“We have lost the ability to repay foreign debt. It has come to a point that making debt payments are challenging and impossible.” - Central Bank Governor Dr. Nandalal Weerasinghe

On 12th April, a mere two days before the Sinhala and Tamil New Year, the Sri Lankan government announced that it will suspend foreign debt repayments and restructure debt with the support of the International Monetary Fund (IMF). Dr. Nandalal Weerasinghe, the Governor of Central Bank of Sri Lanka (CBSL), and the newly-appointed Secretary to the Treasury, K.M.M Siriwardane termed this as a ‘pre-emptive negotiated default’ pending debt restructuring along with the support of the IMF. In a layperson’s terms, this means that Sri Lanka has currently paused repaying its foreign loans, and will require more time to complete payments.

This is the first time a Sri Lankan government has defaulted on debt repayment since independence. In other words, this is Sri Lanka’s first Sovereign Default. Our island nation has never been in a mess like this, and there is no easy way out.

But how did we end up here? and why is our only alternative IMF assistance?

In our previous analyses, we outlined our economy’s structural weaknesses, and how Sri Lanka’s foreign debt stock kept soaring. For many economists, it was clear that sovereign default, debt restructuring and IMF bailout were on the cards, and that the country will face several difficult years ahead.

We have to remember that foreign debts need to be repaid in foreign currency — generally, in USD. Our ability to repay these debts largely depends on our capacity to earn foreign currency (which is where we are lacking) largely due to low exports. The fewer foreign currency earnings a country has, the more difficult it is to repay foreign debt.

Now that Sri Lanka suspended most of its foreign loan repayments, we can use most of its foreign reserves to pay for essential imports; as opposed to trying to do both: paying for imports, and paying off foreign loans. If we try to repay foreign loans when foreign currency reserves are low, there’s not much left available to import goods. This in turn forces countries to cut down on imports.

Why is this crisis unprecedented?

The current economic crisis is unprecedented due to a few reasons.

Firstly, Sri Lanka was unable to borrow from international capital markets through issuing International Sovereign Bonds (ISBs) after April 2019, due to constant downgrading of Sri Lanka’s credit ratings. This made it extremely difficult to repay ISBs maturing in 2020-2022. Issuing new ISBs became a difficult task subsequent to a downgrade of Sri Lanka’s credit ratings in late 2019 caused by tax cuts provided by then-newly elected President Gotabaya in late 2019. This credit downgrade then was followed by a series of downgrades in response to the adverse macroeconomic implications of COVID-19 which made it impossible to issue ISBs. That in turn restricted Sri Lanka’s ability to borrow foreign currency (USD in this case, the most needed foreign currency for Sri Lanka).

ISBs are commercial borrowings that are not tied to a project. This means the government has complete liberty concerning how it wants to spend the money. The government also receives the entire amount of the requested loan in one go. ISBs are also costlier than project loans.

Why are these credit ratings such a big deal?

Credit ratings of a country are an indication of the country’s ability to repay loans. Therefore, a downgrade of such a rating implies a deterioration of the ability to repay loans. Lower the credit ratings are, lower the ability to repay loans.

In the case of Sri Lanka, rating agencies warned that tax cuts provided in 2019 would create a significant revenue loss, which in turn would reduce Sri Lanka’s ability to make foreign loan repayments. By 2020, Sri Lanka already had a high budget deficit (government expenditure exceeds government revenue) and further tax cut means a further reduction of tax revenue, resulting in an even higher budget deficit. This compelled the government to borrow more and more, without having a substantial revenue increase.

As one can see this is a serious macroeconomic concern — one which led to a credit rating downgrade.

This credit rating downgrade is worrIsome, as the country already has a very high external debt servicing ratio (a large portion of export earnings is spent on repaying foreign loans), and is required to make more than USD 4 billion of foreign debt repayment every year, beginning from 2020. More importantly, starting from 2020, Sri Lanka had ISB maturities over USD 1 billion due every year. Settling these ISBs requires repaying the principal amount in one go — also meaning that Sri Lanka needs to have enough foreign currency to pay off the ISBs. The usual way of settling existing ISBs has been to increase foreign currency reserves through issuing new ISBs — because unlike other loans, ISB money is not tied to a project, and the government is at its liberty to use it however it so wishes — and using such foreign currency from reserves to repay ISBs. This is called refinancing, or roll-over of debt. If it sounds like taking one loan to repay another, that is correct; that’s how capital markets work. Treasury bonds and Treasury Bills also work in the same way.

