What must Sri Lanka do to avoid a second default in the near future?

A second default by Sri Lanka could be more devastating than Sri Lanka’s first default in 2022 

Past evidence shows that most countries that default on their external debt, have a history of defaulting once again within the next 10 years. Going by this data, there is a probability that Sri Lanka can default once again.

What will a second default look like?

A second default by Sri Lanka could be more devastating than Sri Lanka’s first default in 2022. In case of a second default Sri Lanka will have to go once again to the lender of last resort, the International Monetary Fund as a bankrupt nation. The conditions by the IMF if we default the second time will be much harsher and rightly so. The bilateral creditors and bondholders will also not be as kind if Sri Lanka goes for a second default. With harsher terms by the IMF, bilateral creditors and bondholders, Sri Lanka if it defaults again will have very little space to breathe. 

With seven million Sri Lankans (one third of the population) categorised as poor after our first default in 2022, the people have already been hit by a wave of austerity measures and their buffer to take another hit is not there anymore. A second default, will result in greater pressure on the Government at the time of the second default to sell state owned enterprises which can even lead to a firesale of resources. So, careful planning is needed to avoid a second default.

What should Sri Lanka do to avoid a second default?

Favourable debt restructuring – Firstly, in the short term, we need to negotiate a good deal with the creditors to get a larger debt relief. As Sri Lankan employees whose EPF funds were invested in Government treasury bonds which were considered safe and had already lost half the value of their money due to inflation were restructured, it is more than fair to ask for a larger haircut from the ISB bondholders. As multilateral debt is not restructured, Sri Lanka needs to negotiate a favourable debt deal with the bilaterals and especially with the bondholders who bought bonds with higher interest rates due to the risk premium which they knew before buying. 

Improving credit ratings – Secondly, we need to improve our credit ratings with better GDP growth, better debt management, good fiscal and monetary policies and political stability so our borrowing costs are cheaper. For example, Japan’s debt to GDP ratio is over 250% which is much higher than Sri Lanka’s which is around 115%. But Japan’s interest rate for a government 10 year bond is just 0.88%. Japan’s Government revenue to GDP was 37% in 2022. So, only 6% of Japan’s Government revenue goes for interest payments even though its debt to GDP ratio is over 250%. But Sri Lanka spent 70% of its Government revenue on interest payments in 2022 even though its debt to GDP is only at 115% because our Government revenue is extremely low (around 8% of GDP in 2022) and our credit ratings are poor making our borrowing costs much higher. Bringing down borrowing costs can make Sri Lanka’s debt more sustainable even if the total principal debt remains the same. 

Economic growth – Sri Lanka needs economic growth especially driven by the tradable sectors. For our economy to expand, we need to have more free trade agreements and improve our ease of doing business to attract export driven manufacturing and services investments. A number of other reforms are needed, like governance related reforms, land and labour reforms and digitisation to improve efficiency in government services. As I have argued in a paper I wrote for the IMF in 2022 which was voted one of the most read IMF articles in 2022, economic growth and innovation are directly related. Economies grow either with population increase, resources increase or with increasing productivity per person. 

As Sri Lanka’s population is aging and Sri Lanka has limited natural resources, it needs to innovate and improve its productivity and efficiency. Sri Lanka needs to spend much more on its education sector. States like Tamil Nadu and Karnataka in India are successful compared to the rest of India because they focused on education much earlier than other states. Sri Lanka needs to spend much more on its education sector, especially STEM education. For Sri Lanka to increase productivity and efficiency, it needs to innovate and research and development investment is needed. As far as R&D goes, Sri Lanka spends a very low amount compared to the global average. 

Greater economic partnership with India – A great opportunity for economic growth is greater economic integration with India. Sri Lankans look at Singapore and Dubai as examples of economic success but both Singapore and Dubai became economic powerhouses because they became the gateway to their regions. Singapore is the gateway to the ASEAN region and Dubai is the gateway to the oil rich Gulf region. India is the fastest growing major economy in the world and is set to be a $10 trillion dollar economy in the near future. Tamil Nadu, the state in India which is closest geographically, is the second most industrialised state in India and Tamil Nadu itself is expected to have a $1 trillion economy by 2034 according to Deloitte. Greater economic partnership with India can drive economic growth for Sri Lanka in the long term and it can attract greater Indian investment into Sri Lanka. 

Conclusion 

Sri Lanka needs to have long term planning and political consensus to ensure it does not default for the second time. A favourable debt restructuring is needed, borrowing costs need to be brought down by improving its credit ratings, economic growth driven by exports and greater integration with the regional economies can ensure a stable future for Sri Lanka.

(The writer is an Economist. He is a Consultant on Economic Policy at the Asian Development Bank. He is an Expert Member of the World Economic Forum and a regular Columnist for the International Monetary Fund on public finance management. He was a member of the Deloitte Global Economist Network. The views expressed in this article are strictly the writer’s own personal opinions.)