Sri Lanka is currently facing the worst economic crisis since independence in 1948. Despite constant confirmation by the Governor of the Central Bank of Sri Lanka (CBSL), international organizations and economists have hailed Sri Lanka. the ability to repay foreign debt by 2022. Several analysts indicate that Sri Lanka is at risk of default as foreign exchange earnings fall below $ 1 billion.
With each passing day, the warning signs regarding the automation are likely to increase. At the beginning of March, the Sri Lankan Ministry of Energy announced a seven-and-a-half-hour power outage as the country was unable to buy enough oil to generate electricity due to a shortage of foreign currency. This week, long queues were seen at petrol stations due to a shortage of fuel. Bus owners’ associations have even expressed concern over the continuation of transportation services due to fuel shortages.
All of these events are the result of the severe payment balance (BOP) crisis that Sri Lanka has been struggling with since 2020. As COVID-19 attacks worldwide, Sri Lanka loses about $ 4 billion in annual foreign exchange earnings. On the other hand, the negative economic impact of COVID-19, reckless economic policy changes such as tax cuts granted in late December 2019, and the government’s stubborn refusal to support the International Monetary Fund (IMF) have led to. further reduction of national debt rates. With these developments, Sri Lanka has not been able to borrow from major international markets by issuing International Sovereign Bonds (ISBs). The country has not released a single ISB since April 2019.
As a result of these developments, Sri Lanka’s foreign exchange earnings have plummeted. By 2020, the government has imposed strict import restrictions, including banning imports of cars, in order to reduce foreign exchange. Although the outflow of forex in foreign exchange has been reduced, foreign debt obligations have not changed. This means that the Sri Lankan foreign exchange gap (shortfall in foreign exchange to meet the outflow of foreign currency) has been widened without the option of issuing ISBs. As there was not enough foreign exchange inflows, the government continued to set up forex savings to pay off existing debts. As a result, foreign exchange reserves fell from $ 7.5 billion in February 2020 to $ 1 billion at the end of November 2021.
A common response to a serious BOP crisis of this nature is to seek IMF support. In fact, the very purpose of establishing the IMF was to help countries deal with BOP issues. However, the Sri Lankan government continued its stubborn refusal to seek help from the IMF or restructuring debt.
China and India Instead of IMF?
As the government stands firm in not seeking IMF assistance, they are looking at other ways to deal with the economic crisis. Given the magnitude of the problem, restrictions on imports were not enough to close the foreign exchange gap. The island nation needed to find ways to increase foreign exchange.
Against this, the Sri Lankan government began seeking the support of two rival global rivals: India and China. Sri Lanka has had strong economic ties with both countries over the decades; economic relations with China in particular have been strong over the past 20 years, with China emerging as a major bilateral lender and FDI provider in Sri Lanka. President Gotabaya Rajapaksa and many other top political leaders of the country have called for economic support from both China and India to address an unprecedented economic crisis.
The possible reason why the Sri Lankan government chose to seek financial assistance from China and India is their unwillingness to make economic changes that are part of the IMF plan. Rajapaksa’s government, soon after he won the election, reduced taxes and abolished certain taxes. The government decided not to proceed with the proposed legislation to ensure the independence of the Central Bank, a policy strongly recommended by the IMF. In addition, the Central Bank of Sri Lanka (CBSL) controlled the exchange rate, which was in direct conflict with the IMF’s recommendations. Therefore, seeking IMF assistance would mean reviewing most of the Rajapaksa government’s economic policies and making economic changes. While most of these policy changes and economic changes are a matter of the hour, some of these changes tend to have high political costs. Such a review of the policy may also mean acknowledging from the government: “We have made a serious mistake. We should not have reduced our taxes. ”
Sri Lanka can receive financial assistance from China and India without such conditions. Yes, there are basic conditions and procedures for obtaining this financial assistance. But such situations are different from those imposed by the IMF, as the interests of China and India are more political in comparison to the IMF economies.
Sri Lanka’s BOP Crisis Over China Debt
In the past, Sri Lanka relied heavily on China to avoid BOP problems. In 2018, Sri Lanka acquired a $ 1 billion Foreign Exchange Fund (FCTFF) Fund from the China Development Bank (CDB). In 2017 and 2018, foreign exchange earnings obtained by leasing Hambantota port to China Merchant Port Company helped Sri Lanka to boost foreign exchange and close the deficit.
After the global financial crisis and Sri Lanka was unable to borrow from the global financial market, the CDB extended another $ 500 million FCTFF to Sri Lanka in April 2020. This was no ordinary export debt; this loan has been used specifically to strengthen the Sri Lankan forex position. According to the Ministry of Finance, this was a previous FCTFF upgrade of the $ 1 billion Sri Lanka received by the CDB in 2018.
The interest rate on loans received in 2018 was the LIBOR six-month USD rate, which is 2.56 percent. Have a grace period of three years and a payment period of eight years. Following the loan increase, out of the $ 500 million acquired in April 2020, the interest rate was once again a LIBOR of six months USD with an average of 2.51 percent. Have a grace period of 3 years and a payment period of 10 years. Sri Lanka was therefore given another two-year loan repayment of $ 500 million granted in 2020 compared to the 2018 loan terms.
In 2021 the CDB also provided two more FCTFFs to Sri Lanka, increasing existing loans. The first was another $ 500 million loan granted in April 2021 with the same interest rate as FCTFF for 2020, at the same time of grace and repayment period. Another 2 billion Chinese renminbi was awarded in August 2021 at the same grace period and payment period.
