Not Just Another Recession
Why the Global Economy May Never Be the Same
Sri Lanka is in the midst of the worst economic crisis in its 74-year history. An acute foreign exchange shortage has caused supplies of food, fuel, and other essential goods to dwindle. Almost 90 percent of Sri Lankans do not have enough to eat, according to the World Food Program. People stand in gasoline lines for days at a time, and schools have been closed for weeks. Power cuts of eight to ten hours a day are not uncommon. Patients die in hospitals for lack of medicine. For those goods that are available, prices are skyrocketing; overall annual inflation exceeds 50 percent, with the price of food rising by more than 80 percent. Since April, when the government announced that it would default on $51 billion in external debt, the Sri Lankan rupee has lost 75 percent of its value.
Popular outrage over the economic situation boiled over last month, igniting protests that eventually toppled President Gotabaya Rajapaksa’s government. Hundreds of thousands of Sri Lankans demonstrated outside the presidential palace, chanting “Go Home Gota” and waving signs decrying corruption and nepotism (three of Rajapaksa’s brothers served in his cabinet). On July 9, protesters stormed the president’s office and residence, forcing him to flee to Singapore.
Sri Lankans have clearly laid the blame for their country’s economic woes at the Rajapaksa government’s feet. But Sri Lanka is not the only developing country at risk of tipping into a debt crisis. The question now is whether Sri Lanka’s implosion will prove an isolated event, the result of uniquely poor economic management, or a harbinger of a regional or even global debt crisis. Previous defaults have come in waves, sweeping through Latin America in the 1980s and East Asia in the 1990s. A similar string of defaults could hit highly indebted developing countries across the world as they cope with the lingering effects of COVID-19, Russia’s war in Ukraine, and rising interest rates in the developed world.
The good news is that international financial institutions such as the World Bank and the International Monetary Fund (IMF) have become more proactive about preventing, rather than reacting to, debt crises. The bad news is that friction between China and Western countries has made it harder for developing nations to renegotiate their debt, since Beijing does not want to bail out private U.S. or European financial institutions and Western governments do not want to bail out Chinese financial institutions. To stave off a string of devastating defaults in the developing world, two things will have to happen at once: at-risk countries will need to seek help from international financial institutions before it is too late, and Chinese and Western creditors will need to do a better job of coordinating their debt restructuring processes.
Until recently, Sri Lanka was a moderately successful middle-income country with an enviable record on health and education. But soon after his election in 2019, Rajapaksa adopted a raft of misguided, arguably reckless, economic policies aimed at stimulating the economy. Chief among them was slashing taxes. His government lowered the value-added tax by seven percentage points and more than doubled the thresholds at which personal and corporate income taxes kicked in. As a result, Sri Lanka’s tax-to-GDP ratio fell to 8.3 percent, among the lowest in the world. The fiscal deficit ballooned. In 2020, international credit-rating agencies downgraded Sri Lanka’s sovereign debt to near-default levels, making it impossible for the country to borrow from world capital markets.
Rajapaksa adopted a raft of misguided, arguably reckless, economic policies.
Most countries faced with such a situation would seek a bailout from the International Monetary Fund and begin negotiating with creditors to restructure their debt. But Sri Lanka’s government, wary of the conditions that typically accompany IMF programs and reluctant to tarnish the country’s reputation for repaying its debts, refused to do either of these things. Instead, it financed the fiscal deficit by printing money and negotiated a new $1 billion loan from the China Development Bank in 2020. It paid back sovereign bondholders with its foreign exchange reserves. By early this year, the country’s reserves were depleted, the money supply had increased by 40 percent in two years, and inflation was rampant. Sri Lanka’s default this spring was the first in its history.
The country’s missteps could not have come at a worse time. Tourism revenue plummeted during the COVID-19 pandemic, as did remittances from Sri Lankans working abroad, especially in the Middle East. But even the decline in remittances was at least partly the government’s fault: Sri Lanka maintained a fixed exchange rate until April 2022, which likely induced workers to send money home through unofficial channels, which offered more favorable exchange rates. After all, remittances rose in all South Asian countries in 2021—except in Sri Lanka.
