Sri Lanka recorded the first casualties from its spiralling economic crisis several days ago, with one protester dead and 24 more injured. This was from police firing gunshots into a crowd who were demanding the removal of a government they hold responsible for the country’s predicament. At present:
Citizens cannot access essentials such as fuel, medicines and food, with some even dying while queuing for fuel.
Protesters of all classes are taking to the streets – members of the middle class face a potentially irreversible decline in living standards, while the masses are being pushed into absolute poverty.
Sri Lanka has formally (apparently temporarily) defaulted on its debts. India and China, jostling for influence and power, are providing emergency funding and the IMF is considering a bailout under its Rapid Financing Initiative.
An apologist could put much of Sri Lanka’s problems down to bad luck: the pandemic and the conflict between Russia and Ukraine are partly to blame, and neither could have been anticipated. On the other hand, poor policy choices by a corrupt, authoritarian governing elite have made Sri Lanka uniquely vulnerable. This has been a disaster in slow motion, entirely predictable, a textbook case of how a government can cause a debt crisis.
Before 2019, Sri Lanka was self-sufficient in food. The government elected that year banned pesticides so that only organic farming was allowed, resulting in the shutting of tea plantations (a source of export revenue) and shrinking the country’s ability to feed itself (Sri Lanka now imports grains). Together with the damage to tourism from the COVID pandemic and rising global commodity prices, this has reduced tax revenues and put more pressure on the Sri Lankan rupee.
The public finances have been further damaged by unsustainable subsidies and unaffordable tax cuts. Equally, there have been futile attempts to maintain an unviable currency peg to the US dollar and bad decisions around debt management. Public debt has near-tripled as a percentage of GDP to 104% in three years, while the rupee has jumped from about 200 to the US dollar in early March to almost 330 today.
Sri Lanka’s governing elites are not alone in making these kinds of poor policy choices. For example, in the run up to the crisis that engulfed Lebanon in late 2019, the central bank swapped debt held in Lebanese pounds into debt in euros and US dollars while maintaining an unviable currency peg.
The fees from these activities generated huge profits for major banks but made the country vulnerable to negative external shocks, such as nervous foreign investors dumping government bonds. This helped to drive down the value of the currency and made debts priced in foreign currency harder to pay back. Just like Sri Lanka, there were protesters on the streets, governing elites waxing eloquently about the need to maintain national unity, and a middle class facing the prospect of being wiped out while millions were pushed into poverty.
The financial crisis in the eurozone in the 2010s was the result of a similar mix of bad policy choices and bad luck, as was the 1990s Asian financial crisis before it, and the Latin American crisis in the 1980s – not to mention Argentina’s protracted debt crisis and restructuring in the recent past.
What can be done to prevent these situations? One common thread is international bailouts from the IMF and other bodies, in which the money is conditional on reining in the state through severe cuts to public spending, privatisations and so on. After a gap of a few years, provided the state meets these conditions, borrowing in international capital markets is permitted to resume and the whole cycle can repeat. These interventions teach elites elsewhere that reckless policies will be bailed out, making it inevitable that similar debt crises will occur in apparently different circumstances in other countries.
Perhaps it is time to consider a different approach, which puts the needs of citizens first and ensures that political elites aren’t rewarded for poor policy choices. Various academics make a distinction between two types of creditors in these situations: “formal creditors”, such as a western European pension fund buying sovereign bonds, and “informal creditors” within the state itself, such as pensioners who have contributed to the state social security fund, or workers who have paid into the public insurance system.
There’s a social contract that these informal creditors will benefit from the money they pay in, yet in a bailout situation, they bear the brunt of austerity, including cuts to social security programmes. Meanwhile, foreign creditors get their money back – albeit with a “haircut” where they lose a proportion (though this risk is usually already reflected in the interest rate at which their money is lent in the first place).
We argue in an upcoming paper that when informal creditors have an explicit say in how a debt crisis is resolved, as in Iceland in the early 2010s, both austerity and the power of governing elites will be limited. Instead, policy choices are tailored to ensuring that the economy recovers faster and a future debt crisis becomes less likely.
The UN Conference on Trade and Development (UNCTAD) published a debt workout guide in 2015 that offers a road map for such a process. It proposes referendums at key points in the lead-up to a bailout to ensure that the public see the options and get a chance to vote on them.
Sri Lanka presents an ideal opportunity to put this into practice. The suffering of ordinary citizens, pensioners, students and the impact on future generations is neither inevitable nor bad luck. Citizens’ views must be taken into account in determining how the crisis is resolved.
This would be a blueprint for future economic crises – and these could well be looming in view of slow post-COVID recovery, the strong US dollar and high commodity prices. In south Asia alone, Pakistan is similarly vulnerable to not having adequate foreign exchange reserves to service its sovereign debts, and despite strenuous official denials, so is Nepal.
The political elites in these countries may already have made the poor financial decisions that have created these vulnerabilities. But there is a good opportunity to send a message that the consequences will be different when politicians and bankers take similar decisions in future.