May 27, 2022 - Economy

Sri Lanka's debt crisis matters to the world

Illustration: Natalie Peeples/Axios

The south Asian island nation of Sri Lanka just defaulted on its debt. Its situation is not so different from a host of other lower-income nations — and there’s no reason to think others won’t share the same fate.

Why it matters: In a sovereign debt crisis, the biggest victims aren’t the international creditors — but the regular people whose economy is stuck in a holding pattern while the government haggles over austerity and repayment schedules.

  • And with global markets so closely intertwined, even small, seemingly containable crises can reverberate in unpredictable ways, says Jeremy Mark, senior fellow with think tank the Atlantic Council and a former International Monetary Fund (IMF) official.

The big picture: Countries like Sri Lanka loaded up on debt before and during COVID. Now, rising interest rates will make these debt loads more expensive — and chill growth that’s needed to help pay them off.

  • The war in Ukraine has made the already-precarious financial positions of many nations even worse, generating food and energy price shocks while interrupting trade and tourism.
  • Don’t forget government corruption (a factor not unique to Sri Lanka): “Some observers argue Sri Lanka’s debt crisis is the product of the hubris, mismanagement and alleged venality of political elites including the Rajapaksa family,” as the FT puts it.

What they're saying: “The question a lot of people have is: Is this just the beginning of defaults?” notes Mark.

  • “We're already seeing a slow moving crisis affecting some weaker countries. And there's nothing to say that this can’t widen, especially if we have a recession in the U.S.," Martin Muhleisen, formerly an IMF director, tells Axios.

State of play: The IMF estimates that about 60% of low-income countries are either in debt distress or at high risk of it — that figure has doubled since 2015.

The impact: Besides a defaulter's inability to borrow from global markets, internal ripple effects from a default can further destroy that country's economy.

  • For instance, domestic banks usually have high lending exposure to their own government — so losses there can in turn curb lending to companies and households. That crimps growth, which further shrinks government finances.
  • In lending lingo, this is called a ‘doom loop.’

How it works: When a country is no longer able to make debt payments, it seeks rescue funds from the IMF while negotiating a debt restructuring deal with its creditors.

  • Typically, creditors take some losses while the country’s government agrees to abide by spending and budget constraints to get back in the market's good graces. These deals can take months, or even years, to hammer out.

But, but, but: China is the new wild card in these negotiations. It's morphed into a lending heavyweight to lower-income countries, recently overtaking Western institutions in lending to this group, according to World Bank data.

  • So far, China hasn't really been playing ball in restructuring negotiations, as Mark recently wrote about.
  • Just look at Zambia — it defaulted back in 2020, and China has been blamed for the lack of progress in talks.
  • Chinese banks are pretty green in the world of sovereign debt negotiations. They appear resistant to the fundamental linchpin of the process: forgiving some of what they're owed, says Mitu Gulati, a law professor at the University of Virginia who focuses on sovereign debt restructuring.

The bottom line: This round of debt crises, if it comes to pass, shouldn’t be as vast as, say, the Latin America debt crisis of the 1980s, when countries defaulted like dominos, Gulati says. That go-round was spurred by rates that rose far more rapidly than they’re expected to now.

  • But that crisis offers an illustration of the economic cost of debt mismanagement, and of a long, drawn-out resolution process: the stagnant 80s are known as the “lost decade” for Latin America.
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