The yield on Sri Lanka’s ten-year government bonds rose by 430 basis points last year and concern is mounting regarding the sovereign’s solvency. Yields above 12% are not unusual for the island nation, but a 7 percentage point spread over the policy rate reflects an increased pricing in of risk. The answer to the question of whether Sri Lanka will ultimately be forced to default on its debt is finely balanced. Fathom’s Financial Vulnerability Indicator (FVI) is flashing red for a number of countries around the world. This note explains the factors specific to Sri Lanka and assesses the reasons for its current predicament.
Sri Lanka’s public debt-to-GDP ratio rose by around 20 percentage points in response to the COVID-19 pandemic and now stands close to 110% of GDP. While this increase in debt is comparable to that in advanced economies, it is about double the increase in most other emerging economies. That said, Sri Lanka’s national debt was already elevated compared to its peers and the recent increase alone is probably not sufficient to be the sole driver of investor pessimism.
Rather, the key to understanding the country’s fiscal woes appears to be its graduation in the late 1990s from a low-income economy to a middle-income one. Under its previous status, Sri Lanka was able to secure loans from international organisations at favourable rates. However, upon joining the ranks of middle-income economies it was no longer eligible for many of these loans. Therefore, as the country has refinanced its debt, the share of external debt under concessional terms has fallen.
Driven by the decrease in the share of concessionary loans, Sri Lanka has seen a marked increase in debt-servicing costs. Interest payments rose from 4.2% of GDP in 2014 to 6.5% in 2020. At a total of 1.7% of GDP, the cost of servicing external debt has never been higher. Prior to the pandemic, Sri Lanka maintained a fairly healthy budget position, helping it to finance the increasing costs of servicing its debt. The fiscal costs of the crisis were large, however, with the budget deficit swelling to more than 12% of GDP in 2020. A period of government belt-tightening, coupled with a bit of luck and/or help, is probably the only way for the country to avoid a sovereign crisis. There appears to be some international goodwill towards Sri Lanka, with a combination of China, India and the Asian Clearing Union enabling the country to settle a payment of $400 million due on 18 January.
Historically 13% of currency crises occur within one year of a sovereign crisis. Given Sri Lanka’s struggles with regards to its external debt payments, it is easy to understand why so-called ‘twin crises’ are a fairly common phenomenon. However, while the rupee’s value has fallen recently, it appears to have done so at a measured rate thus far. Even so, the rapid depletion of Sri Lanka’s FX reserves leaves cause for concern. Pre-pandemic, the stock of foreign reserves equated to around 10% of GDP, but that has dwindled rapidly over the past two years, leaving the central bank with limited room to fight future downward pressure on the currency.
Fathom’s Financial Vulnerability Indicator provides an objective measure of risk. Global aggregates are available to users of Refinitiv Datastream and show that the current macro backdrop is not a benign one for a country facing questions over its financial stability. Indeed, it is often at this stage of the economic cycle (i.e., the mid-to-late recovery) that crises occur, and this is now beginning to show in FVI scores around the world.
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