Sri Lanka's default on its debt in 2022 caused alarm among investors and development economists alike, and raised questions about the factors underlying the country's economic downfall. In this blog, we examine the reasons for Sri Lanka's default and the challenges that lie ahead.
Why did Sri Lanka default on its debt?
For the first time ever, Sri Lanka missed a payment on bonds worth $78 million in mid May 2022. Sri Lanka's economy grew rapidly before reaching its peak in 2018, with GDP growth averaging around 5-6 percent annually. However, in 2019, the country's economy began to decline, with a GDP decline for the first time since 2001 (figures 1 and 2). The decline in economic growth was already a sign that the country's economy faced serious challenges, even before the outbreak of the COVID-19 pandemic. This suggests that while the pandemic may have exacerbated the country's economic struggles, it cannot be the sole reason that Sri Lanka defaulted.
Sri Lanka's political and policymaking environment played a role in its economic situation. In particular, there were significant shortcomings in the design and implementation of economic policies, which had negative implications for the country's financial stability. The Sri Lankan government pursued a number of misguided policies and investment that undermined the country's economic stability and contributed to its high levels of debt.
For instance, the tax cut of 2019 resulted in a significant decline in revenue, which fell below 8 percent of GDP (figure 3). As a result, the fiscal deficit widened, leading credit rating agencies to downgrade Sri Lanka's creditworthiness in April 2020, putting it on the brink of default. Rather than pursuing restructuring and seek IMF financial support, the government opted to pay its debtors using fiscal reserves, and borrowed from the central bank to cover the fiscal deficit.
The government did not underperform only with regard to revenue but also with regard to expenditure. An illustrative instance is the government's spending on infrastructure, such as the Hambantota Port and the Mattala Rajpaksa International Airport. While investment in infrastructure can lead to efficiency gains and stimulate economic growth, there comes a point of diminishing marginal returns where the economy may not be able to fully absorb the additional infrastructure investment. This seems to be the case with Sri Lanka, where both the port and airport projects mentioned costed around $1.7 billion, and did not succeed or meet the expectations (for example, in 2019, before COVID, Mattala airport had 1,403 passengers, whereas Colombo International airport had over 9 million passengers the same year) And in addition, these infrastructure projects were largely funded by external borrowing, contributing to Sri Lanka's significant debt burden.
Sri Lanka's debt burden was further exacerbated by its large and persistent trade deficit and negative current account balances (figure 4). Despite various efforts to boost exports, the country has struggled to reduce its dependence on imports—after 2010, Sri Lanka’s trade balance has worsened, with a deficit exceeding $4 billion annually and peaking at more than $9 billion in 2011 and 2017. This persistent trade imbalance has placed undue pressure on Sri Lanka's foreign exchange reserves, further limiting its ability to service its debt obligations.
The COVID-19 pandemic accelerated the process leading to Sri Lanka's default. Two of Sri Lanka’s key foreign exchange inflows of external money, remittances and tourism, slowed significantly during the pandemic, which meant that the country had to rely more heavily on its reserves to pay for essentials (figure 5). As a result, Sri Lanka's government was unable to meet its debt obligations and was forced to default on its loans.
The challenges ahead
Sri Lanka's recent default on its debt obligations has brought to the fore the challenges that the country will face in the coming years. One of the most pressing challenges is the complex nature of modern-day debt crises, particularly with the rise of new lenders such as China (figure 6). With multiple creditors involved, debt restructuring can become a complicated process, requiring the coordination of various parties to reach a resolution. Furthermore, the emergence of non-traditional lenders has made it harder for traditional institutions, such as the International Monetary Fund, to provide a unified approach to debt restructuring. The presence of emerging donors such as China has added a layer of complexity to the resolution of debt crises, making it harder to find consensus between all involved parties—China’s unique opaque lending practices, its nonparticipation in the Paris Club, and its complicated diplomatic relations with other creditors are examples of this added layer of complexity. Experts working closely with this restructuring, like Shanta Devarajan, acknowledge this issues, and have called for finding ways to remove geopolitical considerations from debt restructuring processes.
Another challenge that Sri Lanka faces in its efforts to restructure its debt is the need for a clear and credible path for future economic growth. As a precondition for debt restructuring, creditors are likely to demand a clear path forward for Sri Lanka's economy, including commitments to structural reforms, fiscal prudence, and other measures that will put the country on a sustainable growth path. Without such commitments, it will be difficult for Sri Lanka to secure debt restructuring, and the country will continue to face the burden of its debt obligations.
For Sri Lanka to overcome these challenges, it is imperative that the government and political elite develop a credible path forward. This will require a commitment to fiscal discipline, the implementation of structural reforms, and a focus on investment in key sectors that can drive economic growth. In addition, Sri Lanka will need to work closely with its creditors and the international financial community to develop a clear and viable plan for debt restructuring. Looking ahead, the road to debt restructuring for Sri Lanka will undoubtedly be challenging, yet there are recent positive developments to be noted. The IMF is currently evaluating the possibility of granting a bailout to Sri Lanka, even in the absence of formal assurance of debt-restructuring support from China. Additionally, the Global Sovereign Debt Roundtable that took place on the 22nd of February not too far from the Island in Bengaluru, has set the stage for the global community to address the structural challenges of debt relief among official creditors, not just for Sri Lanka but for other countries seeking debt restructuring as well.
CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.
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