Sri Lanka’s step towards debt repudiation

Sri Lanka suspended temporarily the repayment of all foreign debts on 12 April 2022, blemishing for the first time their record of external debt service since independence in 1948. The country is saddled with dwindling foreign reserves and $25 billion in foreign debt due for repayment 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 hard default that would see Sri Lanka fully or partially repudiate its debts.

Sri Lanka has declared its inability to perform obligations under the existing external debt contracts in which repayments are due. Creditors are free to capitalise interest payments due to them or opt for payback in Sri Lankan rupees. Credit rating agencies have not yet classified the move as a default even though it qualifies as such under ratings agency and credit default swap contract definitions.

The making of the crisis

Sri Lanka's snowballing economic crisis began surfacing after the coronavirus pandemic as exports, tourism, and remittance inflows contracted sharply. The Russian invasion of Ukraine added fuel to the fire by disrupting the return of tourists, an industry which generates approximately 20% of Sri Lanka's goods and services export income.

Sri Lanka was highly vulnerable to external shocks owing to inadequate external buffers. It lost access to international sovereign bond market at the onset of the pandemic. Ironically, the World Bank elevated Sri Lanka from a lower middle-income country to an upper middle-income country in 2019. This was reversed exactly a year after.

During the early 1990s, the majority of Sri Lanka's foreign debt consisted of concessionary loans mostly from multilateral and bilateral agencies such as the World Bank, the Asian Development Bank, and the Japan International Cooperation Agency. These loan repayments were distributed over 25-40 years with an interest rate of 1% or less. In 2007, Sri Lanka issued its first International Sovereign Bond (ISB) worth $500 million and started raising money using international capital markets. The share of commercial loans increased from 2.5% of Sri Lanka's foreign loans in 2004 to 56% by the end of 2019.

The debt dynamics shifted to a new paradigm. ISBs have a payback period of 5-10 years with an annual interest rate above 6% paid biannually on top of principal payments. The total borrowed amount of an ISB is settled all at once at the bond maturity date rather than being distributed over the years through annual repayments. So, when an ISB matures, foreign debt repayments skyrocket, resulting in a large foreign currency outflow.

The growing mismatch between foreign exchange inflows and outflows dried Sri Lanka's foreign reserves, forcing the government to issue still more ISBs to settle massive debt repayments. The government imposed a wide import ban to conserve dwindling foreign currency reserves. The resulting shortages have stoked public anger, made worse by government mismanagement, years of accumulated borrowing and ill-advised tax cuts. The foreign currency shortage has prevented banks from providing importers with lines of credit, causing long queues for essential items like petrol and milk powder.

While the government oversaw a relatively successful vaccination programme, some arrogant and whimsical decisions caused serious damage. The government borrowed heavily from China since 2005 for infrastructure projects, many of which became white elephants – the so called "blingfrastructure" that are non-revenue generating, non-concessionary, non-transparent and unsolicited. The hastily imposed decision to ban chemical fertiliser eliminated $400 million per year of government fertiliser subsidies. But a crop reduction by about 25% to 30% this harvesting season could cause rice shortage that will likely cost the government $450 million in rice imports per year.

Fiscal profligacy ruled the roost. Sri Lanka appears to have borrowed as much as they could whenever they could. Annual fiscal deficits exceeded 10% of GDP in 2020 and 2021, owing to the pre-pandemic tax cuts, weak revenue performance in the wake of the pandemic, and expenditure measures responding to the pandemic. Public debt increased from 94% of GDP in 2019 to 119% in 2021. Limited availability of external financing resulted in a large amount of central bank direct financing of the budget. The official exchange rate has been effectively pegged to the US dollar since April 2021 despite wider current account deficits and large foreign debt service payments.

Policymakers suffered from the Ostrich syndrome. The debt default has come despite many forewarnings. Leading up to 2021, several rating agencies downgraded Sri Lanka's sovereign credit ratings, including the Standard and Poor, Moody's, and Fitch. These moves indicated concerns about Sri Lanka's ability to fulfil foreign debt repayments. The government dismissed the concerns claiming that the "premature" analysis by the rating agencies was based on "ill-informed" models. As recently as January 2022, the government announced a $1.2 billion economic relief package claiming that the country will not default on its international debt.

The creditors' recourse

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 come in and seize assets, as they might do with a private company in bankruptcy even if the assets are insufficient to cover the totality of the debt. Creditor rights are not as strong in the case of sovereign debts. The legal recourse available to creditors has limited applicability and uncertain effectiveness. It is often impossible to enforce any favourable court judgment.

Sovereign debt markets are still viable because defaults are costly to the borrowing country regardless of the effectiveness of legal recourse. Reputational costs, in the extreme, could result in absolute exclusion from financial markets. Direct sanctions on property and international trade imposed by the creditor country governments and multilateral institutions can add direct costs to hard defaults.

Surely, Sri Lanka values access to international capital markets. They don't want to lose their reputation as reliable debtors. However, maintaining reputation is rarely a debtor's sole concern when the economy is in crisis simply because the immediate pain of any given repayment is more than when the economy is strong. Having incurred too much debt already, Sri Lanka reached a point where the benefits to retaining capital market access by sticking to debt repayment deepens the existential crisis the incumbent government is already mired in.

Imposing a direct cost for a hard default is not necessarily in the creditors' best interests. Many observers of debt crisis believe only direct punishment, not reputation loss, deters hard defaults. Apart from cutting off future lending, creditors can recourse other forms of commercial interference in trade and trade related finance. However, such actions can jeopardise the creditors' recovery of pre-existing debt and gains from trade. The cure may be worse than the disease.

Many creditors have reduced their loan exposure to Sri Lanka. Downgrading by International rating agencies in 2020 effectively blocked the country from accessing foreign capital markets to rollover loans. Sri Lanka leased its strategic Hambantota port to a Chinese company in 2017 after it became unable to service the $1.4 billion Chinese debt used to build it. Sri Lanka had sought debt relief from India and China.  Both instead offered more credit lines to buy commodities from them. Fitch Ratings downgraded Sri Lanka's long-term foreign currency issuer default rating after the government announced the temporary suspension.

There appears to be a broad market consensus that Sri Lanka's default decision was "unavoidable", not strategic. Unavoidable defaults carry limited reputation loss if they are credible. Policymakers can signal credibility by seeking to remediate the factors forcing the default decision. A U-turn from the government's previous position not to resort to another IMF programme should, for now, assure the creditors of Sri Lanka's $51 billion in foreign debts that the suspension of repayments is not a precursor of a hard default.

Can the last resort be a game changer?

The IMF had already highlighted 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 finance desperately needed food, fuel, and medicine imports after months of scarce supplies and just $1.9 billion in reserves at the end of March. The IMF support was a key to steering clear of the balance of payment crises in both 2009 and 2015.

The IMF supported stabilisation programmes tend to be associated with a tough adjustment period. The IMF will likely focus on external debt restructuring, higher taxes, expenditure austerity, flexible exchange rate, targeted subsidies, and cost-plus energy pricing. All of these can make life for the common person difficult if they lead to lower real wages, higher unemployment and reduced social spending.

World Bank assistance can mitigate such unintended consequences. The World Bank typically extends budgetary support to improve competitiveness, inclusion, resilience, and institutions. The World Bank could promote direct cash transfer to the vulnerable, push green energy, and catalyse investments in health, education, and infrastructure. Such assistance would likely be contingent on Sri Lanka entering the IMF programme.

Sri Lanka is in the process of rediscovering the real difference between good economics and politics that works for the politicians when the two are conflicting one another. External support cannot change the game without spontaneous country ownership of reforms that are put in place.