For Sri Lanka, the option of refinancing became unavailable as the country was unable to issue new ISBs since 2020 (note that Sri  Lanka issued its last ISB in 2019 April) as the country’s credit ratings was constantly downgraded. The go-to method of settling ISBs was no longer an option. This is a problem because Sri Lanka has ISB maturities running up to 2030; and being unable to settle this pushed our economy into deeper troubles as the country was at a high risk of defaulting on debt.

It’s noteworthy to remember that pre-2007, Sri Lanka did not have ISBs, and thus never had to encounter such a gigantic challenge in repaying foreign loans.

Data shows that throughout 2020-2025, debt repayments of ISBs amount to approximately 50% of total foreign debt repayments of the government.

Sri Lankan Government Foreign Debt Repayments - Amounts in USD Million

*Note: From 2022-2025, amounts are estimates

Source: External Resource Department through RTI requests - Data includes State-Owned Enterprises loans obtained by Treasury and excludes Sri Lanka Development Bonds (SLDBs)*

Secondly, as COVID-19 hit the globe, Sri Lanka's tourism industry collapsed entirely. Tourists bring foreign currency and largely exchange those foreign currencies through banks. The absence of tourist arrivals resulted in approximately USD 4 billion reductions in foreign currency inflows per year. Tourism earnings reduced from USD 3.6 billion in 2019 to USD 700 million in 2020. Tourism earnings further plummeted in 2021 to USD 260 million. During 2017-2020, tourism earnings amounted to approximately 15% of the country’s total foreign currency earnings; making it the third largest contributor of foreign currency earnings to Sri Lanka. During 2017-2019, earnings from exporting goods and other services amounted to 60% of total foreign currency earnings, while workers’ remittences amounted to approximately 35%.

Now, put these two together. Losing the ability to borrow in foreign currency through issuing ISBs and loss of foreign currency inflows due to the adverse impacts on tourism was a double blow to the economy. While the foreign currency earnings had reduced approximately by 30% in 2020 (in comparison to 2019), Sri Lanka lost access to the most convenient option to borrow USD to match the foreign financing gap.

During 2017-2020 Sri Lanka issued ISBs worth USD 7 billion. If you look at the debt repayment needs, it is clear that Sri Lanka needed to issue ISBs worth 1.5-2 billion every year to meet debt repayment needs. As pointed out before, as a result of the plunging foreign currency inflows to the tourism industry, Sri Lanka lost approximately USD 3.5-4 billion foreign currency earnings annually. This means, Sri Lanka’s annual foreign currency inflows (including inflows through foreign borrowings) were reduced by approximately USD 5-6 billion. Such an amount is of course minute for countries with large economies, like the USA or China - but for Sri Lanka it is quite a big amount.

After 2020, Sri Lanka’s foreign currency financing gap significantly increased without a feasible option to borrow from international capital markets. In such circumstances, the sensible option is to acknowledge that the country cannot repay the foreign loans and seek the assistance of IMF and restructure debt. The government opted to not do this.

Why going to the IMF, and restructuring debt was the sensible option

Debt restructuring means to change the debt’s repayment schedule, and postpone repayment by a few years. This is often accompanied with reduction of debt obligations which is often referred as a ‘haircut’ (If you owe USD 100 million and your creditor agree’s to a 10% ‘haircut’, that means that you get to pay USD 90 million instead). By doing this, a country can reduce the debt repayment burden as it reduces the government expenditure and foreign currency outflow.

For Sri Lanka’s lenders, debt restructuring within Sri Lanka can cause losses. In order to agree with Sri Lanka to restructure debt, the lenders need assurance that they will receive their payments, albeit belatedly. This assurance is hard to come by in a country like Sri Lanka, which has a poor track record of managing public finance. However, entering a programme with the IMF gives the country credibility; that public finances will be managed with caution, and that they will, surely, be able to repay loans in time. Once we sign up for an IMF programme, the IMF will constantly review our public finance management — in other words, the IMF programme(s) will urge the country to meet certain targets in terms of tax revenue, budget deficits, and several other macroeconomic indicators; along with calling for certain reforms to meet these targets. These reforms often includes tax changes, reducing non-essential government expenditure, and introducing a fuel pricing formula. With such commitments, international creditors (Banks and other institutions which lent to Sri Lanka), are likely to develop their confidence about Sri  Lanka’s ability to repay loans. Building confidence this way also allows Sri Lanka to obtain more loans, as worries about defaulting weakens.

