Explained: Why Sri Lanka defaulted on its foreign debt

A few years ago, business on the island nation was booming. Now Sri Lanka is broke. What went wrong?

Experts say Sri Lanka's economic momentum has been curtailed by a series of poor policy decisions.

Sri Lanka, the island nation in the Indian Ocean with a population of nearly 22 million, has plunged into a deep economic crisis. With more than $50 billion (€46 billion) in external debt and a shortage of foreign exchange reserves, the country is currently struggling to pay for essential imports. This has led to sharp increases in the price of essential commodities like rice, fuel, and milk. A fuel shortage recently left much of the country suffering through a 13-hour power cut.

Sri Lanka's foreign debt obligations for this year exceed $7 billion. But the country's forex reserves as of March 2022 is just $1.6 billion. On April 12, the country announced a default on all its foreign debt. Now Sri Lanka is hoping for an IMF bailout to save it from the worsening crisis. A few years ago, Sri Lanka seemed to be on the right track. Tourism was booming, with mega-infrastructure projects were making headlines worldwide. Today the country is insolvent and prices are skyrocketing.

A series of questionable decisions

A financial crisis had been brewing for more than a decade in Sri Lanka, where International Sovereign Bonds (ISB) — or market borrowing — constitute a major portion of the country's foreign debt. "Since graduating into a lower middle-income country in the early 2000's, successive Sri Lankan governments have been increasingly borrowing from private international capital markets through the issuance of sovereign bonds, seriously contributing to the precarity of the balance-of-payments of the country," said Dr. Muttukrishna Sarvananthan, development economist and principal researcher at the Point Pedro Institute of Development in Sri Lanka. "This capital-market borrowing is unconditional, with relatively high interest rates and much shorter durations of repayment."

ISBs account for nearly half of the country's total outstanding external debt. A sharp decline in the market prices of these bonds followed Sri Lanka's announcement on April 12 of a pre-emptive default on its foreign debt. "The sovereign default was a necessary and inevitable evil to convince the IMF about the political stability amidst widespread and continuous public protests all over the island," Sarvananthan said.

Tax cuts gone wrong

Sri Lanka's government recently offered unsolicited value-added and income tax cuts to taxpayers. This led to an extreme loss of government revenue. As a consequence, the Sri Lankan Rupee started to slip. Without the necessary cash reserves in place, in early March Sri Lanka had to allow the rupee to free fall. In such a case, interest rates should also be increased, said Sarvananthan. This serves to stop the huge rise in overall inflation, which reached nearly 20 per cent in April, and 30 per cent for food.

The Central Bank of Sri Lanka did eventually hike interest rates by seven per cent. "However, severe damage has been already inflicted to the economy and it will take at least five years to recover from this mess," said Sarvananthan. A reduction in indirect consumption taxes such as the VAT could have been beneficial for ordinary people, he adds, but the rich and crony capitalists wanted reductions in corporate and personal income taxes. The COVID-19 crisis and the war in Ukraine are also pushing up global commodity prices. "However, primarily the economic crisis is home-made and long-running and therefore Sri Lanka should own it instead of passing the buck," said Sarvananthan.

The government made a slew of policy decisions which resulted in macroeconomic imbalances on all fronts and this exacerbated the economic crisis, says Dr. W.A Wijewardena, former deputy governor of the Central Bank of Sri Lanka. These mistakes range from the tax cuts to poorly thought out borrowing to selling forex reserves to prop up the exchange rate with the dollar to an overly ambitious shift to organic farming which caused a significant drop in agricultural output.

Still a strategic partner

China holds a significant portion of Sri Lanka's total foreign debt, nearly 10 per cent, with more held by Japan, the World Bank and the Asian Development Bank. India holds nearly three per cent. Regional powers India and China have been competing with each other to gain a foothold in the strategic island nation. Sri Lanka is a critical link for China in their Belt and Road global infrastructure projects. For India, Sri Lanka is a geo-politically significant country.

"Sri Lanka had been a neutral nation between these two regional powers without taking a side," said Wijewardena. "In the past, it had helped to receive economic benefits from both countries without offending either one. However, in the recent past, there has been competition between these two powers to help Sri Lanka and gain a foothold in the country over the other." These geopolitically driven motives are the main reason why the administration of current Sri Lankan president Gotabaya Rajapaksa has had the false idea that it could do without IMF's help, he added.

A band-aid for a bullet hole

With Sri Lanka down on its luck, both countries continue to play nice. In January, India agreed to defer an Asian Clearing Union payment of $515 million and extended an emergency trade credit of $500 million. In March, it extended another trade credit of $1 billion through the State Bank of India. Sources say that India is open to an additional $2 billion in aid for Sri Lanka.

"Sri Lanka has requested China for debt restructuring but China is yet to grant this request," said Wijewardena. "Initially it had shown willingness to give another loan of $2.5 billion to enable Sri Lanka to refinance the maturing loans but it was withdrawn later. Instead China provided relief to Sri Lanka by providing a Yuan swap of 10 billion Yuan."

This swap amounts to nearly $1.5 billion, giving a major boost Sri Lanka's forex reserves. But it's still not enough to mitigate the crisis. Sri Lanka's current strategy is to get relief through common debt restructuring with the support of IMF. "It will provide a breathing space to Sri Lanka but not a permanent solution," said Wijewardena. "A permanent solution lies in Sri Lanka gaining the capacity to honor its debt obligations by improving forex inflows through the development of the export of goods and services and by offering facilities for foreign direct investment to take place."