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What’s behind Sri Lanka’s crippling debt crisis?

Sri Lanka is undergoing a large-scale economic collapse and political crisis, with every chance of further violent unrest. Last week, the Speaker of Parliament warned of an impending hunger crisis. This week ‘new’ prime minister Ranil Wickremesinghe, a septuagenarian in his fifth term as prime minister since the 1990s, warned the country was running out of gas and desperately needed $75 million in foreign currency to pay for essential imports to avoid social collapse.

For months, the government of President Gotabaya Rajapaksa has struggled to cope with an inflationary spiral and a lack of foreign exchange reserves that has led to shortages of food, fuel and medicine, and repeated power cuts. In recent weeks, public anger has spilled over into the streets. There have been several cabinet reshuffles and unsuccessful attempts to form a government of national unity.

But so far Rajapaksa has hung on – albeit without a fully functioning government – ​​partly because the opposition is unwilling to fix its mess.

What caused the crisis?

A mixture of long-term factors and short-term triggers. Sri Lanka’s economy has long been dominated by export-oriented crops and, more recently, by the garment industry. Its economy is therefore highly vulnerable to global economic downturns and external shocks, with declining exports leading to regular balance of payments crises from the mid-1960s.

Yet so far, after independence, Sri Lanka has never defaulted on its sovereign debt and has been relatively successful by South Asian standards.

What went wrong?

Gotabaya Rajapaksa comes from one of Sri Lanka’s dominant political families whose influence dates back to the 1930s. In 2005, Mahinda Rajapaksa, Gotabaya’s brother, was elected president, and many other family members have since held positions of responsibility.

Even before the Rajapaksas took power, “financial problems were brewing,” Karl Schultz told Bloomberg. During the family’s first term (during the presidency of Gotabaya’s brother, Mahinda, in 2005-2015), the government took out large loans from China to invest in infrastructure projects. But many of them have stalled, and external debt has more than doubled between 2010 and 2020.

Things got worse from 2019, due to a combination of terrible luck and disastrous political decisions. In April that year, Sri Lanka’s thriving $4.4 billion tourism sector was hit hard by a series of church bombings that killed nearly 300 people, including foreign nationals. .

What was the effect?

Tourism collapsed by up to 80%, then the following spring the pandemic hit, making any recovery impossible. Together, these coups would have defied any government. But the Rajapaksas have proven unequal to the task. Gotabaya Rajapaksa was popular for ending the 26-year civil war as head of the defense ministry in 2009 when Mahinda was president.

Although accused of war crimes in the fight against the Tamil Tigers – and of corruption – he was elected by an overwhelming majority in 2019 on a security-focused platform following the attacks. He then brought back Mahinda as prime minister, along with several other relatives as ministers. But “unlimited authority seems to have gone to the heads of the Rajapaksas,” says The Economist.

What did the Rajapaksas do wrong?

First, they immediately imposed massive but unaffordable tax cuts that seriously weakened government finances, despite warnings that they were recklessly dangerous. They then failed to reverse the trend as the pandemic brought tourism to a halt, downgrades closed the door to new borrowing and foreign exchange reserves dwindled.

Then, with the rapidly deteriorating economy and fiscal situation, in April 2021, the Rajapaksas banned the use of chemical fertilizers to try to save money. The predictable result was chaos and a fall in rice production of between a quarter and a third – and an even bigger collapse for tea, a key export earner.

Although the ban was lifted in November, the damage was done – accelerating the inflationary spiral that was aggravated this spring by the commodity boom following Russia’s attack on Ukraine.

What will happen now?

A formal default looks imminent, and the government’s chances of hanging on seem slim. “This time the threat to the survival of the Rajapaksas is real,” political commentator Kusal Perera told the Financial Times. “They want someone to take over to spread that heat and, after a while, negotiate a way out for them.”

The country must pay $8 billion this year in debt repayments and interest on a $50 billion external debt. But its foreign exchange reserves have now fallen to a few tens of millions of dollars – effectively nothing – leading it to suspend payments last month and start talks with the IMF on a new bailout package.

The government is also seeking new bilateral loans from the United States, China and Japan. Sri Lanka is the “first country to give in” under the growing pressure of the “three-pronged” global crisis, says Larry Elliott in The Guardian – namely, the pandemic, the rising cost of debt and the sharp rise food, fuel and fertilizer prices caused by Russia’s invasion of Ukraine. It’s the first, but it’s unlikely to be the last.

Where’s the next one?

The list is “long and varied,” says Elliott. The trade and development arm of the UN, UNCTAD, recently assessed that 69 countries are currently facing a triple whammy of shocks in the form of rising food prices, rising oil prices, energy and tighter financial conditions.

Of these, 25 nations are in Africa, 25 in Asia and the Pacific, and 19 in Latin America and the Pacific. The IMF has so far opened bailout talks with Egypt and Tunisia – two major wheat importers – and with Pakistan, which has imposed power cuts due to the high cost of imported energy. .

Sub-Saharan African countries at risk are Ghana, Kenya, South Africa and Ethiopia. Argentina recently signed a $45 billion debt deal with the IMF, and other Latin American countries at risk include El Salvador and Peru.