Asian Debt Traps: This Is What Happens When A Country Defaults

Sri Lanka’s dire economic situation and what is happening to deal with it explained in full

Sri Lanka has just defaulted on its sovereign debt for the first time, with the recently appointed new Prime Minister, Prime Minister Ranil Wickremesinghe stating that the country’s economic situation is much worse than he expected it to be. Wickremesinghe knows of what he speaks, the 73 year old veteran has served as Sri Lankan Prime Minister on five previous occasions. He qualified as a lawyer in 1972.

Complete Incompetence – And Worse?

So bad is Sri Lanka’s position that Wickremesinghe has stated that he has been unable to produce a recovery budget of any kind for at least a further six weeks, having been appointed to the role as PM on May 12. That has been due, he has stated, because of a complete lack of records at numerous Ministeries for numerous economic indicators. There is apparently no actual account of Sri Lanka’s true debt position (estimated at US$51 billion). Wickremesinghe has archly pointed out that the previous two Finance Ministers, Mahinda and Basil Rajapaksa, brothers of the current President, had little to no knowledge of banking or economics. The lack of record keeping suggests even worse – disappearing paperwork is usually magicked away to cover up fraud.

Gota Rajapaksa, the current President, has refused to leave office, stating that he intends to sit out his full elected term, which ends in 2024. With over 20 Rajapaksa family members in Ministerial positions over the past decade, the subversion of Sri Lankan democracy by a ruling family is apparent.

Bankruptcy For 22 Million People

Wickremesinghe has had to deal with this and has been hampered by any immediate ability to provide figures to the IMF. That has meant that for the time being, what amounts to a bankrupt Asian nation is having to rely upon aid to keep it ticking over. That will have to be enough for at least several months – 6 weeks to come up with some sort of fiscal data, time required to analyze this, and time to negotiate debt restructuring. That means that Sri Lanka’s 22 million people – with energy supplies, medicines, food, and fertilizers all in short supply, are going to have to survive on fumes.

Doctors are stating that essential drugs are running out. New borns and Mothers are at risk because there are no provisions to carry out C-sections. The diabetic, hyper-tensioned, cancerous and all manner of on-going medical conditions that exist in a tropical country will all have to face a lack of treatment. Death rates will inevitably soar.

Farmers have been hindered by an inconceivable earlier decision to ban the importation of fertilizers. The summer monsoon has just begun and many paddy fields lie fallow. There is an acute shortage of oil and energy – meaning power cuts. Fishermen cannot go out to sea. Farmers are idle. Families are having to resort to subsistence farming from their own small plots – if they have one. The President meanwhile thinks he is still democratically viable and in charge.

Wickremesinghe has a tough job to balance all this out, although the people’s anger and desperation will ultimately be taken out on Rajapaksa. His response? To order a ‘shoot on sight’ notice to anyone protesting ‘beyond reason’.

Bringing In The Big Guns

What Wickremesinghe has done though is to appoint advisors. In a much-needed show of common sense, he has appointed Clifford Chance, the UK-based lawyers, as well as France’s Lazard financial advisors to help renegotiate Sri Lanka’s huge debt. The choices are interesting. Lazard’s are considered leaders in dealing with China, where they assisted Zambia last year in negotiations between China and the IMF concerning the African nations US$16 billion of debt, in negotiations that took over a year. Lazard’s will need to be on their game – Sri Lanka’s debt is over three times higher and includes loans Sri Lanka took from China in addition to Japan, and India. In total though, Sri Lanka’s debt to China is about 18% of the total – meaning Lazard still have to deal with another 82% of non-China debt. That is indicative of a country whose Government have been taking money left, right and centre and probably covering up the true extent. It also means that while China has lent just under 30% of Sri Lanka’s debt, other creditors are collectively larger.

Clifford Chance meanwhile will be responsible for dealing with bonds issued by Sri Lanka to private investors. They will also have their work cut out, Sri Lanka’s bondholders are represented by Rothschild, notoriously tough negotiators who will be unwilling to take a haircut.

As can be seen, all this is going to take time, and will mean Sri Lanka will have to source bridge financing and other loans (at high interest rates given the situation they are in) for possibly two-three years. If it took Zambia 13 months to sort out US$16 billion, Sri Lanka’s debt, which is more complex, and three times larger, will take longer. There are other complications: China has already signaled to Sri Lanka that debt refinancing rather than debt restructuring is needed. Who will come aboard to help China take the strain?

