their reputation as reliable debtors. However, maintaining reputation is seldom a debtor’s only concern when the economy is in crisis simply because the immediate pain of a given repayment is greater than when the economy is strong. Having already taken on too much debt, Sri Lanka has reached a point where the benefits of retaining capital market access by sticking to debt repayment are deepening the existential crisis in which the incumbent government is already mired.
Imposing a direct cost for absolute default is not necessarily in the interest of creditors. Many observers of the debt crisis believe that only direct penalties, not loss of reputation, deter default. Besides interrupting future lending, creditors may resort to other forms of commercial interference in trade and trade-related finance. However, such actions may jeopardize the collection by creditors of pre-existing debt and business gains. The remedy may be worse than the disease.
Many creditors have reduced their exposure to loans in Sri Lanka. The downgrade by international rating agencies in 2020 effectively barred the country from accessing the foreign capital markets for revolving loans. Sri Lanka leased its strategic port of Hambantota to a Chinese company in 2017 after it was unable to repay the $1.4 billion Chinese debt used to build it. Sri Lanka had requested debt relief from India and China. Instead, the two offered more lines of credit to buy them basic goods. Fitch Ratings lowered the long-term default rating of Sri Lanka’s foreign currency issuers after the government announced the temporary suspension.
There seems to be a broad consensus in the market that Sri Lanka’s default move was “inevitable”, not strategic. Unavoidable flaws lead to limited reputation loss if they are credible. Policy makers can signal their credibility by seeking to address the factors that force the default decision. A reversal from the government’s previous stance of not resorting to another IMF program should, for now, assure creditors of Sri Lanka’s $51 billion in foreign debt that the suspension of repayments is not the first sign of a payment default.
Can the last resort be a game-changer?
The IMF had already stressed the urgency for Sri Lanka to implement a “credible and coherent strategy to restore macroeconomic stability and debt sustainability”. A bailout will free up foreign currency to fund desperately needed imports of food, fuel and medicine after months of shortages and only $1.9 billion in reserves at the end of March. IMF support was key to averting the balance of payments crises in 2009 and 2015.
IMF-supported stabilization programs tend to be associated with a period of difficult adjustment. The IMF will likely focus on foreign debt restructuring, tax increases, spending austerity, flexible exchange rate, targeted subsidies and cost-plus energy pricing. All of these factors can complicate the lives of ordinary people if they lead to lower real wages, higher unemployment and reduced social spending.
World Bank assistance can mitigate these unintended consequences. The World Bank typically provides budget support to improve competitiveness, inclusion, resilience, and institutions. The World Bank could promote direct cash transfers to vulnerable people, promote green energy and catalyze investments in health, education and infrastructure. Such assistance would likely depend on Sri Lanka joining the IMF program.
Sri Lanka is rediscovering the real difference between good economics and politics that work for politicians when the two clash. External support cannot change the situation without the spontaneous appropriation by the countries of the reforms put in place.