Sri Lanka: Sovereign Debt management and Sustainability Crisis

Sri Lanka is currently grappling with a severe foreign exchange crisis and facing a daunting 2022 to meet maturity obligations of International Sovereign Bonds (ISBx). After the US based Fitch’s Ratings downgraded Sri Lanka’s Long-Term Foreign Currency Issuer Default Rating (IDR) to ‘CC’ from ‘CCC’ in December 2021 indicating very high levels of credit risk, concerns have been raised among international lenders. Fitch had earlier downgraded credit rating from ‘B’ to ‘CCC’ in November 2020.

According to Fitch, apart from USD 6.9 billion debt service payments including principal and interest in 2022, Sri Lanka has estimated huge cumulative debt service burden of USD 26 billion during the period 2022-2026.

Foreign exchange reserves have also declined alarmingly by more than half to about USD 1.6 billion at the end of November 2021 from USD 4 billion at the end of 2020 – equivalent to less than one month cover for the country’s imports.

It is surprising to note the present state of the economy considering Sri Lanka’s GDP per capita of USD 3,851 (2019) before the Covid pandemic. The current inflation rate is not so alarming as the case with worst performing countries of the world.

 It all began with Sri Lanka’s graduation from low-income to lower-middle-income status in 2009, which led to a drop in bilateral and multilateral concessional loans.  In the absence of domestic financing, the government began issuing ISBs.  Initially, the bonds were very attractive with subscriptions amounting to 3.2 times of the offer price in 2007. 

From 2015 to 2018, the country issued around USD 8 billion worth of ISBs, amounting to nearly 12% of GDP.  By 2019, 47% of the Sri Lankan debt was owed to ISB holders. ISBs were issued at higher rates than prevailing market rates. The government often borrowed huge sums for long-term investment at the cost of short-term cash flow, for example, Mahaweli Program of 30 years.

China’s debt of over USD 8 billion in projects including Hambantota Port and other infrastructure projects incurred huge losses, instead of generating revenue as these projects were based on political considerations rather than on commercial viability. This also made Sri Lanka vulnerable to Chinese influence. The BRI extended commercial loans for infrastructure projects without strict conditionality, normally imposed by multilateral development banks.

 Analyzing Sri Lanka’s debt pattern, a recent report (Oct 2021) by the United Nations Conference on Trade and Development (UNCTAD), stated that the country has suffered from lack of long-term finance for manufacturing and infrastructure.  Combined with a liberal trade regime, this led to a balance of payment crisis, currency devaluation and dependence on foreign loans.  Sovereign bonds repayments cannot be easily negotiated or restructured, which is causing uneasiness among the policy makers.

Most of the debt was utilized for trade & commerce, instead of creating strong manufacturing base for promoting exports. Even majority of the bank lending, ranging between 48% – 81% of the eight largest Sri Lankan banks in 2020, went for consumption, trade, services, etc.  Sri Lanka has become a  import-dependent, consumption –driven economy that is financed by overseas debt.

The economy’s sustainability was further dented by the  April 2019 Easter Terror Attack and by Covid-19 pandemic, adversely impacting tourist arrivals.  In the aftermath of Easter Attack, Sri Lanka saw a 21% decline in tourist arrivals. The pandemic also curtailed foreign remittance, which is another major source of forex.

Sri Lankan government’s aim to make the country the first in the world to have complete organic agriculture with ‘Green Agriculture’ aggregated the crisis.  Hit by the fertilizer ban, Sri Lanka’s agriculture exports, dominated by tea (53.3%), now see a very bleak prospect with reduced crop production for 2022. Vast tracks of farmland were abandoned leading to domestic food shortages.  The government was forced to withdraw the ban imposed in May by October 2021, but it had already created havoc in the food supply chain.

The Sri Lankan government is primarily relying on China for all kinds of support. Following the fertilizer ban, it relied on import of Chinese organic fertilizers. This was also entangled into controversy due to quality and contamination issues. To make matters worse, China pressurized the Sri Lankan government to pay USD 7 million as out of court settlement as compensation, amidst forex crisis.

This crisis forced the Sri Lankan government to announce (January 4) a USD 1.2 billion worth new economic relief package to the agitating farmers and general public including government employees and pensioners.

The country is currently resorting to Foreign Currency Term Financing facilities and Line of Credit (LoC) for import of essentials from friendly and neighboring countries.

According to the UNCTAD report, policy prescriptions from multinational institutions have not had the desired effect in Sri Lankan debt distress. Sixteen IMF packages have led to currency devaluation, privatization and trade liberalization, but no sustainable growth.  Sri Lanka also ranks very poorly in the World Bank’s ‘Doing Business Indicators’ in a number of areas including contract enforcement, taxes, registering property and obtaining credit.

Under these circumstances, the country hopes for policy makers’ ‘out of the box’ solutions for course correction as existing/conventional recourses to mitigate the forex crisis have dried up. The year 2022 is crucial for Sri Lanka to avoid economic catastrophe.