For the first time since independence, Sri Lanka is at high risk of defaulting foreign loan commitments. Some international media as well as global investment firms have already pointed out that Sri Lanka will default on its foreign debt in the upcoming months.

This leads to the question of how much Sri Lanka owes — and to whom? Why and how have we borrowed so much that we can’t seem to pay it back? This is our take on unravelling those questions.

First off, why did Sri Lanka borrow so much?

To put it simply: mostly because Sri Lankan governments haven’t been raising enough revenue.

Governments borrow when they do not have sufficient revenue to meet its expenditure. Governments are vested with the responsibilities of providing national security, maintaining law and order, developing infrastructure and providing social welfare. Sri Lanka is no exception to this.

Paying state-sector employee salaries — like those of teachers, doctors, the police, and the military for instance — and paying contractors for building highways, irrigation systems, and other new infrastructure are part of the government’s costs. Costs which the government needs to keep raising money for in order for it to keep spending. And one of the main sources of government revenue is... taxes. Taxes are imposed on goods, services, individuals and companies - but when the government fails to generate enough revenue through taxes, it ends up borrowing to bridge the gap.

When governments borrow, they can borrow from domestic sources or from foreign sources. Domestic borrowings are largely done through issuing Treasury Bills and Treasury Bonds; which are also referred to as government securities.

In this article, we’ll be looking at the Sri Lankan Government’s (GOSL’s) borrowing from foreign sources.

A refresher of Sri Lanka’s foreign debt

Over the last five decades, a large portion of infrastructure development projects in Sri Lanka were financed through foreign loans. During the late ‘70s and throughout the ‘80s, Sri Lanka carried out a number of development projects — such as the Mahaweli development project — with significant financial assistance received through foreign loans granted by other countries, and multinational organisations like the World Bank.

For decades, Sri Lanka was heavily reliant on concessionary foreign loans for its development process, to the extent that some development economists identified Sri Lanka as a donor darling.

Due to the heavy reliance on borrowing, Sri Lanka’s public debt stock increased rapidly after the liberalization of the economy in 1977. As the government of Sri Lanka continued to borrow for infrastructure development and consumption, the country’s debt stock skyrocketed during the 1980s. By 1989, ==Sri Lanka’s public debt (which is the domestic debt + foreign debt)== amounted to 109% of its GDP. Foreign debt as a percentage of the country’s GDP also reached a peak with 62% recorded in 1989.

While foreign debt stock skyrocketed as a percentage of GDP, the country still managed to muddle through crises with the support of the International Monetary Fund (IMF). This was largely because most of Sri Lanka's foreign debt at the time was concessionary loans. Such concessionary loans had low-interest rates, and longer payback periods; which varied from 20-40 years with an approximate grace period of 10 years. Because of the low-interest rate and very long payback period, the GOSL did not have to pay a massive amount of money as foreign debt repayments each year.

However, things started to change after the country was upgraded to a middle-income country  in 1997. Subsequent to the upgrade to middle-income status, multilateral development agencies reduced the concessionary loans provided to Sri Lanka. While we upgraded to a middle-income country on GDP Per capita terms (average annual income per person), we continued to have a lot of economic issues as well as many infrastructure needs.  Furthermore, the government still had high budget deficits and did not have the capacity to invest on infrastructure on its own.

So what did Sri Lanka do? We started to look at alternatives. One potential option was to borrow from international capital markets, and the other was to increase reliance on loans provided by Export-Import Banks (EXIM Banks), mainly from the China EXIM Bank. These loans were commercial borrowings that had higher borrowing cost. This shift resulted in a complete change in Sri Lanka’s foreign debt dynamics during the last two decades. By the end of 2020, 51% of Sri  Lanka’s foreign loans were commercial, non-concessionary loans.

==In simple terms, non-concessionary loans refer to loans that have higher interest rates and have a small payback period. The payback period differs based on the loan amount. in essence, a non-concessional loan has a higher debt repayment burden compared to a concessional loan which usually has a lower interest rate and long payback period. It is important to note that this isn’t the technical definition of a concessionary or non-concessionary loan, which is measured based on the grant element. Those who want to know the detailed technicalities== ==can read about it here====.==

Foreign Debt Composition, 2004-2020

From whom did we borrow this money? And for what?

During last two decades, Sri Lanka obtained foreign loans for two major reasons. One was to finance infrastructure development like highways and airports. The other was to repay foreign loans obtained in the past (or ‘refinancing’, according to economic jargon).

Sri Lanka’s infrastructure development was mainly financed through project-based foreign loans. Borrowings from international capital markets was the main source of obtaining foreign currency through which older loans were repaid. Most of these international capital market borrowings were obtained through issuing International Sovereign Bonds (ISBs).

Let’s take a look at how much we have borrowed for infrastructure development, and from where we managed to get the cash.

During the years 2000 to 2020, each government carried out a number of massive projects across numerous sectors, all which were financed through foreign loans.