Interim Assistance

Until Sri Lanka’s external debt becomes sustainable, lending facilities such as the proposed Paris Club, multilateral agencies such as the World Bank, the Asian Development Bank, and other countries will be reluctant to come forward to help in a material way. Debt sustainability can only be achieved once an acceptable universal restructure plan is agreed between the creditors.

The Sri Lanka Government has sought a credit facility of US$500 million from the Exim Bank of India – an amount sufficient for just five weeks of fuel supplies. It will not be enough in a negotiation process likely to take well over a year. In addition, US$48 million is said to be available from two previous Indian credit lines. That’s just enough for three days. Meanwhile, Indian assistance is also reaching saturation point with several Indian states also facing financial issues. Sri Lanka will be looked after at the back of an Indian queue.

On top of this is an acute shortage of rice. Due to the above-mentioned fertilizer problems, Sri Lanka is unable to produce any rice yield until February 2023. As a result, rice will have to be imported – but there is no foreign exchange. Sri Lanka is having to reach out to bodies such as the UN Food & Agriculture Organisation for help – just as grain prices have shot up and shortages exist elsewhere.

The IMF

Sri Lanka is hoping the IMF will bail it out, but again this seems unlikely given the sheer time it will take to get to the root of Sri Lanka’s problems, understand them, and restructure what it owes. There may be some state-owned assets that the country could sell, however Sri Lankan airlines is loss-making (previous management: the Rajapaksa’s) as are many of Sri Lanka’s other state-owned assets such as the Ports Authority and Maritime aquaculture industry. Management has taken development funding, but no development has taken place, leaving numerous industries under-invested and decaying. Besides, who wants to buy an airline right now?

Trade Agreements

Another approach to fast track investment and growth would be to open up the Sri Lankan economy via Free Trade Agreements. This would be a complete reversal of the current way the Sri Lanka economy is operated, which is basically to squeeze the domestic consumer market. But that stops when default occurs – leaving no-one with disposable income. Sri Lankans are struggling to buy food. The domestic economy is collapsing.

It is the Chinese who are trying to force Sri Lanka’s hand to open up their markets and engage in free trade. A China-Sri Lanka Free Trade Agreement has been under discussion since 2015, with very little progress made. Studies have however shown that Sri Lanka produces 566 products with Asian regional price advantages, of which, 243 items were or could be exported to China. There were an additional 299 products with trading potential with China, and especially in vegetable products, rubber, and plastics. President Rajapaksa’s approach? To dismiss the concept by stating ‘The Chinese want too much’. In fact, Sri Lanka’s gain by accessing the Chinese consumer market would be significantly larger than China’s gain by accessing Sri Lanka’s consumer market by a factor of a multiple of about 60 times – even if Sri Lanka could manufacture enough for Chinese consumers to buy.

Summary

In the longer term, Sri Lanka’s debt will be negotiated, and the economy start to recover – provided a professionally competent government can be installed. The Rajapaksa era is coming to an end game, and although Belt and Road critics point to ‘China debt-traps’ as a likely culprit, the real reason behind Sri Lanka’s fall from grace has been corruption and sheer incompetence. The fact that that has taken place under the auspices of a ‘democratic’ platform is a cause for concern as is the covering up – and placing of blame elsewhere – for the failings of Sri Lanka’s political system. Twenty members of the Rajapaksa family have served in Ministerial positions in Sri Lanka over the past decade or so. The result is a failed nation, US$51 billion in debt with starvation, death and the potential for serious unrest all very real. President Rajapaksa remains so, stating that he was ‘democratically elected’ and intends to see out his term of office. What is needed, apart from debt restructuring, is an examination of how Sri Lanka’s democracy became so subverted it is ending up in poverty. Understanding how democracy became so undermined will be key to preventing such abuse afflicting other countries in coming years.

Meanwhile, no-one knows how the country is going to get through the rest of the year and into 2023. People will starve, and will die. But that’s OK if a democratically elected President remains in office and the democratic principles are upheld. Or is it? Political commentators in support of democracy may think about what that means in an era when the United States is hosting a series of summits promoting the concept. The question is – what type of democracy? A Sri Lankan variant isn’t working.

Free Trade, meanwhile, remains a vital component part of any hope of a rescue package for the country. Getting through the next few months will be tough. Globally we are about to find if the international community, including the bankers, and lawyers, creditors and lenders are up to the task. Because if Sri Lanka cannot be handled, then what happens to the next country to default?

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• Sri Lanka’s Problems Are A Result Of Gross Fiscal Mismanagement And Misappropriation, Not Because Of China Debt Traps, Covid, Or Ukraine