In May 2022, Sri Lanka was declared to be in default on payments against external borrowings that were due on April 18. Despite six months having passed since that date, uncertainty surrounds the path that debt restructuring, if successful, will take. Meanwhile, the economy remains stuck in a deep trough, and large sections of the population are being pushed into extreme poverty.

With foreign exchange needed for the import of essentials (from fuel to food and medicines) in short supply, shortages spell physical deprivation. Inflation runs at 70 per cent, pushing the cost of living for many beyond limited earnings and/or meagre savings. And well before austerity measures to satisfy the International Monetary Fund (IMF) are put in place, the economy is shrinking, with the gross domestic product (GDP) having fallen by 8.4 per cent in the three months ended June 2022, compared with the corresponding previous period. Meanwhile, in lieu of a speedy resolution of this devastating crisis, which triggered a mass revolt that brought down the Gotabaya Rajapaksa government, Sri Lankans have now been offered an unconvincing solution of how things can be improved. At the centre of that is an effort by the IMF to make almost nothing look like something.

IMF prescription

On September 1, an IMF delegation that visited the island came to a staff-level understanding to provide the government a financing package totalling $2.9 billion over four years.

Even assuming that flows of a significant share of this money are front-loaded, the “assistance” by itself can do very little to resolve the crisis. The government estimated in June that it would need around $5 billion to finance essential imports over six months. The IMF’s support cannot help with that, and will contribute at most to a temporary improvement in the country’s foreign reserves position.

Moreover, the IMF staff-level agreement has yet to go through the organisation’s board and is likely to receive support only if other creditors agree to a plan that ensures “restructuring” and “rescheduling” of Sri Lankan debt in ways that render it sustainable.

In practice, restructuring refers to a combination of debt write-offs, easing of debt terms, and the provision of new money on concessional terms that can meet the foreign financing needed to support imports and service debt. Coming to an agreement on some such combination is a tough call, though imperative, given the actors involved.

As at the end of 2020, Sri Lanka’s long-term external debt stock outstanding was around $46 billion, of which 20 per cent was owed to multilateral institutions such as the World Bank and the Asian Development Bank (ADB), 36.6 per cent to private creditors, and around 24 per cent to bilateral creditors.

In sum, it is not just bilateral creditor governments providing credit to advance “strategic” objectives that are responsible for accommodating unsustainable demands for credit from the Sri Lankan government. Multilateral institutions have contributed a chunk.

And, in the thirst for deriving high yields by deploying the cheap liquidity that central banks have poured into the world economy since the global financial crisis, private financial agents too have bought into Sri Lankan debt, without exercising due diligence. All of them, besides the corrupt governments that are routinely named, have played a role in precipitating the crisis.

Dealing with debt

The resulting combination of creditors only makes the task of dealing with debt stress difficult. It has become accepted practice that multilateral agencies, while willing to provide additional credit to address a crisis, will not take a haircut or write off part of the debt owed to them, as that would damage their credit ratings in markets from which they have to borrow to execute their “developmental” role.

This is unfortunate since these institutions can be persuaded to do the needful by the governments that control them. But exercising that option when resolving debt has been precluded by the privileged position granted to these lenders.

This is true of the IMF as well, which is also culpable in Sri Lanka’s crisis. It has accommodated Sri Lanka with balance of payments support on 16 previous occasions. And, through the conditions it attached to those lines of credit, it has had a significant influence on Sri Lanka’s economic policies. Those policies were central to shaping the economic structure that has proven inadequate to ensure balance of payments stability or help withstand shocks of the kind following the pandemic or the Ukraine war.

The second group that is difficult to bring to the table to contribute to crisis resolution consists of private creditors, whose share in total credit has been rising across emerging markets and has soared in Sri Lanka in recent years. Dispersed bondholders accounted for almost 31 per cent of the stock of long-term external debt at the end of 2020.

Even if some among them think that it is best to take losses and exit in a situation of severe crisis, as is true in Sri Lanka’s case, the process runs into obstacles because of the holdouts who want to maximise their gains. In Sri Lanka’s case, one such creditor, Hamilton Reserve Bank, which holds more than $250 million of Sri Lanka’s 5.875 per cent International Sovereign Bonds that fell due on July 25, has filed a suit in a New York federal court seeking full payment of principal and interest.

