Understanding the sovereign debt crisis in Sri Lanka

News: The Sri Lankan government has decided to default on all its foreign debt worth $51 billion as it awaits financial assistance from the International Monetary Fund (IMF).

The government stated that it took the decision to preserve its dwindling foreign reserves to pay for the import of essential items. Ratings agencies such as Fitch, and Standard & Poor’s have downgraded Sri Lanka’s sovereign debt.

What is Sovereign debt?

Sovereign debt refers to the debt issued or accumulated by any government.

– Governments borrow money to finance the various expenses that they cannot meet through their regular tax revenues. They usually need to pay interest on such debt along with the principal amount over time, although many governments simply choose to borrow fresh debt to repay existing debt.

Historically, governments have tended to borrow more money than they could actually repay in order to fund populist spending.

Can Governments borrow money in local currency?

Yes. Governments can borrow either in their local currency or in foreign currency like the U.S. dollar.

– Governments usually find it easier to borrow and repay in their local currency. This is because governments with the help of their central banks can easily create fresh local currency to repay debt denominated in the local currency. This is known as debt monetisation and it can lead to increased money supply, which in turn causes prices to rise.

Why repayment of debt denominated in a foreign currency is difficult?

This is because governments depend on the inflow of foreign currency to gather the necessary foreign exchange to pay their foreign debt.

– For instance: The Sri Lankan government or the central bank, for example, cannot create U.S. dollars out of thin air to pay their foreign debt denominated in U.S. dollars. Instead, they depend on U.S. dollars flowing into Sri Lanka in the form of foreign investment and payments received in exchange for the export of various goods and services to build up their foreign reserves.

Why is Sri Lanka unable to pay its sovereign debt?

Tourism sector hit hard: Sri Lanka depends heavily on its tourism sector to bring in the foreign exchange necessary to import essential items such as food and fuel.

– The tourism sector contributes to about 10% of Sri Lanka’s gross domestic product. Since the coronavirus pandemic and the ensuing lockdowns, Sri Lanka’s tourism sector has been hit hard. This, in turn, has affected the inflow of U.S. dollars into the Sri Lankan economy.

Thus, the Sri Lankan government has been finding it hard to obtain the U.S. dollars necessary to make good on its foreign debt obligations.

Efforts to fix exchange rate failed: Sri Lanka’s efforts to fix the exchange rate of the Sri Lankan rupee against the U.S. dollar in order to raise the price of the rupee may have also played a role in the foreign debt crisis. The country’s central bank at a certain point banned the payment of more than 200 Sri Lankan rupees for one U.S. dollar.

This rate was way below the actual market price of the dollar, which caused trades to be pushed into the black market and also caused a drop in the supply of U.S. dollars in the forex market.

What is the cost of defaulting on foreign debt?

International lenders may be reluctant to lend any more money to the Sri Lankan government unless such lending is part of a restructuring agreement.

Impact on ratings: This fact will also be reflected in the ratings that international ratings agencies give to debt issued by the Sri Lankan government.

Going forward, the cost of fresh borrowing is likely to be high for the Sri Lankan government as lenders will be incurring greater risk while lending to a government that has been unable to make good on its previous commitments.

Source: This post is based on the article “Understanding the sovereign debt crisis in Sri Lanka” published in The Hindu on 15th Apr 22.