Sri Lanka: the canary in the mine that warns of what is coming on top of emerging countries

Running the Ministry of Finance in Sri Lanka might be the least coveted job in the world right now. The island’s government defaulted on a public debt payment of 12,000 million dollars in April, registered year-on-year inflation of 54.6% in June, and suffers constant blackouts due to the lack of foreign currency to import hydrocarbons. As if that wasn’t enough, the last rice crop has collapsed this year following an untimely ban (later lifted) on the use of chemical fertilisers.

A combination of shortcomings that worries Unicef ​​because of the risk to the nutrition of Sri Lankan children. According to estimates by the United Nations agency for children, so far in 2022 two out of three families have been forced to reduce their food consumption in this country of 22 million inhabitants where cooking gas is scarce. An economic crisis that has inevitably become political: after a first block resignation of ministers in April (among them, the head of Economy), and in the midst of massive protests throughout the country, its president Gotabaya Rajapaksa announced last Sunday that he was leaving too.

According to Mick Moore, from the British think tank International Center for Tax and Development, one of the main reasons why the Sri Lankan economy is today on the ropes is the gigantic tax reduction approved in November 2019 by Rajapaksa, his brother. younger Basil Rajapaksa (was the Minister of Finance), and his older brother Mahinda Rajapaksa (was the Prime Minister). “When Sri Lanka decided to cut taxes by 30%, it was already a country with very low taxation, it collected approximately 10% of GDP, when the normal for an economy of that size is 20%”, says the expert from the center of British studies.

Of those days, Moore remembers the immediate downward reaction of the bond market, which “understood that the loans could not be fulfilled.” “When the pandemic arrived a few months later, the Government could have recovered the previous level of taxation, reduced public investment, or admitted the impossibility of paying its debts, but it did not do any of the three,” says Moore, who blames the mismanagement to the incompetence and arrogance of the Rajapaksa after decades dividing up high government positions.

Between the drop in tourists due to covid, insufficient collection, and the rise in the price of raw materials after the Russian invasion of Ukraine, Sri Lanka’s freely available reserves plummeted from 7.6 billion dollars at the end of 2019 to an insignificant 50 million in May 2022 (the State still owes 50,000 million dollars).

According to Ahilan Kadirgamar, a specialist in political economy at the Sri Lankan University of Jaffna, the IMF is also responsible for the last chapters of the crisis. “The crisis has been aggravated by a series of informal recommendations made by this organization before reaching a rescue agreement, such as not intervening in the exchange rate market, which triggered the price of the dollar from 200 to 360 rupees, with the consequent pass-through to consumer prices,” he says.

Kadirgamar also attributes to the IMF the decision of the Sri Lankan central bank to increase the reference interest rate, strangling small companies with financing costs that went from 20% to 30%, as well as the abrupt cut in public spending on construction, “the only way, in an informal economy, to obtain income for those who have seasonal jobs in the fields”. According to Kadirgamar, a rise in interest did not make any sense with an “imported” inflation and when no one expects the arrival of foreign capital to a country in crisis. In his opinion, a crisis like the current one requires the Government to assume emergency functions to collect raw materials with which to guarantee the operation of export sectors, such as the production of clothing and tea, and to distribute food and essential fuels. for the survival of citizens. “In the 1970s there was a public distribution system that no longer exists, but Sri Lanka has many cooperatives that could help by bringing these basic products that the most vulnerable people would not otherwise have access to.”

The role of the IMF

Moore disagrees with holding the multilateral body accountable. In the first place, because the IMF programs are not presented as a general remedy for the economy but rather as an emergency solution in the face of serious shortages. Secondly, because the aid package of 3,000 million dollars that is being negotiated “is very different from the type of program that from the left is usually attributed to the IMF.” “In addition to demanding more tax collection, it includes asking the Government to implement a system of subsidies to protect the poorest and improve the quality of public spending but not cut it,” he argues.

But before reaching that agreement with the IMF, which would occur with the presentation of a debt restructuring plan at the end of August (the objective is a reduction of at least 33%), an obstacle called China must be resolved. . Beijing accumulated in April 2021 10% of Sri Lanka’s foreign currency debt and, for the moment, has shown no signs of accepting any haircut. Something that, according to the 2019 Nobel Prize in Economics, Abhijit Banerjee, could explain the IMF’s delay in resolving the crisis. In his opinion, it is possible that the IMF does not want to reward with its money the Chinese policy of flooding Sri Lanka with loans that no other country wanted to give it for infrastructure works. “I have a feeling that the IMF could be sending a message to other countries that have borrowed from China, making this painful so that others know that even if they end up being bailed out, the government may fall,” says Banerjee.

A warning to sailors

The island’s difficulties have triggered alarms about the impact that the global economic slowdown may have on the weakest economies. “Sri Lanka is one of the canaries in the mine, along with Lebanon and probably Pakistan,” says University of Massachusetts professor Jayati Ghosh. “There are several countries with serious debt problems, such as Egypt, Ghana and Tunisia, with the possible risk of a cataract of defaults if there is no urgent multilateral action.” According to a report by The Financial Times newspaper published on July 10, so far this year, 50 billion dollars of sovereign bonds have already been issued in emerging markets, “the most dramatic net outflow in at least 17 years.”
The solution, says Ghosh, lies in the decision of the G7 countries and the international financial institutions (IFI) to restructure the debt of these countries, including private creditors and countries like China. The IFIs also have to do their part by abolishing surcharges and other punitive measures, he explains, and it is necessary to curb “the speculation in the commodity markets carried out by the big oil and food companies.”

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Sri Lanka: the canary in the mine that warns of what is coming on top of emerging countries