In Praise of Lesser Evils
Can Realism Repair Foreign Policy?
Sri Lanka is facing an economic meltdown. The COVID-19 pandemic hurt many low- and middle-income countries, but the island nation of 22 million people stands out as one of the hardest hit. Sri Lanka is experiencing the worst economic downturn of its history, grappling with staggering levels of government debt, spiraling inflation, and a foreign exchange crisis that has led to the scarcity of many essential goods. Long lines snake outside gas pumps. The power cuts out frequently. Shops are running out of medicines and other necessities. In April, the government defaulted on its external debt, paving the way for a loan program from the International Monetary Fund.
Since late March, protesters have taken to the streets to demand the resignation of President Gotabaya Rajapaksa, whom they blame for the economic turmoil. Rajapaksa has held firm, but the political ground seems to be shifting beneath him. Much of his cabinet has resigned, and his ruling coalition has lost its majority in parliament. To rescue the economy, he must now seek a bailout from the IMF. Such a program will give Sri Lanka the best chance of stabilizing its economy, even as it carries significant political risks for the government. But without help from the IMF, the economy will go into a tailspin and tear apart the social fabric of the country.
Economic and financial conditions tightened in Sri Lanka over the course of the pandemic as exports, tourism, and remittance inflows contracted sharply. As a result, Sri Lanka’s sovereign credit ratings tumbled and the government lost access to international capital markets. Sri Lanka is drowning in debt. Without access to foreign capital markets, it is in the perilous position of having to service that debt with its own reserves, which stand at a shaky $1.9 billion as of March 2022. Its debt repayments amount to approximately $5 billion per year over the next five to seven years, an unfathomable sum given the state of Sri Lanka’s finances. On April 12, the government defaulted on all its external debt after initially insisting that it could settle maturing international sovereign bonds.
Sri Lanka’s economic malaise, however, predates the pandemic. The country embarked on ambitious infrastructure projects in a euphoric mood after the defeat of the Tamil Tigers in 2009 ended a decades-long civil war. The government tapped readily available capital on the heels of the global financial crisis and sought deals with newly emerging bilateral lenders, especially China. Indeed, Sri Lanka has seen one of the fastest transformations of its external debt composition, with the share of more costly commercial debt going up from seven percent in 2006 to 55 percent in 2019. By then, international sovereign bonds made up 38 percent of the country’s total foreign debt while China held another ten percent—a complex web of creditors that would make any future attempt to restructure the debt difficult. Despite these vulnerabilities, successive governments felt no urgency to tackle the buildup of debt. They seem to have made the lackadaisical assumption that they needed only to use foreign currency revenues to meet interest rate payments and that they could keep rolling over the more substantial principal payments.
Sri Lanka is experiencing the worst economic downturn of its history.
But Sri Lanka’s foreign exchange earnings from exports of goods and services failed to keep pace with its rapid accumulation of foreign debt. The infrastructure push incentivized the economy to rely excessively on non-tradable sectors, such as construction and real estate, to drive growth. A few of the debt-financed mega-infrastructure projects, such as the Hambantota port and Mattala Rajapaksa International Airport, turned out to be poor investment choices, as they struggled to generate foreign exchange earnings. To compensate for this failure, the central bank relied on selling bonds to boost foreign exchange reserves, a tactic that can work in normal times but tends to fail in times of crisis when countries are frozen out of capital markets. These measures backfired when the country was unable to access financial markets at affordable rates in the early months of 2020 as the pandemic shock hit.
Extraordinary government spending during the pandemic aggravated Sri Lanka’s macroeconomic imbalances. Indeed, Sri Lanka’s government was already disposed toward populist economic policies before the pandemic hit. One of Rajapaksa’s first acts on being elected to office in November 2019 was to backpedal on an existing program with the IMF, slashing taxes that trimmed 25 percent off revenues even before the pandemic emptied the treasury coffers. The large-scale money printing led to the depreciation of the Sri Lankan rupee, which was artificially reversed only when Sri Lanka’s central bank imposed an unrealistic conversion rate that resulted in drying up available hard currency even faster.
The resulting scarcity of foreign currency has held up critical imports such as milk powder, gas, and petroleum. Such shortages of essential goods have meant queues, power outages, and rising prices as inflation hit a 13-year high of 17 percent in February 2022. The economic hardships, in turn, have spurred growing calls on the government to stop servicing its debt and to enter into a debt restructuring process, alongside a bailout program with the IMF. That path offers the only feasible route out of the crisis.
