Hello and welcome to The Sphere of Reason Blog! For my first post I am going to share with you a research paper that I wrote on the causes of the Debt Crisis in Sri Lanka. Being half Sri Lankan I heard family members and their friends, frequently talking about the events.I also got the chance to hear the first hand experiences of people living in Sri Lanka during the period of the crisis, who struggled greatly due to a shortage of recourses and lack of cooperation from the government.Overall this greatly motivated me to attempt to figure out the root causes of the debt crisis.

In April 2022, Sri Lanka unilaterally suspended debt repayments and experienced the first ever default in its history. There are multiple global and domestic factors which have all played a role in contributing to the situation.  In this paper I will explore the economic policies implemented by the government, the interplay of external shocks and domestic polices as well as the general sovereign borrowing practices of the government in recent years, which all lead to this crisis. On balance, it remains uncertain which factor was most significant yet the maturing sovereign bonds can be seen as a profound cause with Covid-19 acting as the catalyst of the crisis and all other factors mentioned acting as secondary causes which contributed to the deterioration of the Sri Lankan economy and therefore to the debt crisis.

Sri Lanka gained its independence in 1948, freeing itself from the grip of the British Empire. The country maintained its colonial economy while adopting some “capitalist” aspects[1] However this largely failed as surpluses from crop production were exported and the majority of the economy remained pre-capitalist with low productivity. Fast forward half a decade later and the country is still facing identical problems. As seen on the graph taken from the World Bank in the last 15 years the current account balance has fluctuated greatly since 2009 when the civil war ended but significantly decreased from 2020 at -1.19 billion to -3.28 billion US Dollars in 2021, showing how the country was running a  severe current account deficit[2] Alongside this, a graph of the foreign exchange reserves indicates how since its peak in 2018 the value of the country’s foreign exchange reserves dropped significantly preceding their eventual depletion in 2022.[3]These negative effects on the macroeconomic objectives of the economy all contributed to the crisis but one must not disregard the other factors which also put the economy in a state of despair.

Figure 1: Foreign Exchange reserves (US$) from 2015-2024

Figure 2: Current Account Balance (US$) 2014-2022

Sri Lanka’s economic growth has been predominantly export led with heavy reliance on sales of tea, coconuts, and rubber. Therefore, the country is prone to exogenous shocks. As a result of events such as Covid-19 and the Russia-Ukraine war, exports have suffered greatly. Domestic issues also had an unfavourable impact on the economy with the long-term effect of the Civil War, which lasted for thirty years, and the most prevalent one: the Easter Sunday bombings. Internal security problems and the Covid pandemic have also negatively affected the tourism sector, which is the third largest source of foreign currency, as due to the pandemic less people were visiting the country and this was exacerbated by the bombing and the civil unrest. Furthermore, remittances formed a large part of the development and growth of the economy but decreased the value of the GNI development indicator as in the pandemic people were coming back to their home country due to structural unemployment worldwide when the global economy shut down. Together a drop in global demand leading to exports suffering, alongside a decrease in tourism and remittances all created a triple shock having an adverse effect on the economy. Simultaneously, these factors created a ‘twin deficit’ economy[4]. Due to the macroeconomic concept of automatic stabilisers occurring, the government were forced to increase their spending on welfare payments and on providing aid for those affected by Covid-19 and the Easter bombings.  Such additional outlays combined with dramatically decreasing tax revenues as more people fell into poverty resulted in a severe budget deficit. With the exports decreasing and ordinary Sri Lankans having less disposable income to be able to afford imports, the country had to face a substantial current account deficit4. This ‘twin deficit’ meant that the government was losing valuable revenue which could be used to service and pay off its existing debt which then triggered the beginning of the debt crisis. 