Furthermore, once a country enters into an IMF program, that respective country receives a short-term loan to strengthen foreign currency reserves. A loan like this from the IMF would provide much-needed foreign currency inflows. This will help reduce our foreign currency shortage, and allow the country to pay for imports without disruption.

Entering into an IMF program is a process. In the case of Sri Lanka, subsequent to initial discussion rounds starting on 18th April, the Government of Sri Lanka (GoSL) will have to submit a Letter of Intent to the IMF, outlining the country's commitments toward economic stability. Interestingly though the previous Letters of Intent sent by Sri Lanka in 2009 and 2016 outlines the government's commitments to increase tax revenue, reduce tax exemptions, reduce non-essential government expenditure and introduce pricing formulas for fuel and electricity. Some of these pledged reforms — like the fuel pricing formula introduced in 2018, and tax reforms in 2017 — were carried out, but were short-lived due to regime changes. Others were ignored or forgotten. In the cases of a few others, the exact opposite was implemented; like how the government provided a number of tax concessions under the Strategic Development Projects Act, despite promising to reduce tax concessions in 2009.

These reforms suggested by the IMF or ‘conditions’ of IMF lending are often referred to as ‘structural reforms’ — meaning, changes in how the government works. As pointed out before, such reforms often include the tax changes, relaxation of business regulations, changes in the way in which exchange rate is determined, adoption of fuel and electricity pricing formulas, reducing government expenditure, and many other changes. The need to carry out these reforms is often emphasized in IMF staff reports to Sri Lanka and the IMF reviews regarding the programs with Sri Lanka. Since becoming a member of the IMF in 1950, Sri Lanka sought IMF’s assistance 16 times. While this is the 17th time seeking assistance, this is the first time we’ve requested help specifically to restructure debt.

A bit about imports and restrictions

For some reason, the government opted to avoid restructuring debt and seeking IMF assistance in both 2020 and 2021. Instead of reducing foreign currency outflows through restructuring debt, they instead focused on reducing imports to curtail foreign currency outflows.

This was a tricky path to take in the medium term, because there were a few issues with this particular strategy. Over 50% of Sri Lanka’s imports are intermediary goods - meaning that our production is heavily dependent on imports. Restricting these imports inevitably results in reduced capacity to produce, and then a decline in exports. Other imports were food items (such as milk powder) and electronics, like phones and computers. Cutting down these imports is almost impossible given the importance of such products to day-today life.

There was another reason why it was difficult to address foreign currency shortages through curtailing imports. Towards the end of 2020, global price levels of most goods started to increase significantly. This was made worse by the rapid increase in shipping rates. Consequently, import costs increased in 2021, even when the number of imports reduced. The prices of imported goods increased, but businesses were able to continue importing because of Sri Lanka’s low interest rates - they simply borrowed the necessary cash, and went about importing goods. Furthermore, the Central Bank kept providing loans to the government which increased money stocks in the economy. More money circulated in the economy resulting in a higher level of consumption and production. As noted before, most of the consumption and production in Sri Lanka are dependent on imports. This made it difficult for the government to curtail import expenditure, which in turn resulted in the government failing to reduce foreign currency outflow.

It is likely that the government’s anticipation of reducing import bills stems from the significant reduction in import bills in 2020. In comparison to 2019, the import bill reduced by 20% in 2021. In numerical terms, the reduction was USD 3.9 billion.