Some of these holdouts often tend to be vulture funds that buy doubtful debt at a massive discount (Sri Lankan bonds are now selling at about 25 cents to a dollar) and push for full payment. Their demands are not open for negotiation.

To sidestep this obstacle, the international financial network, which in practice includes the IMF, is seeking a resolution in which private creditors are offered a reasonable exit deal. This should not come as a surprise. Advanced country governments have always worked to bail out private creditors from their jurisdictions when the latter are entangled in the debt of countries experiencing repayment difficulties.

If private creditors that did not exercise due diligence are to be let off lightly, the burden of the adjustment needed to ensure resolution has to be borne by governments in their role as bilateral creditors. Most western, advanced country bilateral creditors work together as the “Paris Club” to share some of the burden when resolving debt crises in poor countries.

Bilateral creditors

The difficulty in Sri Lanka’s case is that while most private creditors are from the advanced economies in the West, the bilateral creditors that matter most are from Asia, with middle-income countries like China and India, besides high-income Japan, being particularly significant.

Recognising this special circumstance, the global financial network and the governments of the advanced nations that support it have spun out a narrative in which Sri Lanka’s debt problem is seen as the result of the largesse of its Asian neighbours driven by strategic rather than economic considerations. The same strategic objectives are expected to push them to contribute disproportionately to resolution.

China, India, and Japan together account only for a fifth of Sri Lanka’s external debt, and China alone for around 10 per cent. They are by no means primary contributors to the debt that precipitated the crisis. But a large write-off on their part could perhaps be adequate to ensure successful resolution of the crisis and offer a reprieve to private creditors.

Not surprisingly, “Paris Club” creditors are reported to have approached China and India asking them to coordinate Sri Lanka’s debt-restructuring talks. If these countries assume leadership, they will be under pressure to ensure successful resolution and, hopefully, that will force them to take on a disproportionate share of the burden of adjustment.

The belief that such an arrangement can be worked out has been strengthened by the recent experience with the debt-restructuring exercise in Zambia. China, an important bilateral creditor, agreed to collaborate with “Paris Club” members and co-chair with France the committee of official creditors for Zambia. That led to an agreement that satisfied the IMF, which released a $1.3 billion Extended Financing Facility loan to be provided over 38 months.

The arrangement that has still to go through multiple steps before finalisation is the first instance of implementation of the Group of 20’s Common Framework for debt treatment. There is much hope that it will work and provide a blueprint for resolution elsewhere. If China can join the exercise in Zambia, it can be persuaded to do so in Sri Lanka as well, goes the argument. But Sri Lanka is not a low-income country and is therefore not eligible for Common Framework treatment.

Sri Lanka’s external debt, currently at more than $50 billion, is much larger than Zambia’s $17 billion. And a lot of Sri Lankan debt is owed to private creditors. There is a lot of difference between the two contexts and replicating the Zambian experiment in Sri Lanka will be difficult.

Moreover, even if some form of a rescheduling arrangement is worked out for Sri Lanka, the $2.9 billion to be released by the IMF will not come without conditions.

Among the conditions reportedly agreed to by the Ranil Wickremesinghe government are the adoption of tax and expenditure measures that guarantee a primary budgetary surplus of 2.3 per cent of GDP by 2025; price increases for fuel and electricity that ensure cost recovery in a context where international prices are rising and the domestic currency is depreciating; and a shift to a market-determined exchange rate that is likely to trigger a sharp depreciation of the currency, increasing the rupee costs of imports and the local currency burden associated with servicing debt.

In sum, austerity of a severe kind is being recommended as a way of restoring debt sustainability. That is unlikely to work, as past experience makes clear, and will hurt citizens already devastated by the debt crisis.

It may, however, be enough to convince profit-hungry financial investors to return to the country. But it will not put Sri Lanka on a trajectory where it will be safe from another debt crisis. The aim appears to be to kick the can down the road, giving global finance some respite to continue its predatory ways.

(C.P. Chandrasekhar taught for more than three decades at the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi. He is currently Senior Research Fellow at the Political Economy Research Institute, University of Massachusetts, Amherst. Courtesy: Frontline magazine.)