Opinion: Repay foreign debt or finance essential imports

The available
foreign reserves of the country can be used to either repay foreign creditors
or to finance imports of essential goods and services required by its citizens.
This is the dilemma facing Sri Lanka today. Repaying the full value of the bond
using the limited foreign reserves available would provide a windfall gain to
those currently holding these bonds.[1] But it will be at great
cost to the citizens of the country who will face shortages of essentials like
food, medicine, and fuel.

In these
circumstances, it is in the best interest of all its citizens, for the
government to defer payment of the US dollar 500 million International
Sovereign Bond (ISB) coming due on 18 January 2022, until the economy can fully
recover and rebuild.

Just as an
individual with co-morbidities is more vulnerable to develop severe illness if
infected with COVID-19 and more to likely require hospitalisation and even
treatment in an ICU, Sri Lanka was vulnerable to economic shocks long before
COVID-19 struck. The country was already facing several macroeconomic
challenges. Muted economic growth. An untenable fiscal position. Although a
tough consolidation programme was put in place to bring government finances to
a more sustainable path, sweeping tax changes implemented at the end of 2019
reversed this process, with adverse consequences to government revenue
collection. Weak external sector due to high foreign debt repayments and
inadequate foreign reserves to service these debts. COVID-19 only exacerbated
these macroeconomic challenges. And like a patient who gets over the worst of
COVID-19 has a long road to recovery; the economy of Sri Lanka faces many
challenges to get back on track.

The onset of
COVID-19 in early 2020, only worsened an already grim macroeconomic situation.
The country lost the confidence of international markets, and the ability of
the sovereign to rollover its external debt became difficult if not impossible.
In these circumstances, there was a solid argument for a sovereign debt
restructuring. But the response from the government and the Central Bank of Sri
Lanka (CBSL) was a firm “No”. The argument was that Sri Lanka never defaulted
on its debt and it was not going to do so now. The official position was also
that the government had a ‘plan’ to repay its debt and hence there was no
reason to engage in a debt restructuring exercise. However, Sri Lanka faced
high debt sustainability risks: the debt to GDP ratio at 110% was one of the
highest historically and interest payments to government revenue at over 70%
was one of the highest in the world.

Fast forward to
2022. The country’s foreign reserves declined to US $ 3.1 billion.[2] Useable reserves are much
lower. CBSL has sold over US $ 200 million of the country’s gold reserves to
meet its debt obligations. In the first week of 2022, CBSL announced further
swap facilities and its commitment to repay the International Sovereign Bond
(ISB) of US $ 500 million due in January. According to statistics from the
Central Bank, in addition to the ISB payment, there are pre-determined outflows
from foreign reserves amounting to US $ 1.3 billion in the first two months of
2022. Further, based on trade data for the last 5 years, the country on average
has a trade deficit of around US $ 2 billion to finance during the first
quarter of the year (see Table 1). With expected inflows from tourism under
threat with the onset of the Omicron variant and continuing decline in worker
remittances, financing this external current account deficit will add further
pressure on available foreign reserves. 
India which accounted for around 20% of recent tourist arrivals is now
requiring returnees to the country to quarantine. This will likely further
dampen tourist arrivals.

In this context,
the country faces a trade-off between using its limited foreign reserves to
repay its debt or utilising it to finance essential imports. US $ 500 million
is sufficient to finance imports of fuel for five months; or pharmaceuticals
for one year; or dairy products for one and a half years of; or fertilizer for
two years.

Table 1: Summary of External Sector Performance Q1 –
2017 to 2021 (US $ mn)

  Q1 2017 Q1 2018 Q1 2019 Q1 2020 Q1 2021
Exports 2,774 2,989 3,156   2,650   2,982
Imports 5,279 5,971 4,817   4,503   5,041
   o/w Sugar & confectionary 63.8 88.1 48.9 73.1 137.4
            Medical pharmaceuticals 125.2 130.0 121.8 125.4 143.8
            Fuel 882.6 1,075.2 1,019 948.2 977.2
Trade balance -2,505 -2,982 -1,661 -1,853 -2,059
Earnings from tourism 1,122   1,329 1,396   682   13
Worker remittances 1,911 1,979 1,617   1,600   1,867
Overall balance -176 -311 912 143 -1,101
International Reserves (US $ bn) 5.1 7.3 7.6 7.5 4.1
                     (months of imports) 3.1 4.1 4.3 4.6 2.9

Therefore, it is
in the best interest of the country and its citizens for the government to
defer payment on its debt and use its limited foreign reserves to ensure
uninterrupted supply of essential imports. But this requires a plan. To
minimise the cost to the economy, the government must immediately engage its
creditors in a debt restructuring exercise. This will require a debt
sustainability analysis (DSA) by a credible agency to identify the resources
required for debt relief and the economic adjustment needed to put the country
back on a sustainable path.[3] This will be critical to
bring creditors to the negotiating table and provide them comfort that the
country is able and willing to repay its debt obligations in the future.

The cost of not
restructuring is much higher. A non-negotiated default (if and when the country
runs out of options to service its debt) would lead to a greater loss of
output, loss of access to financing or high cost of future borrowing for the
sovereign. It could even spill over to the domestic banking sector, triggering
a banking or financial crisis.

The consequences
are clear. What will we choose?

Roshan Perera is a Senior Research Fellow at the Advocata
Institute and the former Director of the Central Bank of Sri Lanka

Sarath Rajapatirana is the Chair of the Academic Programme at Advocata
Institute and the former Economic Adviser at the World Bank. He was the
Director and the main author of the 1987 World Development Report on Trade and

The Advocata Institute is an Independent
Public Policy Think Tank. Learn more about Advocata’s work at www.advocata.org.

[1] Holders of Sri Lanka’s
sovereign bonds have anticipated a debt restructuring for over one and a half
years and the losses have been reflected on a marked to market basis.

[2] Foreign
reserves at end December 2021 reached US $ 3.1 billion with the inclusion of the swap with the
People’s Bank of China which was excluded in previous months. 

[3] Since the IMF
just completed its Article IV review this assessment has probably already been

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