The government possibly assumed that this trend would continue, and Sri Lanka would be able to manage its foreign currency shortage by reducing the import bill. An important fact was that approximately one-third of import bill reduction was a direct result of reduced fuel import expenditure as fuel import expenditure declined by USD 1.35 billion in 2020. This reduction was due to low fuel prices in global market and long-lasting lockdowns to curb COVID-19. It was foolish to think that Sri Lanka would be able to save foreign currency through fuel imports in 2021; in which year, our fuel import cost increased by approximately USD 1.2 billion, almost reaching the fuel import cost in 2019. In spite of import restrictions, imports increased by USD 4.6 billion in 2021, largely because of the rise of global prices, increased shipping costs, and increased demand for consumer items like mobile phones and computers. On the other hand, exports only grew by USD 2.5 billion in 2021 — making country’s foreign currency outflows grow faster than the inflows. As we noted before, Sri Lanka did not have the luxury of obtaining foreign currency through issuing ISBs and bridging the foreign currency deficit.

That left the country with only one dangerous option - which was to utilize the available foreign currency reserves to pay for imports, and repay foreign debt, all while ignoring the risk of running out of foreign reserves. CBSL opted to use this option.

As a result of this, Sri Lanka’s usable foreign reserves depleted from USD 6.5 billion recorded in 2020 January, to approximately USD 150 million by the end of March 2022.

Using our foreign currency reserves was not a sustainable option, given Sri Lanka’s massive foreign debt repayment obligations. To make this strategy work even in the short term, the government had to introduce some adverse policy changes.

Two of these major policy changes were (a) the ban on fertilizer imports and (b) maintaining a fixed exchange rate regime. Both of these policy changes only made matters worse.

The fertilizer ban adversely affected Sri Lanka’s food production, and resulted in a food shortage and price hikes. Adopting the fixed exchange rate caused a significant growth in the grey market to exchange foreign currency; as banks were compelled to provide a lesser amount of rupees per dollar. People opted for unofficial foreign currency exchange channels which offered higher rates for foreign currencies. This resulted in a significant drop in workers’ remittances as earnings were not sent to Sri Lanka’s banking system. In 2021, workers’ remittances declined by approximately USD 2 billion compared to the remittances received in 2020. This in turn caused a further depreciation of foreign currency reserves.

At the start of 2022, Sri  Lanka was in a position where the government and CBSL were required to decide whether to use available limited foreign currency reserves to pay for essential imports or to repay foreign loans. In January, CBSL was adamant that the country can continue to repay foreign loans and took measures to settle an ISB of USD 500 million.

“Sri Lanka has paid the USD 500 million sovereign bond that matured today.” Former Central Bank governor Ajith Cabraal, on 18 Jan 2022.

@an_cabraal should be arrested & held accountable for this mess.#lka #SriLankaCrisis #GoHomeRajapakshas #GoHomeGota2022 #SriLankaEconomicCrisis pic.twitter.com/lOBM4Azr57

— Seelan (@Seelan92) April 14, 2022

Sri Lanka’s Foreign Currency Reserves and Foreign Debt Repayments

As foreign currency reserves fell, the government struggled to pay for fuel imports, which resulted in a fuel shortage. As the fuel shortage worsened, the Ceylon Electricity Board (CEB) struggled to generate sufficient electricity as a significant percentage of Sri Lanka’s electricity supply is generated using fuel.

What next?

As a result of foreign currency reserves almost hitting zero, Sri Lanka finally defaulted its foreign debt repayments. This default is not going to make the situation worse — nor will it make things better immediately. This is just one initial but crucial step of a long process to get out of this unprecedented economic crisis. Shortages will continue for a while. Prices will remain high. But this ‘pre-emptive default’ ensures that our economy will not crash, that we will have enough cash for electricity in the medium term, and that we will not end up having complete blackouts for days on end.

The Sri Lankan team will start discussions with the IMF on 18 April, which will allow Sri Lanka to obtain financial support, most likely through an Extended Fund Facility (EFF). This will provide the necessary foreign currency in the short term to finance imports. With clearly indicated commitments to restructure debt, enter into an IMF program, and cut back government expenditure, SL will be able to obtain foreign loans to import essentials and provide social transfers from multilateral agencies such as the World Bank, and countries like the USA, China and India. However, these processes also takes time; and given our very low level of foreign reserves, shortages are likely to continue in near term. Therefore, expediting bridging financing remains a key priority to avoid shortages and provide support to vulnerable groups.

What the IMF program means and how it will play out is a long story. That will be left for our next article.

Appendix

Sri Lanka’s Foreign Currency Reserves and Foreign Debt Repayments