Sri Lanka in Crisis: Is this a Warning for Emerging Markets?

Sri Lanka is facing a foreign exchange crisis, widespread protests, and an imminent threat of default. Its entire cabinet quit last weekend following nationwide protests over shortages of critical products and an inflation rate of nearly 17%! Just this Tuesday, there has been a suspension of bond payments from the government.

 

How Did We Get Here?

In 2019, President Gotabaya Rajapaksa (after winning Sri Lanka's election and months before a parliamentary ballot), decided to heavily slash taxes. A month later the pandemic struck and crippled Sri Lanka’s tourism-based economy. Foreign exchange reserves have quickly dwindled to a mere $2.36 billion which is far below the $9 billion in debt repayments due this year.


This comes after rating agencies have been continuously downgrading Sri Lanka’s credit rating which has made it incredibly difficult for the government to raise funds from international capital markets. As such, the country has defaulted.


There are three main reasons for this low credit rating of Sri Lanka:


1) Weak Institutions

  • Endemic corruption and nepotism. Domination of the government by one family. Four brothers at the apex of government and countless relatives the judiciary, police, and armed forces all do the bidding of the Rajapaksa.

  • The precarious financial system and official NPL's of banks bare no relationship to the true picture. For example, they have loaned out money to builders which has led to a frenzy of construction that has changed the capital’s skyline, but which is not matched by corresponding demand – this has created further problems for those exposed to the sector.


2) Bad Polices

  • After the president’s tax cuts revenues are around 10% of GDP. This is far too small for a nation of Sri Lanka’s size and so the government runs a structural budget deficit. The few taxes that are collected are generally regressive, indirect taxes that have exacerbated the country’s cost of living crisis.

  • An agricultural policy that banned chemical fertilizer was introduced overnight and crop yields dropped by half, causing national food security issues such that ordinary people struggling to eat.

  • A highly inflexible labour market that makes it difficult to dismiss workers even for flagrant misconduct.


3) Bad Investments

  • A large state-owned enterprise sector which demonstrates very low productivity, vast over-manning sclerotic inflexibility, and is (of course) massively indebted. The Ceylon Electricity Board, Ceylon Petroleum Corporation, and Sri Lankan Airlines are exemplars and are simply unsustainable.

  • Insufficiency of generating capacity and neglect of solar: an inexplicable oversight for a country close to the equator. Lack of hard currency has left the country unable to import coal/oil so lengthy power cuts hobbling the economy and leaving the masses to swelter in the heat and humidity of the tropics.

  • Absurd white elephant paid for by expensive loans - a harbour without ships and an international airport without planes, all strangely in the ruling family's home area and bearing the Rajapaksa's name.

Altogether this has caused rating agencies to say that Sri Lanka is very unlikely to repay anyone who lends to it!

 

Who Will be Affected?


The Sri Lankan government has said that this crisis will be resolved by an IMF bailout, more borrowing from China, and receiving aid from India. There will be short and long-term implications of this strategy:


Short-term:

  1. Investors who have loaned out money to the Sri Lankan government will not receive their coupon payments anytime soon. Anyone who owns Sri Lankan bonds will have found their prices have plummeted and if their portfolio is unhedged (e.g., retail investors like Sri Lankan households) they face a significant loss.

  2. Of course, the worst impact is on the Sri Lankan public who are now facing a significant downturn in their standard of living as the cost of necessities rises sharply (see picture), at least until aid arrives or the IMF loans out money.

  3. The lack of critical imports like fuel and medicine will only mean that there is increasing social unrest and dissatisfaction with the Rajapaksa.

  4. In addition, the widespread protesting and shortage of critical inputs will mean Sri Lanka’s GDP declines significantly this year because firms can no longer produce.

  5. Wealthier households who can afford their own generators may be better off, but they too have been impacted by widespread inflation; a dissatisfied middle class would be a huge blow to the Rajapaksa family.

Long-Term:

  1. Investors gear their portfolio away from emerging markets as Sri Lanka’s crisis poses a warning about other fragile economies. This would mean less investment and economic growth in countries like Bangladesh, Chile, etc.

  2. The public may face a violent regime change and incredible uncertainty for the future. High social tensions could lead to reignited ethnonationalism which would mean many Sri Lankan Tamils will probably seek to leave the country.

  3. If Sri Lanka takes a loan from the IMF, it will force the country to raise its taxes and open its economy to the world. Sri Lankans will be faced with a larger tax burden in the future and less government spending.

  4. China taking over through debt imperialism e.g., Chinese owning critical infrastructure such as ports which would mean a continuous stream of Sri Lanka’s income will be diverted towards Chinese capital/landowners.

 

What Next?

Regime Change:


Worryingly there is no obvious political configuration with the coherence and credibility to replace the current regime. There are no simple steps that will deliver quick solutions to the country's deep-seated travails. A dysfunctional coalition, rife with corruption, was in power between 2015 and 2019 which culminated in a security failure that enabled the Easter bombing of April 2019. Hence people are not enthusiastic about replacing the current regime with an opposition, with a recent record of failure.


The future does not bode well for developing countries. Although our attention is focused on other unfolding tragedies, the coming days in Sri Lanka will be critical if it is to avoid a catastrophe of its own.



 

References/Further Reading

https://www.ft.com/content/70dd2610-14f4-4144-87bb-739da2f6647a

https://www.aljazeera.com/news/2022/4/8/no-sri-lankan-rich-or-poor-spared-as-economic-crisis-worsens

https://www.statecraft.co.in/article/landslide-victory-for-the-rajapaksa-brothers-in-sri-lanka


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