Most of these large infrastructure projects were initiated after 2005, while the groundwork for some projects were put in place during the early 2000’s. During 2005-2021, Sri Lanka declared open two expressways (Southern Expressway and the Colombo-Katunayake Expressway); the Outer Circular Highway connecting those two expressways; constructed the first coal power plant in the country; built a new international port; and built an airport. On top of that, multiple main roads in the country were renovated, along with the reconstruction of the Northern Railway Line and the extension of the Southern Railway Line. Sri Lanka also initiated constructions of Central Expressway connecting Colombo and Kandy, of which the first phase was declared open in early 2021.

Most of these infrastructure development projects were funded by project loans, most of which were obtained from the China Export-Import Bank (EXIM Bank). In addition to project loans, we also borrowed through issuing ISBs.

The table below shows how much Sri Lanka borrowed for major infrastructure development projects from different lenders, and includes the terms of the loans.

Infrastructure project debt

As per the data, large amounts of money was spent on massive infrastructure projects.

The question is: are these projects necessary at a time when the country is going through high budget deficit and foreign exchange issues? While the Colombo-Katunayake Expressway and the Southern Expressway to Matara can be justified as projects which benefits the public at large, it is questionable as to whether a second airport and further extension of Southern Expressway all the way down to Hambantota is necessary; especially at a time when the government has to deal with  budget deficit and current account deficits.

Was it also an economic priority to extend Southern Railway Line to Beliatta? ==GOSL borrowed over approximately one billion USD to extend the Southern Expressway from Matara to Hambantota, which is more than four times the amount borrowed to construct the Colombo-Katunayake Expressway.== Similarly, the loans obtained to extend Southern Railway Line from Matara to Kataragama exceeds the loans obtained for the Colombo-Katunayake Expressway.

Are we in a Chinese debt trap?

Based on this table, you may understandably think that most of our borrowings are from China. However, while there is a significant increase of Chinese lending to Sri Lanka after 2005, it is important to clarify that China is not the major foreign lender to Sri Lanka. As mentioned previously, Sri Lanka started to issue ISBs to borrow in foreign currency (USD), and that eventually became the major source of foreign borrowing for the country. ==By the end of 2020, approximately 40% of Sri Lanka’s outstanding government foreign loans were ISBs — not project loans, which is what is highlighted above.==

This graph should clarify your doubts on the sources of Sri Lanka’s foreign loans obtained by the GOSL. As the graph shows, China isn’t the biggest lender, despite of most of our large infrastructure projects being financed by them. ISBs are not only the biggest portion of outstanding foreign loans, but also the biggest concern Sri Lanka is facing in managing foreign loan repayments.

Our friend, the ISB

Now we come to the nature of ISBs.

ISBs are commercial borrowings that are not tied to a project. This means the government has complete liberty concerning how it wants to spend the money. The government also receives the entire amount of the requested loan in one go.

This helps the government increase foreign currency reserves, thereby reducing balance of payment vulnerabilities as ISBs provide financial autonomy to manage cashflows. This is very different to a project loan obtained from other countries, multilateral agencies or Export-Import Banks (EXIM Banks). The money borrowed through project loans has limitations as it cannot be redirected to anything else, other than the specific project it was borrowed for.

Furthermore, the projects are carried out by contractors from the lending country; like how the Northern Railway Line reconstruction was by Indian government-affiliated IRCON International company, while the construction of the Hambantota port was by the China Harbour company.  ISBs don’t have such limitations or restrictions.

However, ISBs are costlier than project loans. They are issued in the international capital markets; thus the interest rate is much higher than those of project loans. For the ISBs issued, Sri  Lanka has been paying annual interests ranging from 5.13% to 8.75%; while the interest rate for most project loans were 2% (In the case of most loans obtained from World Bank and Japan, the interest rate was below 1%, but both lenders reduced providing such loans to Sri Lanka as the country upgraded to middle income status). On top of the high interest, ==ISBs have to be settled at one go when the bond matures.==

How much are we in the hole for? Well . . . .

==This is a very crucial factor in understanding Sri Lanka’s foreign debt troubles.==

Let’s assume that Sri Lanka issued an ISB of USD 500 million with a maturity period of five years. For this ISB, the GOSL has to pay the annual interest payment in two installments every year, though there are no loans to repay each year. The USD 500 million loan remains unchanged, and has to be repaid in one go at the end of five years. This is very different to the repayment structure of a project loan. For project loans, loan repayments are spread across 20-30 years — with no massive one-off payments.

This one-off payment puts enormous pressure on a fragile economy like Sri Lanka’s. It also results in a massive outflow of foreign currency as it is repaid in USD. This directly affects the country’s foreign exchange reserves and the Balance of Payment status. However, this pressure can be circumvented by increasing foreign currency inflows - which largely happens through increasing exports, or through Foreign Direct Investments (FDIs).

However, Sri Lanka failed to increase export earnings, as the country’s exports continued to fall as a percentage of the GDP (see our previous piece on the economy). Our FDIs also had a similar fate and was very low as a percentage of the GDP. Consequentially, Sri Lanka’s foreign debt repayments continued to increase while the foreign currency inflows remained stagnant. This led the country’s external debt servicing ratio — which indicates what percentage of export earnings is spent on making foreign loan repayments — to soar, and reach a peak of 33.5% in 2020.