It can be also plausibly argued that one of the possible root causes of the debt crisis was the nature of Sri Lanka’s sovereign bonds. Being a middle-income country, Sri Lanka is able to issue bonds on the capital market because the markets see it as rich enough to be able to make the interest payments and to eventually repay or refinance the bond. Yet investing into developing countries comes with a great risk, especially if the bond is not linked to an asset or a specific project. In order to compensate for such risk and to attract sufficient amount of interested investors, Sri Lanka has to borrow at a comparatively higher interest rate than more developed countries such as the UK to compensate for such higher risk. Based on data published by the World Bank, private lenders make up 46% of the debt repayments with another 30% going towards multilateral institutions[5]. Sri Lanka’s debt to GDP ratio has always been high with levels in the 1990s bordering similar levels to those in 2022, however, the difference is that a greater proportion of its external debt comes from the capital markets[6] A large portion of bonds issued since 2017 were purchased by investors from the West. Due to quantitative easing in Europe and countries such as the UK or USA, the investors had access to relatively cheap funding. Given the historically low interest rates in the western countries, those western investors turned to Sri Lanka in search of higher returns. As most of these bonds were issued in the international capital markets and denominated in US dollars, this left the country vulnerable to interest rate rises in the US. With historical pace of the US interest rate hikes starting in 2022, the amount of money the country had to pay back to its lenders has been dramatically increasing. This debt burden was further exacerbated by the country’s infatuation with servicing its debts instead of focusing on spending on the essential services to maintain the social welfare of the citizens. The public finance squeeze and the escalating cost of debt funding resulted in the Sri Lankan government opening talks with China, seeking the opportunity to either refinance its existing debt or borrow more money instead of trying to restructure the existing debt with the incumbent creditors. Arguably, this occurred due to Sri Lanka’s close relations with China, at the back of Chinese substantial infrastructure investments such as the construction of a new airport, Hambantota port, motorways, and factories.  China also provided 4.2 million US dollars’ worth of security equipment and during the pandemic. In addition, they supplied Sri Lanka with 26 million doses of vaccines, adding further debt to the bonds funded by China contributing to the increase of the overall debt[7] Despite these loans being greatly beneficial to Sri Lanka’s socioeconomic situation, arguably China exploited their relationship by taking ownership of some the infrastructure project when Sri Lanka was struggling to repay the previous loans China had granted them. Yet, most importantly, once the Sri Lankan government realised that their foreign exchange reserves were dangerously low and that they were running out of money, they decided to borrow new loans from China in order to finance their existing interest payments coming due. This step however placed them in an even worse position as the size of the country’s total debt just kept growing. The government turned to China in a desperate attempt to save the country from restructuring its debts as any sign of Sri Lanka defaulting on its debt obligation would result in the foreign investors losing their confidence in Sri Lanka’s ability to service their debt burden and subsequent material increase in the cost of their borrowing. This first payment in 2020 can be seen as the catalyst for the demise of the economy as it entered Chinas ‘debt trap’.[8]Yet arguably, the initial response from the government of not initially going to the IMF for aid meant that it was behind on some of the conditions needed for the IMF to provide them with financial help. This included implementing austerity measures (which only occurred later on) , not privatising certain companies and refusing to  implement many economic liberalization policies. In addition, many Sri Lankan NGOS believed that the solution the IMF posed was one that was at the detriment to society.[9] The IMF very much provides a neoclassical and neoliberal approach, so their policies put the lenders first instead of the population. Opponents contest that the negative consequences of the poor macroeconomic situation in the country on the people such as lower quality education is overlooked, and this is not fair. With rich investors subsequently pulling out of their deals, the country faces more unemployment, a decrease in output and a current account deficit which is not solved by money from the IMF going straight to repay private lenders.

Evidently, the poorly executed decisions made by the government were key contributing factors to the crisis. In addition, the dynastic politics has gripped the country since 2004 as the Rajapaksa family have dominated the Sri Lankan government with them assuming full control in 2019. Gotabaya Rajapaksa became president with his brother, Mahinda, becoming prime minister. Commentators believed Rajapaksa to be a despot, despite him being democratically elected, due to his brash actions with little regard for the people. To begin with, the government drastically cut income tax for the highest bracket of income earners and decreased the value added tax by 6%.[10]These tax cuts were not in line with the IMF policy ultimately forming one of the reasons why the institution refused to help the country any earlier. The government also made the decision in April 2021 to halt imports of chemical fertilisers as they aimed to make Sri Lanka self-sufficient, promoting a toxin free diet for its citizens. Yet due to the abrupt nature of the policy, this left many farmers struggling to quickly obtain organic fertiliser to maintain their crops leading to a decrease in output resulting in food prices greatly increasing and social discontent became rife. This led to exports decreasing and a recessional pattern in growth emerged. Alongside this, a kleptocratic government was running the country with subcontractors on large infrastructure projects were pocketing the money and the president refusing to invest into current expenditure having a profound impact on Sri Lankan’s lives. There have been multiple scandals which primarily involve bribery such as the wife of the former CEO of Sri Lankan airlines allegedly accepting a bribe of 2 million dollars from the French company Airbus so that she could influence the company into buying 10 aircraft from their company in 2013.[11]Yet as the airlines were already in severe debt, they had to cancel the purchases causing a fallout of almost 17 billion rupees. As the business is state owned, this payment therefore contributed to the national debt value, causing the country to fall into further financial ruin. This was invaluable funding, wasted by the government, which could have been spent on improving socio-economic issues the country faced such as extreme poverty and poor levels of healthcare. Evidently, political mismanagement has had a key role to play in the causation of the debt crisis with the governments decisions ultimately dictating the economic position of the country.

