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The ‘Debt’ Trap

Sri Lanka and its population continues to take the brunt of food and economic crisis as the country is grappling with various issues like protests, inflation, economic crisis, shortage of essential items like food, medicine and fuel. On 12th April 2022, the country revealed that it was going to default on its external debt of US$ 51 billion as the country is on the verge of running out of its foreign reserves.

What led to the Crisis?

The current crisis in Sri Lanka is a result of large tax cuts, external debt, a debt trap, a fall in foreign remittances, a fall in its tourism industry, an agricultural crisis, the Russo-Ukrainian War, etc. The country was a long way into an economic crisis in 2015. Large tax cuts made under the rule of Mr. Gotabaya Rajapaksa, affected government revenue and fiscal policies, leading to soaring budget deficits. This massive loss of revenue due to tax cuts resulted in rating agencies downgrading the country’s sovereign credit rating making it harder for the country to take on more debt.
Followed by this, the Central Bank of Sri Lanka began printing money to cover the government’s spending while ignoring warnings from the IMF of an economic explosion. IMF’s advice to hike interest rates and raise taxes while cutting spending was ignored. On 6th April 2022, the Central Bank of Sri Lanka has allegedly printed 119.08 billion Sri Lankan rupees, the highest amount printed by CBSL on a single day for the year 2022.

Source: Central Bank of Sri Lanka

Apart from this, a major reason of crisis is the Sri Lankan foreign debt that has increased from USD 11.3 billion in 2005 to USD 56.3 billion in 2020.  The current foreign debt is 119% of its GDP in 2021. The country announced an economic emergency in the year 2021 due to falling national currency exchange rate, inflation rate rising as a result of higher food prices, and pandemic restrictions in tourism led to further decrease in country’s income. Loans to Sri Lanka by the Exim Bank of China, to build Hambantota International Port and Mattala Rajapaksa International airport turned out to be unprofitable white elephants for the country. Easter Bombings in 2019 and COVID-19 pandemic effected the country’s tourism industry which contributed to over one-tenth of GDP of Sri Lanka.

Source: Central Bank of Sri Lanka

Banning inorganic fertilizers and agro-chemicals based fertilizers in April-2021 to promote organic farming negatively impacted the self-sufficient rice production of the country. Such farming under the organic program was ten times more expensive and producing half of the yield by farmers.

Russo-Ukrainian War exacerbated the sluggish economic conditions of Sri Lanka as the country is heavily reliant upon these two nations in terms of tourism and Russia is the second largest market to Sri Lanka in tea exports.

Source: World Bank

Which other countries could go the Sri Lankan way?

Besides Sri Lanka, Lebanon, Suriname, Ukraine, Tunisia, Ghana, Kenya, Ethiopia, El Salvador, Pakistan, Ecuador, Nigeria, Zambia are already running into default while Belarus is on the brink and more countries are in the danger zone of rising borrowing costs, inflation and debt. As per an estimate, the total debt from these countries is pegged at $400 billion. Argentina alone has a debt of more than $150 billion, followed by Ecuador and Egypt at $40 billion and $45 billion respectively. These countries which are home to 900 million people, i.e., 12% of world’s population, are reeling in high inflation, unemployment, deep recession, mounting debt and slow economic growth also sending signs that the developing world is at risk.

Debt in the Developing World
CountryFiscal DeficitDebt-to-GDP Ratio
El Salvador5.5%87%

Source: WION

Why is the Developing World in Debt?

The developing world has been pushed into debt majorly because of three reasons:

  • Pandemic Era Deficit
    All governments had to increase spending to meet the requirements of hospitals, vaccines and economic stimulus while the revenue plunged. The countries that are dependent on tourism has taken a bigger hit widening the deficit.
  • Strong Dollar Draining Forex Reserves of Economies
    Increased interest rates of the Fed to tackle inflation is leading to dollar gaining on local currencies. This implies that countries must now pay more to service foreign debt and import goods, draining foreign reserves of economies.
  • Poor Leadership
    Lack of economic diversity, tax cuts, improper policy implementations, ignoring warnings and signs of economic collapse led to crisis in economic world.

For example, banning chemical fertilizers in Sri Lanka impacted agricultural output of Sri Lanka causing food crisis. Betting on Bitcoin as a legal tender in El Salvador plunged the country into crisis since Bitcoin is 48% down in the last six months.

Other factors like Russia’s war on Ukraine, China’s zero COVID lockdowns and Western sanctions on Russia are only making it worse.
While India is doing better in terms of managing the debt of the country, there are a few gaps and looming crisis in State finances. For example, Punjab, West Bengal, Bihar and Andhra Pradesh has identical Debt-to-GDP ratios as that of Sri Lanka which is a consequence of a fall in vertical devolution, effect of GST regime and a slowdown in growth. Measures like special allocations and transfers are needed from government to address the worst effects of these states.

Is there a way out?

The immediate option for these debt-ridden countries for a way out of the crisis is an IMF bailout, they should further focus on diversifying their economy like that of countries like India, China and Mexico that are resilient and not facing a default. Countries should also exercise fiscal prudence in framing and implementing their policies, cut spending, manage borrowing and lending better, creditors should offer contingency plans, introduce better ways to manage shocks and crises, expand eligibility criteria of the common framework which is developed by the G20 to help poor debt-ridden countries to restructure their debt, increase accountability and transparency by reviewing terms of lending by certain creditors and introduce plans to pause repayments during financial difficulties of nations.

Niharika Jayanthi

Editor, TJEF

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