The Sri Lankan government was clearly reluctant to turn to the IMF, concerned that the fiscal austerity measures required by the fund—including cutting expenditures and raising taxes—would restrict its ability to provide financial relief across the board. But it has also failed to put forward a convincing alternative plan to tackle the debt and the shortfall in foreign exchange. Instead, to ride out the immediate crisis, it chose to rely on the temporary salve of bilateral government-to-government deals for short-term currency swaps and credit lines, and lined up equity sales for foreign direct investment, including selling government stakes in hotels, real estate, and the energy sector.
This strategy always carried high risks. Relying on bilateral relationships can be dangerous, especially in the context of intensifying geopolitical rivalries. China is Sri Lanka’s single largest bilateral creditor, with an expanding footprint in the country. Although India’s share is smaller, that country continues to hold formidable influence on Sri Lanka by virtue of its political and economic sway in South Asia. Both China and India have responded to Sri Lanka’s appeals for economic assistance with currency swaps and credit lines. But these deals have been delayed, presumably as the governments iron out differences behind closed doors. New Delhi, for example, has been aggrieved by the cancellation of an agreement to allow India and Japan to develop and operate a vital terminal in the port of Colombo. Sri Lankan officials have now handed over majority ownership of an alternative Colombo port terminal to an Indian company. They have also allowed India to proceed with a long-delayed investment project in oil infrastructure along Sri Lanka’s eastern coastline. India announced an economic relief package for Sri Lanka in January that, after some delay, has finally begun to materialize.
Chinese investment in Sri Lanka has ballooned in the last decade. Notably, Sri Lanka enacted a distinct set of laws and regulations in 2021 to enable the Chinese-funded Colombo Port City project, which gave a Chinese company a 99-year lease to develop and operate sections of the new Port City in in the hope of a significant injection of cash. But China has yet to respond to an appeal for debt relief made by the Sri Lankan president in January.
Regional and global rivalries also complicate how Sri Lanka can tackle its debt. Sri Lanka’s bonds are held primarily by private creditors in the United States. China will want to ensure that any relief it offers Sri Lanka is not used primarily to pay off these bondholders. These concerns will invariably make a future debt restructuring process more difficult.
With support from China and India already delayed, the Sri Lankan government received another enormous blow with the Russian invasion of Ukraine. The shock on international oil prices aggravated the acute foreign currency crisis. And Sri Lanka’s tourism industry, which accounts for about five percent of its economy, has also suffered a setback. Russian tourists made up the largest contingent (17 percent) of arrivals in January, and that share plunged to eight percent in March.
In the middle of March, Sri Lanka’s central bank finally took a decisive step. It devalued the currency by 20 percent, with the rate to be determined by the market thereafter. Doing so, without the backing of the IMF, has meant substantive speculative pressure on the beleaguered currency, with the rupee losing value by as much as 55 percent. After a change in its leadership in April, however, the central bank now seems to be laying the groundwork for a rescue by the IMF. It raised policy interest rates by a record seven percent overnight. The other items on the IMF list include an ambitious fiscal consolidation focused mostly on raising revenues, reforming state-owned enterprises, and increasing energy prices. If, as is most likely, Sri Lanka is compelled to engage in debt restructuring through the adoption of an IMF program, the fund will expect the government to make further tough commitments, such as freezing public sector wages and curtailing subsidies.
IMF programs typically run for three years. It takes that long, or even longer, to make real progress on stabilizing the debt and other macroeconomic fundamentals and to set the economy on course for stronger growth. Unfortunately for the Sri Lankan government, that cycle runs into the country’s next scheduled national election, in 2024. Electoral considerations will weigh heavily on how the Rajapaksa government manages the economic tightening that will follow the adoption of an IMF program. Indeed, the required policy corrections mean that economic conditions are likely to worsen for the average voter before they get better. The recent interest-rate hikes will raise domestic borrowing costs, as well as slow growth. Slower growth, alongside the depreciation of the currency, will see the ratio of debt to GDP (the public debt is already at an astronomic 120 percent of GDP) shoot up even further.
The war in Ukraine and the lingering effects of the pandemic, including a troubling surge in China, continue to threaten global economic stability—and the prospects of Sri Lanka’s recovery. The government is right to underwrite the country’s economic risks with an IMF program. In the best-case scenario, such a program will bring clarity and certainty to the country’s economic plan and help calm investors. In the interim, if bilateral relief packages materialize along with a steady uptick in exports, tourism, and remittances, Sri Lanka can tide over its immediate foreign exchange crisis. The government will have to hope that the economic pain and austerity will ease sufficiently by 2024, when it faces voters again. But the risk of not embarking on such a program now is far greater: failing to address the gravity of the crisis could lead to further economic devastation and to the government’s undoing.
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