To prevent severe adverse impacts from ISB settlements, the government and the Central Bank need to ensure that Sri Lanka’s foreign currency reserves are not severely affected. Stagnating export performances meant we needed to look into other methods of increasing foreign currency inflows to repay foreign debt. This is usually done by issuing a new ISB to repay debts from the old ones; and is known as refinancing (or, rolling over debt) - which we have been doing since 2014. Between 2015-2020, Sri Lanka issued 10 ISBs worth USD 11,550 million, most of which were utilized for settling foreign debt repayments — and now, we are not at a position to issue more ISBs.

What is our biggest concern now?

The problem with running a fragile economy based on rolling over ISBs is that the process of refinancing depends on a number of factors, most of which are out of the Sri Lankan government’s control. ==Sri Lanka’s ability to sell ISBs and borrow money from international investors is largely determined by the country’s credit ratings.== These credit ratings are often used by investors to assess a country’s ability to repay its loans on time.

Thus, credit ratings of countries account for the political and economic stability, external sector vulnerabilities of the economy, historical and anticipated budget deficit/surplus, ability to attract Foreign Direct Investment (FDI) and many more.

As we explained in our previous article, Sri Lanka has been struggling with number of serious structural weaknesses over the years. Continuous deterioration of economic vulnerabilities and worsening structural weaknesses (like low tax revenue and sluggish export growths) has an adverse effect on our country’s credit ratings. Economic vulnerabilities became even more prevalent following COVID-19, with the collapse of the tourism industry.

Structural weaknesses of the economy became more apparent and Sri Lanka’s credit ratings continued to decline drastically. Fitch ratings downgraded Sri Lanka’s ratings from B in 2019 September to CCC in January 2021 indicating challenging foreign-currency sovereign external debt repayment burden over the medium term.

https://twitter.com/newsdotlk/status/1472207979852144641

The government keeps trying to dispute this, from rolling out press releases (above) to passive-aggressive tweets (below).

https://twitter.com/an_cabraal/status/1419681474526302212

None of this matter. ==The fact is that, our ratings are down.== This made it impossible for Sri Lanka to issue ISBs and settle previous loans. The go-to method of rolling over debt was no longer an option, especially after losing around USD four billion of annual foreign currency inflows from tourism.

This further widened external financing gaps. The country did not have sufficient foreign currency inflows to pay for imports, and meet foreign loan repayments. Nor could the country issue ISBs because of downgraded credit ratings.

The usual way out of such a crisis is seeking the IMF’s support and potentially restructuring our debt, but the government went the other way instead; by restricting foreign currency outflow by imposing import restrictions, used existing foreign currency reserves to make loan repayments, and continuing to insist that it will neither seek IMF’s assistance, nor restructure debt.

https://twitter.com/NewsWireLK/status/1460541332649230340

What is the outcome of this? By now, Sri Lanka has almost run out of foreign currency reserves. Usable foreign currency reserves plunged below USD one billion by the end of January 2022. The foreign currency shortage has caused numerous other shortages, including those of essential items, as there is no way to pay for imports.

As the situation worsens, Sri Lanka is now struggling to import the required amount of fuel. This has led to diesel and petrol shortages, and long queues in fuel stations. The fuel shortage resulted in powercuts as long as 7.5hrs, as the government doesn’t have enough fuel to operate thermal power plants. Foreign loans are now everybody’s problem.

This is obviously a complex matter, so let’s try recapping this in a politician-friendly manner:

Conclusion

==The gist of this saga is that Sri Lanka borrowed more than it can pay====. As a country, Sri Lanka had spent far beyond its means. Most of this spending has come from borrowings. Successive governments failed to address structural issues in the economy such as low tax revenue and poor export performances. In spite of failures to provide comprehensive and long-term solutions to these long-lasting structural weaknesses, our governments continued to borrow freely and spend just as freely. What happens when you continuously ignore issues and continue to borrow? Sooner or later there comes a day when you have to face the music and run into serious trouble.==

Outstanding International Sovereign Bonds as at 31 January 2022 (1)

Despite this debt burden hanging over our heads, recent governments have failed to increase tax revenue and foreign currency inflows sufficiently. Instead they’ve obsessed over large infrastructure development projects such as expressways. Now the ‘dark days’ (literally and metaphorically) have arrived.

==What can the government do now? For starters, it should accept the simple fact that the debt troubles we’re currently experiencing cannot be resolved by short-term fixes or speeches — we need serious economic reforms to address structural weaknesses.==

It is essential to set up a plan to address these weaknesses and seek IMF support to restructure debt. Because as hard as to swallow, we need to acknowledge that Sri Lanka is in no position to continue repaying foreign loan without compromising on the supply of essential goods and services due to foreign currency shortages. It has come down to a choice between undisrupted electricity supply or fuel supply, and paying off our foreign loans. The way out is to postpone foreign debt repayments (AKA restructure debt!) and gradually repair our economic issues. Most importantly, the GOSL should learn from their mistakes and be more cautious in borrowing.