Sri Lanka has announced a pre-emptive default on all its foreign debt totaling $51 billion

Sri Lanka has just defaulted on its foreign debts totaling $51 billion for the first time since its independence. It has led to a situation called Sovereign Default. The immediate debt default was to ensure fair and equitable treatment of all creditors ahead of IMF assisted recovery programme for the nation.

Sovereign Default

• It refers to the failure of the government of a sovereign entity to pay back principal and interest payments when they are due.
• It earns a lower credit rating, making it less appealing to investors, and making it difficult for the government to obtain additional funds from the international market.
  

Sri Lanka has sought help from International Monetary Fund (IMF) to prevent further deterioration of the country’s financial position. A comprehensive debt restructuring programme is now “inescapable.”

Sri Lanka is not the first country to default on its external loans. In 2020 Lebanon, Argentina, Belize, Zambia, and Suriname, defaulted. In 2015, Greece became the first developed country to default on its IMF loan.

Background

Sri Lanka is grappling with its worst economic crisis since independence from the British in 1948. Today, the country’s people face crippling 12-hour power cuts and an extreme scarcity of food, fuel, and medicines. Sri Lanka relies on the import of essential items, such as petrol, food products, and medicines. Most governments will keep foreign currencies on hand to trade for these items, but a shortage of foreign exchange is being blamed for the sky-high prices in Sri Lanka.

Post-independence export-oriented products such as tea, coffee, rubber, and spices dominated Sri Lanka’s agriculture. A large share of its GDP came from the foreign exchange earned from exporting these crops. They used that money to import necessary food products. Over time, the country also began exporting garments. The nation also started earning foreign exchange from tourism and remittances (money sent to Sri Lanka from abroad, perhaps by family members). So any decrease in exports would come as an economic shock, putting foreign exchange reserves under strain.

For this reason, Sri Lanka regularly had balance of payments crises. It received 16 IMF loans from 1965 until the present. Each of these loans came with conditions like maintaining a tight monetary policy, cutting government subsidies for food, depreciating the currency, etc. But usually, in periods of economic downturns, sound fiscal policy dictates that governments should spend more to inject stimulus into the economy. Now, this became impossible with these IMF conditionalities. 

Despite this, IMF loans continued to flow, and a struggling economy absorbed more and more debt. Sri Lanka received its most recent IMF loan in 2016. From 2016 to 2019, the nation got US$1.5 billion over three years. The conditionalities were familiar, and the economy’s health deteriorated throughout this time.

Growth, investments, savings, and income declined while the debt increased. In 2019, two economic shocks further worsened an already dismal position. First, there were bomb blasts in churches and luxury hotels in Colombo in April 2019. The explosions caused a sharp reduction in tourist visits, with some sources claiming an 80 percent drop and depleted foreign exchange reserves. Second, the new government under President Rajapaksa irrationally cut taxes. The country lost 2% of the GDP in revenues because of these tax cuts. 

The Covid-19 outbreak in 2020 made the bad situation worse. Tea, rubber, spices, and textile exports all suffered. Profits from tourism continued to decline.

In April 2021, the government made another fatal miscalculation. To avoid depleting foreign exchange reserves, all fertilizer imports were prohibited. Sri Lanka was declared a 100% organic farming country. This policy, which was withdrawn in November 2021, resulted in a sharp drop in agricultural output, and more imports became necessary. But foreign exchange reserves remained depleted. Because of the fertilizer prohibition, tea and rubber production also fell, resulting in fewer export earnings. Due to lower export incomes, there was less money available to import food, resulting in food shortages. Because there was less food and other items to buy but no decrease in demand, the prices for these items rose. 

Inflation increased in February 2022. What happens next? In all likelihood, Sri Lanka will now seek another IMF loan to help it get through the current crisis, which would come with new conditions.