Financial crises and debt defaults often hit developing countries in waves. After Mexico announced in 1982 that it could no longer service its foreign debt, many other countries followed suit. Twenty-seven developing countries, 16 of them in Latin America, ultimately restructured their debts in the wake of Mexico’s default. After Thailand devalued its currency in 1997, foreign investors raced to pull their money out of many East Asian countries, causing financial crises in Indonesia, Malaysia, the Philippines, and South Korea. The ripple effects of the 1997 Asian financial crisis were felt as far away as Russia and Brazil.
So it is little surprise that investors and analysts are asking whether Sri Lanka’s default will be a one-off event or the first of many crises to hit developing countries this year. Already, in 2020, Argentina, Belize, Ecuador, Lebanon, Suriname, and Zambia all defaulted on their sovereign debt. But fears of a broader debt crisis in the early days of COVD-19 went unrealized and eventually receded. Currently, Chad, Ethiopia, and Zambia are negotiating with creditors under a G-20-supported program designed to facilitate debt restructuring, but so far no other countries have sought similar treatment. There is a good case to be made, therefore, that each of these country-level crises is sui generis. Indeed, the G-20 framework takes a case-by-case approach in the debt restructuring talks between debtor countries and their creditors.
The specifics of the Sri Lankan case also suggest that its crisis could be an isolated event. After 70 years of responsibly managing its debt, Sri Lanka elected a populist president who ran the country into the ground in less than three years. Few developing countries have endured such extraordinary mismanagement. Only Belize—also devastated by the collapse of tourism during the pandemic—and Sudan have built up similarly dangerous levels of debt relative to GDP.
Systemic risk factors could touch off a string of defaults.
But even if Sri Lanka really is a special case, there are systemic risk factors that could still touch off a string of defaults in developing countries. For one thing, developing country debt is often packaged and traded together, bought and sold in large portfolios that are constantly rebalanced against other assets. Reducing one’s holdings of Sri Lankan debt can most easily be done by reducing one’s exposure to all developing country sovereign bonds. This is why so-called sudden stops—large capital outflows from developing countries—are recurring events. Between March and June, roughly $22 billion in private capital fled the developing world.
For another thing, common global factors, not country-specific policies and politics, are often largely to blame for debt crises. In the lead-up to the Latin American crisis of 1982, many countries believed they could safely pile on large amounts of debt in a world of near-zero real interest rates and strong global growth. U.S. commercial banks, for their part, saw business opportunities in expanding their loan books to developing countries even though regulators were warning about the risks. As a result, from 1978 to 1982, total Latin American debt rose more than tenfold, from $29 billion to $327 billion.
But when the U.S. Federal Reserve raised interest rates to reduce inflation, the era of affordable debt in developing countries came to an abrupt end. Banks stopped lending out new money and started charging higher rates. Those countries that had leveraged up to indulge in overconsumption, exchange rate overvaluation, and greater public-sector involvement in the economy had to adjust rapidly and sharply. In some cases, public unrest put a stop to austerity policies and left governments no choice but to restructure their debt. In other cases, governments simply opted to default rather than make the painful cuts to social programs that would have been necessary to service their foreign debt on schedule.
The parallels between 1982 and 2022 are hard to ignore. A narrative of affordable debt has once again encouraged many developing countries to borrow heavily to prop up consumption and public employment, especially during the pandemic. And once again, global growth is decelerating rapidly and central banks in developed countries are raising interest rates to control inflation. Private capital has become less accessible and more expensive as creditors seek to reduce their exposure to developing countries.
