The writer is a senior fellow at Brown University and global chief economist at Kroll
The new leaders of Sri Lanka might be forgiven if they wish for a recession in the US. Rate cuts in America and a weaker dollar might make the small Indian Ocean nation’s debt obligations easier to service. Deeply indebted, with foreign exchange reserves exhausted and low on fuel and hope, Sri Lanka’s crisis suggests trouble is coming in emerging markets, and there isn’t much they can do about it.
Aspects of Sri Lanka’s default are specific to its plight. The former president cut value-added and income taxes in 2019, resulting in lost revenue of 2 per cent of GDP. The country’s finances were dealt an additional blow when Covid-19 destroyed the tourism industry. And then last year, a bid to make Sri Lanka’s farms organic led to an official ban on chemical fertilisers. Rice production plummeted, forcing the government to use $450mn of foreign reserves on rice imports.
In many other ways, though, it’s a familiar story for emerging markets. Assessing the economy in March, the IMF noted Sri Lanka had run budget deficits exceeding 10 per cent of GDP in 2020 and 2021, its public debt jumped from 94 per cent of GDP in 2019 to 119 per cent in 2021 and it had a significant foreign exchange shortage owing to debt service payments and a big current account deficit. The IMF proclaimed Sri Lanka’s public debt unsustainable, the biggest red card the lender can show.
The final blow was from external events, with Russia’s invasion of Ukraine. Energy and food prices skyrocketed around the world. Sri Lanka defaulted on its debt two months later in May, having chosen to use remaining foreign reserves on staples rather than pay creditors. Before the country was officially in default, its leadership belatedly requested an IMF bailout.
But Sri Lanka will not be the last country to have to choose to between subsidising essentials and paying creditors.
Many low- and middle-income countries are suffering from high food and fuel costs. Energy prices, already on the rise before the Russian invasion, are forecast to remain high. The UN’s food price index rose 23.1 per cent in the year to June.
In its latest World Economic Outlook, the IMF forecast growth in emerging markets and developing economies to fall from 6.8 per cent in 2021 to 3.6 per cent this year. External demand for emerging countries will get worse before it gets better. The US and Eurozone are likely to go into recession by the end of 2023. China, on track for its lowest growth rate in several decades (barring 2020), is focusing stimulus measures on technology and public services. Those will be less import- and commodity-intensive than in previous downturns, with fewer opportunities for spillover into other emerging economies.
As growth weakens in emerging markets, borrowing costs are rising. With US prices escalating at the fastest pace in 40 years, the Federal Reserve is raising interest rates aggressively. That is pushing borrowing costs up across the globe. It is also driving the US dollar higher. This renders trade invoiced in dollars more expensive — pushing inflation higher — and dollar-denominated debt more difficult to service.
Sri Lanka, like many emerging nations, is heavily indebted to China. The world’s biggest bilateral creditor accounts for about 10 per cent of Sri Lanka’s foreign debt. The World Bank estimates almost 25 per cent of emerging and developing countries’ external debt is owed to China, though only China knows for sure. So far, it has been reluctant to restructure any of it.
The Common Framework, an agreement whereby G20 countries, sovereign creditors from the so-called Paris Club and private creditors agree to the same terms of a debt restructuring for a low income country, has yet to yield any such agreements. Many were hoping the Common Framework would be expanded to middle-income countries, but Sri Lanka suggests that won’t happen.
Beyond Sri Lanka, the list of developing countries that look vulnerable is long and varied. More than 20 emerging market countries have foreign bond yields over 10 per cent. Pakistan, Ghana, Egypt, and Tunisia are all in rescue talks with the IMF. Relief might come for them in the form of a US downturn, damping demand for energy, reducing global borrowing costs as the Fed cuts rates and pushing the dollar down. But a recession in the world’s largest economy would hardly be good news overall. The IMF’s title for the World Economic Outlook might as well be a commentary on the prospects for emerging markets: “Gloomy and More Uncertain.”