The Real Cause of Sri Lanka’s Debt Trap

Sri Lanka’s default highlights the dangers of relying on international sovereign bonds – with high
interest rates – to fund development.

Sri Lanka’s debt default – announced in April of last year amid foreign currency shortages that had
triggered rolling blackouts, fuel queues, and street protests – has been subject to endless debate by
local and international observers. The root causes of the country’s debt problem have been attributed to
various factors, including corruption and nepotism, alleged predatory lending from China (the so-called
“Chinese debt trap”), and a structural balance of payments deficit. These debates aside, it is increasingly
clear that the immediate cause for Sri Lanka’s collapse is the structure of the country’s debt itself –
specifically, its deep and growing exposure to international sovereign bonds (ISBs) issued at high
interest rates.

In the immediate aftermath of Sri Lanka’s civil war in 2009, the country embarked on a mainly
bilaterally-financed infrastructure investment program. However, alongside these borrowings for
investments in ports, energy, and transport, the Sri Lankan government also binged on international
sovereign bonds, issuing $17 billion worth of ISBs from 2007 to 2019, in face value terms. According to a
2021 report by the Advocata Institute, Sri Lanka’s ISBs were issued at high coupon rates (often between
5-8 percent), with some 36 percent of these ISBs being subject to classic collective action clauses,
which make restructuring much harder for debtor governments. As a result of this debt-fueled growth
strategy (or lack thereof), the country’s ratio of public external debt stock to GDP grew from 29 percent in
2010 to 44 percent in 2021.

The ISB Debt Trap

In historic terms, Sri Lanka’s current external debt ratio is hardly a precedent. The country endured
higher external debt burdens, crossing 60 percent of GDP, in the 1990s, but managed to avoid a total
default. The difference between now and then is that a greater share of the country’s external debt is
borrowed from international capital markets at high interest rates.

From 2010 to 2021, the ISB share of Sri Lanka’s external debt stock tripled, going from 12 percent to 36
percent. Yet in 2021, ISBs accounted for a monster 70 percent of the government’s annual interest
payments. These figures highlight the extent to which high interest borrowing from international capital
markets can eat into the foreign currency cash flows of a country, especially when it is wracked by
external shocks such as the COVID-19 pandemic and conflict in Ukraine.
For underdeveloped countries like Sri Lanka, borrowing from international capital markets is
exceptionally risky. Typically, ISBs are not linked to projects and therefore do not produce a
corresponding asset or economic growth, nor is there much transparency on how governments budget
and spend funds accrued from these bonds. The bondholders themselves comprise a diverse set of
interests who are difficult to coordinate with to negotiate a restructure. For example, bondholders like
Hamilton Reserve have held out and sued the Sri Lankan government.

Additionally, the bonds themselves are tradable and their prices subject to the decisions of credit ratings
agencies. When credit ratings agencies downgrade a country, the price of that country’s bonds
decreases and its yield rises. Since the yield acts as the benchmark for coupon rates on future bonds,
this makes future borrowing more expensive, and can lead to a snowball effect where a country takes on
more debt at higher interest rates to pay back outstanding obligations, which were borrowed at lower
rates.

Sri Lanka’s experience is not unique among underdeveloped countries, many of which have fallen for
the same ISB debt trap. The allure of low interest rates in the wake of the 2008 financial crisis was
seized upon by underdeveloped countries to cover chronic balance of payments issues linked to
deteriorating terms of trade from an unindustrialized production base. At the same time, low rates
pushed Western institutional investors to seek profits from other sources of income, including the stock
market, CDOs, and emerging market debt. The consequences of this shift in debt structure among
underdeveloped countries has devastating consequences for citizens who have to bear the brunt of the
ongoing debt crisis.

A glance at the composition of total debt stock and debt servicing of underdeveloped countries is telling
– the higher the share of ISBs in outstanding debt, the greater the annual interest paid. We find that
some of the most debt distressed countries in the world, including those that have defaulted after 2019 –
such as Argentina, Lebanon, Ecuador, and Ghana – all have in common a deep exposure to bond
markets.

The high level of ISB interest payments tends to exacerbate stresses from external and cyclical shocks,
which underdeveloped countries are vulnerable to. For example, the COVID-19 pandemic brought
global tourism to come to a virtual standstill in 2020 and 2021, causing Sri Lanka to lose around 24
percent of its annual export revenue. Shortly thereafter, global oil and other commodity prices rose
sharply due to the war in Ukraine.
IMF Offers No Solutions

Sri Lanka desperately needs bridge financing to shore up its reserves and ensure a steady supply of
essentials such as fuel and fertilizer so that it can resume basic economic activity and restore a sense of
normalcy for workers and businesses. As it stands, the country expects to sign its 17th agreement with
the IMF in March, nearly a year after negotiations first began. To call the IMF package a bailout would be
a misnomer, as the $2.9 billion on offer (to be disbursed in tranches), is scarcely enough to cover Sri
Lanka’s annual fuel bill, let alone the $4-5 billion it would normally require for annual debt servicing.

What an IMF agreement will do is restore international creditor confidence and improve the country’s
credit ratings. Steps have already been taken to depreciate the currency, increase taxation, implement
cost-recovery based pricing for utilities, and privatize state-owned enterprises. Some experts frame this
as a positive and an end in itself, as it would help Sri Lanka regain access to international capital
markets.