But there are also important differences between 1982 and the present. Developing countries have become more resilient in the last three decades, and international financial institutions have gotten better at preventing crises rather than simply responding to them. In 2020, when fears of a systemic debt crisis arose, advanced economies acted swiftly to shore up the finances of highly indebted developing countries. They authorized a new allocation of Special Drawing Rights (SDRs), an international reserve asset maintained by the IMF that can be converted into U.S. dollars or another currency to service debt. By August 2021, the equivalent of $650 billion had been added to global reserves, of which $274 billion went to emerging and developing countries and $21 billion to low-income countries.
At the same time, the G-20 group of major economies launched an initiative to suspend debt service to help developing countries weather the COVID-19 crisis. Between May 2020 and the end of 2021, official bilateral creditors rescheduled $12.9 billion in principal repayments from low-income countries. Unfortunately, only one private creditor chose to participate in the initiative, and only low-income countries were eligible to participate. Middle-income countries such as Sri Lanka were excluded from the scheme.
Highly indebted countries have gotten more proactive about seeking help.
Today, many countries have used up their new SDRs, but a process of reallocating unused SDRs is underway. Rich countries with excess foreign exchange reserves have lent their SDRs to a special trust dedicated to growth and poverty reduction that the IMF administers on behalf of low-income countries. And the IMF has established a parallel “resilience and sustainability” trust for middle-income countries.
Meanwhile, highly indebted countries have gotten more proactive about seeking help. Pakistan, for example, just renegotiated its program with the IMF, committing to undertake significant economic reforms to tame inflation, restructure state enterprises and the power sector, and strengthen governance. This will unlock $1.2 billion in IMF loans, and even more if the program remains on track. An IMF agreement of this type typically also opens the door for additional support from other international financial institutions.
The case of Pakistan suggests that countries may be learning to act before it is too late, although it is too early to tell if Pakistan or similar countries will be able to implement IMF programs and fully avail themselves of rescue packages. Democratically elected governments cannot always be trusted to manage debt properly. They tend to have short time horizons, and because of the near-continuous nature of campaigns, they almost never find it politically convenient to make necessary but unpopular economic decisions. So problems are left to fester, masked by ever growing levels of debt, until the situation becomes untenable. But the looming threat of a debt crisis and the absence of viable new financing alternatives have encouraged some countries to take preventive belt-tightening measures. Just this month, for instance, major credit-rating agencies upgraded the outlook for Angola, Brazil, Lesotho, Mexico, and Paraguay in part because of their improved fiscal position.
These shifts in the international financial landscape make it less likely that Sri Lankan–style crises will spread across the developing world this year. But there is one additional complicating factor: growing friction between China and the West. Western-backed financial institutions do not want their financial support to developing countries—whether in the form of cheap loans or debt relief—to go toward servicing Chinese debts. Nor does China want to bail out Western bondholders and commercial banks; its debt restructuring talks with Sri Lanka have made no progress since the government there approached the IMF for a program. This has not proved fatal in the Sri Lankan case, since Chinese debt accounts for only about ten percent of the country’s foreign debt and an even smaller share of the debt that must be serviced this year. But elsewhere in the developing world, suspicions between Chinese and Western lenders could complicate debt restructuring talks, especially because China is not always transparent about its lending.
To ensure that economic headwinds and rising interest rates do not ignite additional debt crises in the near future, more countries will have to follow the example of Pakistan and seek help from international financial institutions before it is too late (and then follow through on their commitments to make necessary reforms, even when doing so is painful). These countries will have to build domestic political support for necessary reforms and stay the course for several years. For their part, official creditors—whether American, Chinese, or European—will need to give developing countries enough of a financial cushion that they can gradually phase in reforms. Creditors will also need to set their geopolitical squabbles aside and focus on the needs of at-risk countries.
Sri Lanka’s debt crisis was the result of bad economic policies, an unwillingness to make hard decisions, and to a lesser degree, tensions between China and the West. Most developing countries have at least some of these risk factors. If they can commit to making necessary reforms, invite international financial institutions to come to the rescue, and maintain an even-handed approach to negotiations with their creditors, they are likely to weather the storm. If not, the number of defaults in the developing world will mount.
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