The Sri Lanaka Default | Gist of Rajya Sabha TV / RSTV (now Sansad TV) - UPSC PDF Download

Context

• Sri Lanka declared that it will be defaulting on all of its $51 billion in external debt after weeks of economic upheaval.
• Colombo described the action as a last-ditch effort after running out of foreign currency for imports.
• The island country is experiencing its worst economic downturn since gaining independence, with frequent blackouts and severe food and fuel shortages.

Sri Lankan Crisis: A backgrounder

(a) Fragility of Sri Lankan Economy

• Post-independence from the British in 1948, Sri Lanka’s agriculture was dominated by export-oriented crops such as tea, coffee, rubber and spices.
• A large share of its gross domestic product came from the foreign exchange earned from exporting these crops. That money was used to import essential food items.
• Over the years, the country also began exporting garments, and earning foreign exchange from tourism and remittances (money sent into Sri Lanka from abroad, perhaps by family members).
• Any decline in exports would come as an economic shock, and put foreign exchange reserves under strain.

(b) Series of BoP Crises

• For this reason, Sri Lanka frequently encountered balance of payments crises.
• From 1965 onwards, it obtained 16 loans from the International Monetary Fund (IMF).
• Each of these loans came with conditions including that once Sri Lanka received the loan they had to reduce their budget deficit, maintain a tight monetary policy, cut government subsidies for food for the people of Sri Lanka, and depreciate the currency.
• But usually in periods of economic downturns, good fiscal policy dictates governments should spend more to inject stimulus into the economy. This becomes impossible with the IMF conditions.
• Despite this situation, the IMF loans kept coming, and a led the economy soaked up more and more debt.
• The last IMF loan to Sri Lanka was in 2016. The country received US$1.5 billion for three years from 2016 to 2019.
• The conditions were familiar, and the economy’s health nosedived over this period. Growth, investments, savings and revenues fell, while the debt burden rose.

(c) Terror attack changed the course

• A bad situation turned worse with two economic shocks in 2019.
• There was a series of bomb blasts in churches and luxury hotels in Colombo in April 2019.
• The blasts led to a steep decline in tourist arrivals – with some reports stating up to an 80% drop – and drained foreign exchange reserves.
• Second, the new government under President Gotabaya Rajapaksa irrationally cut taxes.
• Growth demands stability and stability lies on effective leadership which is totally blurred in Sri lanka which is suffering from ongoing financial crisis.

(d) Pandemic

• In March 2020, the COVID-19 pandemic struck.
• In April 2021, the Rajapaksa government made another fatal mistake. To prevent the drain of foreign exchange reserves, all fertiliser imports were completely banned.
• Sri Lanka was declared a 100% organic farming nation.
• This policy, which was withdrawn in November 2021, led to a drastic fall in agricultural production and more imports became necessary.
• A fall in the productivity of tea and rubber due to the ban on fertiliser also led to lower export incomes.

(e) Immediate triggers of the crisis

• Leadership issues: Another instance that proved detrimental for Sri Lankan leadership is government where few members of the cabinets were immediate relatives of the Prime Minister (Rajapaksas).
• Ukraine War: The invasion of Ukraine has further exacerbated the economic calamity of the country as Russia is the second biggest market to Sri Lanka in tea exports and its tourism sector is heavily reliant upon these two nations as most of the tourist arrivals are from Russia and Ukraine.
• All these factors led to the implosion of Sri Lankan economy.

Is China the real culprit behind?

• Many people think that one of the key causes of the problem is Sri Lanka's economic ties to China. This phenomenon is referred to as "debt-trap diplomacy" in the United States.
• To boost the lender's political clout, a creditor country or institution will prolong debt to a borrower nation. If the borrower extends the debt but is unable to pay it back, the creditor will have the last word.

A reality check

Sri Lanka’s economy, in recent months, started experiencing, what economists refer to as a ‘twin crisis’: in form of a combined balance of payment and sovereign debt crisis.

(a) Debts

• The most “burdensome debt” in terms of maturity and rates is typically owed to international sovereign bonds.
• Loans from China accounted for only about 10% of Sri Lanka’s total foreign debt in 2020.
• The largest portion – about 30% – can be attributed to international sovereign bonds.
• Japan actually accounts for a higher proportion of their foreign debt, at 11%.

(b) Losses from Ports

• Defaults over China’s infrastructure-related loans to Sri Lanka, especially the financing of the Hambantota port, are being cited as factors contributing to the crisis.
• But these facts don’t add up. The construction of the Hambantota port was financed by the Chinese Exim Bank.
• The port was running losses, so Sri Lanka leased out the port for 99 years to the Chinese Merchant’s Group, which paid Sri Lanka US$1.12 billion.

Repercussions of the crisis

• Crisis of food: For Sri Lankans, the crisis has made life a never-ending cycle of standing in line for necessities, many of which are rationed.
• Energy sources depleted: Soldiers are stationed at petrol stations to reassure consumers as they wait in long lines in the scorching heat to fill up their tanks. Some have even passed away while waiting.
• Sacking of the public savings: Even middle-class individuals who have savings are dissatisfied, worried that they may run out of necessities like gas or medicine.
• Public outrage: Meanwhile, social media and news flow have been severely restricted in Sri Lanka, and both its stock market and currency have fallen substantially. Police action, possibly violent, seems inevitable as unrest is growing.

What’s next for Sri Lanka?

• In all probability, Sri Lanka will now obtain a 17th IMF loan to tide over the present crisis, which will come with fresh conditions.  
• Sri Lanka is now seeking financial support from the IMF and turning to regional powers that may be able to help.
• Earlier, President Rajapaksa had weighed the pros and cons of working with the IMF and had decided to pursue a bailout from the US.
• Sri Lanka has also requested help from China and India, with New Delhi already issuing a credit line of $1 billion in March.

Way forward

• Fiscal consolidation and discipline: What the Lankan economy would need is a robust path towards revenue based fiscal consolidation.
• Near-term monetary policy tightening: It is needed to ensure that the recent breach of the inflation target band is only temporary.
• Institution building reforms: such as revamping the fiscal rule, would also help ensure the credibility of the strategy, as the IMF report suggests. 
• Flexible exchange rate policy: Other (longer-term) reforms would need to include the creation of a flexible exchange rate policy and a medium-to-long-term debt reduction strategy, while ensuring most government spending in targeted social areas continues for developmental objectives.