However, given the magnitude of the economic crisis Sri Lanka has faced, these loans are not enough to get out of the BOP’s major problems and to address the severe shortage of foreign exchange reserves. During a recent visit by Chinese Foreign Minister Wang Yi to Sri Lanka, Rajapaksa inquired about debt restructuring opportunities, taking into account the ongoing economic crisis. Despite this request, the CBSL governor continues to insist that they will face all charges due to international debtors.
Although China’s debt restructuring will provide a place to rest in Sri Lanka, it is by no means the only way out of this crisis. Contrary to Sri Lanka’s sensitivity to the feeling of being a victim of China’s “debt trap”, Sri Lanka’s debt problems extend beyond China. Sri Lanka’s economic crisis stems from deep-seated economic problems that have been largely unsustainable for decades. Instead of addressing these issues, Sri Lanka continued to borrow from the international currency market by issuing ISBs. By the end of 2021, Sri Lanka’s 36 percent foreign debt was ISB and only about 14 percent of total public debt owed to China.
The simple fact is that China cannot save Sri Lanka from debt default by restructuring China’s debt received by Sri Lanka. Sri Lankan debt payments to China, including FCTFF payments over the next three years, amount to about 20 percent of total foreign debt payments while ISB payments account for about 50 percent of foreign debt payments. In addition, ISB payments include a single payment of $ 1 billion or more annually, which poses a significant risk to the country’s BOP position. Currently, Sri Lanka does not have enough money to save money to make these major ISB payments, including the $ 1 billion ISB that matures in July this year, unless U.S. dollars which appears to be off the air in Sri Lanka.
It is also clear that although China wants to maintain strong economic ties with Sri Lanka, they are careful not to risk it unnecessarily. Previous exchange arrangements confirm this.
In 2020, Sri Lanka entered into a bilateral currency exchange agreement with the People’s Bank of China (PBoC). This, however, was a waiting arrangement of RMB 10 billion ($ 1.5 billion) to be used for bilateral trade and other purposes for three years. Thus, it was calculated as part of the foreign exchange reserves. In December, the PBoC allowed Colombo to withdraw R10 billion from Sri Lanka’s last facilities, allowing the island nation to nearly double its foreign investment from $ 1.6 billion to $ 3.1 billion. According to the Chinese ambassador to Sri Lanka, the exchange was a unique arrangement offered by China.
However, considering that the exchange is in the RMB, it will not be used to repay the loan in U.S. dollars. This exchange does not help Sri Lanka to pay for ISBs, which is a major problem related to the repayment of foreign loans. Therefore, this currency exchange differs from the exchange rate offered by India in the past, which provided US dollars in Sri Lanka to address issues related to the dollar deficit. Currency conversion with PBoC does not provide for that currency. This means that China has taken a less risky option to manage its economic relations with Sri Lanka, instead of providing US dollar loans to Sri Lanka to control the foreign exchange deficit.
Reconstruction of Economic Relations with India
In this unprecedented economic crisis, Sri Lanka was not the only to seek support against China. Over the past two years, Sri Lanka has continued to strengthen economic ties with India and has repeatedly sought support. India has also used this opportunity to expand its economic presence in Sri Lanka due to the growing Chinese economy in India’s immediate neighbors.
In February, as foreign currency shortages worsened, Sri Lanka signed a $ 500 million debt with India to buy fuel. This was part of the financial package India agreed to provide to Sri Lanka to address the economic crisis. Last week in February, the Sri Lankan Finance Minister was due to visit India to receive the remaining portion of India’s promised financial package. Under this, Sri Lanka is expected to receive a $ 1 billion loan to import important goods from India. However, visit was indefinitely postponed due to “last-minute planning problems.”
With these debt services, Sri Lanka will not be able to manage other priorities in the short term. However, these debt services will not help Sri Lanka get out of an unprecedented economic crisis. It just delays the inevitable default.
These debt services could cause India to become the leading source of imports for Sri Lanka, surpassing China. In 2018, China became the largest exporter to Sri Lanka, surpassing India, which has been a major source of imports in Sri Lanka for almost two decades.
This economic crisis has also allowed India to fulfill its international interests by increasing its presence in key areas of Sri Lanka. The Indian state-owned oil company, Lanka Indian Oil Company (LIOC), has signed an agreement to develop Trincomalee oil farms as a joint venture with Sri Lanka. Similarly, 51 percent of the joint venture is owned by Ceylon Petroleum Corporation and LIOC owns the remaining 49 percent. The agreement had been suspended for years due to project disputes, but the crisis gave India the opportunity to close the agreement.
What Does the Future Hold?
As has been noted many times in this article, Sri Lanka is on the verge of default. Deep economic downturn has worsened since the beginning of the epidemic. With Sri Lanka facing an unprecedented economic crisis, the country’s relations with China and India have also taken a positive turn. So far, Sri Lanka has been trying to balance both countries and gain benefits from China and India, as both countries have strategic goals in Sri Lanka. This was Sri Lanka’s strategy to avoid seeking IMF assistance and economic reform. However, this is a dangerous game that you can play in a country that is facing a recession. In cases like these, vulnerable countries, Sri Lanka in this case, do not have much negotiating power; they risk endangering the country’s interests by becoming part of the global competition.
On the other hand, no matter what decisions the government makes – and whether Sri Lanka resumes debt, non-payment, or successfully continues to repay its debt – Sri Lanka will face many challenges in the coming years. In such a situation, the support of China and India is very important in Sri Lanka. However, Sri Lanka must be careful to protect its national interests when entering into economic agreements. The country needs to facilitate investment and trade to address unresolved economic problems instead of trying to benefit from the country’s conflicts.
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