However, taking on more debt from international capital markets is the last thing Sri Lanka needs if it is
to find a way out of its debt problem, as this would simply contribute to a snowballing of ISB debt. A good
example of this is the case of Egypt, which secured an IMF deal in December 2022 and now plans to
issue sukuk (Islamic bonds) at a yield of 11 percent to pay off an outstanding Eurobond, which carries a
fixed interest rate of 5.557 percent.

This pattern of going to the IMF and then relying on ISBs for external financing was already tried by the
Sri Lankan government from 2016 to 2019, during the country’s 16th IMF program. At the time, Sri Lanka
had entered into a three-year extended arrangement with the IMF for a paltry $1.5 billion. Using the
“credibility” gained from this arrangement, Sri Lanka issued around $12 billion in sovereign bonds
(around 70 percent of the face value of total bonds issued in the country’s history). This was done on the
justification that these funds were needed to refinance bilateral project loans. As the data on structure of
outstanding debt and interest payments bears out, this refinancing strategy has been disastrous for Sri
Lanka, making its annual interest repayment bill higher than it would have been had it stuck with bilateral
loans.

Sri Lanka’s long-term prospects for recovery will require a paradigm shift from what it has done up to
now. One of the country’s immediate goals should be to deleverage from ISBs exposure, and be more
strategic about the kinds of debts it takes on. In the medium to short term, bilateral borrowing remains
the country’s safest and most reliable method for financing its external commitments. Curiously, recent
revelations by local media suggest that Sri Lanka’s finance minister had secured bilateral financing from
China to avoid defaulting in the first place, but was blocked from pursuing this path for political (likely
geopolitical) reasons.

This is not to say that Sri Lanka should go to bilateral partners with a begging bowl or accept unsolicited
project proposals without due diligence. Rather, the country must take its fate in its own hands and
formulate its own industrial development strategy, in which bilateral partners can play a constructive and
supportive role. In a sense, this would mean tackling the root cause of Sri Lanka’s debt itself – the
massive and protracted trade deficit.

REFERENCE: https://thediplomat.com/2023/03/the-real-cause-of-sri-lankas-debt-trap/
CASE OF SRI LANKA ACCORDING TO THEIR DEBTS.

COLOMBO, April 13, 2022— Sri Lanka’s economic outlook is highly uncertain due to the
fiscal and external imbalances. Urgent policy measures are needed to address the high
levels of debt and debt service, reduce the fiscal deficit, restore external stability, and
mitigate the adverse impacts on the poor and vulnerable, says the World Bank in its
twice-a-year regional update.

Released today, the latest South Asia Economic Focus Reshaping Norms: A New Way
Forward projects the region to grow by 6.6 percent in 2022 and by 6.3 percent in 2023. The
2022 forecast has been revised downward by 1.0 percentage point compared to the
January projection, mostly due to the impacts of the war in Ukraine.

Countries in South Asia are already grappling with rising commodity prices, supply
bottlenecks, and vulnerabilities in financial sectors. The war in Ukraine will amplify these
challenges, further contributing to inflation and deteriorating current account balances.

“The World Bank is deeply concerned about the uncertain economic outlook in Sri Lanka
and the impact on people,” said Faris Hadad-Zervos, World Bank Country Director for
Maldives, Nepal, and Sri Lanka. “We are working on providing emergency support for poor
and vulnerable households to help them weather the economic crisis and we remain
committed to the wellbeing of the people of Sri Lanka, and to a narrative of sustainable
and inclusive growth that will require concerted and collective action”

Sri Lanka needs to address the structural sources of its vulnerabilities. This would require
reducing fiscal deficits especially through strengthening domestic revenue mobilization. Sri
Lanka also needs to find feasible options to restore debt sustainability. The financial sector
needs to be carefully monitored amid high exposure to the public sector and the impact of
the recent currency depreciation on banks’ balance sheets. The necessary adjustments
may adversely affect growth and impact poverty initially but will correct the significant
imbalances, subsequently providing the foundation for stronger and sustainable growth and
access to international financial markets. Mitigating the impacts on the poor and vulnerable
would remain critical.

In South Asia, though GDP growth continues to be solid during the recovery, all countries in
the region will face challenges ahead. On a positive note, exports of services from the
region are on the rise as the pandemic subsides.

The war and its impact on fuel prices can provide the region with much-needed impetus to
reduce reliance on fuel imports and transition to a green, resilient and inclusive growth
trajectory. The report recommends that countries steer away from inefficient fuel subsidies
that tend to benefit wealthier households and deplete public resources. South Asian
countries plan to move towards a greener economy by gradually introducing taxation that
puts tariffs on products which cause environmental damage.

Another challenge the region faces is the disproportionate economic impact the pandemic
has had on women. The report includes in-depth analysis of gender disparities in the region
and their link with deeply rooted social norms, and recommends policies that will support
women’s access to economic opportunities, tackle discriminatory norms, and improve
gender outcomes for inclusive growth.
Sources: World Bank Macro Poverty Outlook and staff calculations.

Note: (e)=estimate, (f)=forecast, * = excludes Sri Lanka. To estimate regional aggregates

REFERENCE:https://www.worldbank.org/en/news/press-release/2022/04/13/sri-lanka-face
s-unsustainable-debt-and-balance-of-payment-challengesS