In mid-2022 the government eventually received an emergency loan from the IMF based on conditions which led to an abrupt devaluation of the local currency causing fuel and food prices to rise significantly. This created an adverse impact on the daily lives of the people as wages stagnated and the cost of living increased. The plan also fell short of ensuring that Sri Lanka’s debt was sustainable but rather aimed at bringing down external and domestic debt, with external debt being the primary cause of the crisis[12]. Yet a more pressing issue persists that currently there is no comprehensive place in which a country can restructure its sovereign debt in one procedure. Instead, countries are made subject to various ‘trial and error’ plans created by the IMF.A recent example is Sri Lanka’s revenue budget forecast for 2024 which contains unrealistic predictions for the year, with plans with plans to cut vital public spending and privatisation of energy and telecoms firms.[13] Evidently, the IMF focuses on paying back the creditors instead of also considering the population of the struggling country. Therefore, to bring about great improvements in the economy of Sri Lanka, drastic changes must be imposed by the government and IMF on the economy. They should solely focus on improving the lives of the people, rather than making them worse off during attempts to foster growth.[14]

As it stands Sri Lanka’s aims for the next year are to introduce economic liberalization policies in the hope to nurture an increase in investment and ensure sustainable growth to ease the consequences of the crisis. Yet there is still much to be done for the country to fully recover from the depletion of its foreign exchange reserves and large debt to GDP ratio. On balance, there are multiple causes which all feed off each other to form the crisis. Yet the underlying cause of the debt crisis was the maturing sovereign bonds which left the country with large payments that the country struggled to pay off with its spiralling GDP figure and the volume of these sovereign bonds they had issued in a short space of time. However, one factor, alongside this, that made the situation turn from one of the countries struggling to pay their debts to a fully-fledged debt crisis, the fall-out from the Covid-19 pandemic. The nature of their borrowing wiped away chance of Sri Lanka being able to maintain foreign exchange reserves, with the Covid-19 being posed as the catalyst for the crisis as it exacerbated existing issues as well as creating new ones, leading to the economic deterioration of the country.  

[1] Lakshman, W. D. “The IMF-World Bank Intervention in Sri Lankan Economic Policy: Historical Trends and Patterns.” Social Scientist, vol. 13, no. 2

[2] World Bank data indicator, Current account balance in US$-Sri Lanka,1975-2022

[3] Trading economics, Sri Lanka foreign exchange reserves indicator,2020-2024

[4] European Parliamentary research institute, Ulrich Jochheim, Members' Research Service, May 2022

[5]Rema-Chandra Athukorala, UNDP Regional Bureau for Asia and the Pacific,The Sovereign debt crisis in Sri Lanka: Causes, policy, response and prospects, August 2022,p15-16

[6] Bram Nicholas and Shiran Illanperuma, The Diplomat ‘The real cause of Sri Lanka’s debt trap’,May 2023

[7] C. P. Chandrasekhar, Jayati Ghosh and Debamanyu Das, Paying with Austerity: The Debt Crisis and Restructuring in Sri Lanka,PERI, December 2023,P29-30

[8] Singh, Saurabh. (2020). China's strategic relations with Sri Lanka via researchgate,p2-4

[9] IPE,CSO and TU’s reject cosmetic consultations of IMF,19/03/24

[10] IPE,CSO and TU’s reject cosmetic consultations of IMF,19/03/24

[11] Reuters, ’Sri Lanka to probe graft allegations over airbus deal’, February 3 2020

[12] C. P. Chandrasekhar, Jayati Ghosh and Debamanyu Das, Paying with Austerity: The Debt Crisis and Restructuring in Sri Lanka,PERI, December 2023,P30-32

[13] Eurodad, Mark Perera,’We can Work it out:10 civil society principles for sovereign debt resolution, September 2019

[14] Debt justice, Sri Lanka debt crisis statement, January 2023, p2