Sri Lanka: Historic sovereign debt default looming due to foreign currency debt payments being suspended

Event

The Sri Lankan government has come to the inevitable conclusion that it is no longer possible to ensure normal public debt servicing. On 12 April, amid a deep economic crisis and holding insufficient external liquidity to honour its challenging debt repayments this year, the Sri Lankan government announced a temporary moratorium on all of its foreign currency debt. Meanwhile, it offered to repay external public debt in (recently sharply devalued) Sri Lankan rupees. Colombo is discussing a new financial support programme with the IMF and is seeking preliminary debt rescheduling with its creditors, including private and bilateral creditors.

Impact

The economic crisis in Sri Lanka – which appeared already prior to the start of the Covid-19 pandemic – has deepened over the past two years amid tourism gloom and falling workers’ remittances. It has translated into a broad social, economic and political crisis. Faced with unsustainable public finances (cf. graph below), very high external financing needs and no market access, the government has been striving desperately to find the necessary funds among external creditors (the IMF excluded) to continue to honour its public debt servicing. 

However, the combination of dwindling foreign exchange reserves (reduced by two thirds compared to the level at the end of 2020) and government priority for external debt repayments, came at the cost of fuel and food shortages – and even medicine shortage now – and record inflation (at 18.7% in March 2022 – i.e. one of the highest in Asia).

In consequence, this has led to nationwide social unrest and growing anti-government protests, even among the Rajapaksa government’s popular base. As a result – and while it is still resisting resignation pressures – the government came to the only possible outcome: starting negotiations for a new IMF programme and announcing the suspension of all external debt payments for an undetermined period. This means that for the first time in its history, the country will soon default on its external debt. The aim of this last-resort decision is to save foreign currency and ensure imports of essential goods can proceed in a critical socio-economic context. Foreign exchange reserves remain indeed under sharp downward pressure and show import cover of barely a few weeks. This precarious liquidity situation might persist for some time, not only due to heightened import costs on the back of higher commodity prices related to the war in Ukraine, but also due to a potentially long period for finding a deal with the IMF and with external creditors. The president and government – dominated by the Rajapaksa dynasty – are indeed weakened by their very unstable positions, which will complicate negotiations with the IMF. Finding an orderly and comparable deal with notably private creditors and China could be tricky. In this context and considering austerity measures ahead, given the country’s deficient public finances, the economic, social and political instability risks are going to remain high. Hence, the short-term outlook is negative for both the ST and MLT political risk ratings.

Analyst: Raphaël Cecchi – r.cecchi@credendo.com