Sri Lanka’s economy is in recovery mode from the pandemic shock, but faces a growing external debt problem. Sri Lanka asked China to restructure its debt during the recent visit of Foreign Minister Wang Yi.

China, however, faces the difficult dilemma of deciding whether to do so. Sri Lanka should take urgent steps to implement measures to combat the economic crisis, which China can usefully support through multilateral institutions such as the International Monetary Fund and the World Bank.

Chinese Foreign Minister Wang Yi visited Sri Lanka on Jan. 9-10 to mark the 65th anniversary of diplomatic relations between the two countries. The high-level visit took place at a time of economic uncertainty with Sri Lanka in the throes of an economic crisis and China facing an economic downturn.

A rapidly spreading Omicron virus poses additional challenges. Several questions are being debated in political and diplomatic circles in Sri Lanka following the Minister’s visit: What is the state of Sri Lanka’s economy? Will China increase its aid? What are Sri Lanka’s political choices?

Even before the pandemic, the economy was under macroeconomic stress, as evidenced by slowing growth, large fiscal and balance of payments deficits, and high external debt. The pandemic and containment measures have tipped the economy, with growth dropping to -3.6% in 2020. Despite this toll, signs of an economic recovery in the first nine months of 2021 point to possible growth from 3 to 4% in 2020. 2021.

dark clouds

However, dark clouds of risks hang over the economy in 2022, including the spread of the Omicron virus, worsening external debt, rising inflation, social tensions and declining consumer confidence. businesses.

The economic crisis caused by the pandemic has set back Sri Lanka’s enviable social progress, with at least half a million more people becoming the “new poor”. Women felt increased pressures during this period, causing some to leave the workforce. They seem to be more at risk of losing their jobs than men, which leads to an increase in the unemployment rate for women.

The pandemic has also significantly aggravated Sri Lanka’s debt problem. Public spending fell in 2020-21 as the government rushed to put in place measures to mitigate the reduction in economic activities while revenue generation fell to historic lows due to the economic contraction, previous job losses and income tax cuts. The budget deficit has increased sharply. The country’s unfavorable debt dynamics reflect persistent fiscal and current account deficits: significant currency depreciation, the cost of 30 years of terrorism, sluggish post-terror growth, and a shift from subsidies to foreign commercial borrowing.

Growing concerns over debt servicing capacity led international credit rating agencies to downgrade Sri Lanka’s ratings, shut down access to international bond markets, foreign capital outflows and currency pressures. Sri Lanka’s external debt reached US$49.2 billion (S$66.7 billion) in December 2020, with substantial debt repayments of US$4-5 billion (S$5.4-6.8 billion Singapore dollars) per year required between 2022 and 2026, supported by dangerously low foreign exchange reserves.

“Debt Trap”

China and Sri Lanka have enjoyed warm diplomatic relations since Sri Lanka first recognized China in 1950. China’s global rise has shifted its diplomatic relations with Sri Lanka in a more commercial direction. Since the early 2000s, China has become one of the main providers of commercial loans to Sri Lanka for infrastructure projects, including the Port of Hambantota.

Some claim that by accepting such loans, Sri Lanka is now stuck in a ‘debt trap’. But Sri Lanka is not in the Chinese debt trap. Much of Sri Lanka’s external public debt is owed to capital markets, while debt owed to China accounted for around 10% of its gross domestic product in 2020. During the January 2022 high-level talks, Sri Lanka reportedly asked China to restructure the debt. refunds and a credit facility on favorable terms for imports.

This created a dilemma for China; he does not want to lose Sri Lanka’s friendship or business opportunities, but neither is he keen on unilaterally granting moratoriums or restructuring Sri Lanka’s debt, which would serve as an example for others to emulate. other indebted developing countries.

China fears this will set a precedent that could lead to unlimited commitments to respond to a number of countries that have received large amounts of Chinese loans and are now under some degree of debt distress. Thus, it is not clear whether China will accept Sri Lanka’s request.

In public, the government has ruled out asking the IMF for help, fearing that the IMF’s demands for austerity policies (e.g., a floating exchange rate, higher taxes, public spending cuts and the removal of food and fuel subsidies) are politically unpopular. .

Instead, he opted for a series of homegrown remedies, including looser monetary policy, import restrictions, foreign exchange controls, renting state land to investors, and a surge in tourism and tourism. exports. The limitations of these policies and the spread of Omicron suggest the need for urgent action to deal with Sri Lanka’s economic crisis. Three concrete steps are involved.

First, a national conference involving the main political parties should be convened to forge a political consensus on the extent of the economic crisis and the implications of policy choices. Second, a team of national experts should be tasked with developing a comprehensive program of structural reforms to stabilize the economy, ease the hardship of the people, deregulate the economy and green the economy.

Building on the existing work of think tanks can be helpful. Third, Sri Lanka should start talks with the IMF on a program of debt restructuring and financial assistance. There is a growing risk that time is running out to address these challenges in an orderly fashion.

Rather than considering a bilateral approach to rescue Sri Lanka, China can usefully add its powerful voice to calls for Sri Lanka to seek IMF assistance and channel technical assistance funds through the World Bank. to support work on a structural reform program for Sri Lanka.