The author is a Senior Fellow at Brown University and Chief Global Economist at Kroll
Sri Lanka’s new rulers could be forgiven if they want a recession in the United States. US rate cuts and a weaker dollar could make it easier to service the small Indian Ocean nation’s debt. Deeply in debt, with depleted foreign exchange reserves and running out of fuel and hope, Sri Lanka’s crisis suggests trouble is coming to emerging markets, and there’s not much they can do about it.
Certain aspects of Sri Lanka’s default are specific to its fate. The former president cut value added and income taxes in 2019, leading to a revenue loss of 2% of GDP. The country’s finances took a further hit when Covid-19 wrecked the tourism industry. And then last year, an attempt to make Sri Lanka’s farms organic led to an official ban on chemical fertilizers. Rice production plummeted, forcing the government to use $450 million in foreign exchange reserves for rice imports.
In many other ways, however, it’s a familiar story for emerging markets. Assessing the economy in March, the IMF noted that Sri Lanka had recorded budget deficits above 10% of GDP in 2020 and 2021, its public debt had fallen from 94% of GDP in 2019 to 119% in 2021. and that he had a large foreign debt. shortage of foreign exchange due to debt service payments and a large current account deficit. The IMF has proclaimed Sri Lanka’s public debt unsustainable, the biggest red card the lender can show.
The final blow was dealt by external events, with Russia’s invasion of Ukraine. Energy and food prices have soared around the world. Sri Lanka defaulted on its debt two months later in May, having chosen to use remaining foreign exchange reserves on commodities rather than pay creditors. Before the country was officially in default, its leaders belatedly requested an IMF bailout.
But Sri Lanka will not be the last country to have to choose between subsidizing the essentials and paying the creditors.
Many low- and middle-income countries suffer from the high cost of food and fuel. Energy prices, already on the rise before the Russian invasion, are expected to remain high. The UN food price index rose 23.1% in the year to June.
In its latest World Economic Outlook, the IMF projects that growth in emerging markets and developing economies will decline from 6.8% in 2021 to 3.6% this year. External demand from emerging countries will deteriorate before it improves. The United States and the euro zone are expected to enter recession by the end of 2023. China, on track for its lowest growth rate in several decades (except 2020), focuses its stimulus measures on the technology and utilities. These will be less import- and commodity-intensive than in previous downturns, with fewer opportunities for spillovers to other emerging economies.
As growth falters in emerging markets, borrowing costs rise. As US prices climb at the fastest rate in 40 years, the Federal Reserve is aggressively raising interest rates. This drives up borrowing costs around the world. It also pushes up the US dollar. This makes exchanges billed in dollars more expensive – pushing inflation higher – and dollar-denominated debt harder to repay.
Sri Lanka, like many emerging countries, is heavily indebted to China. The world’s largest bilateral creditor accounts for around 10% of Sri Lanka’s external debt. The World Bank estimates that nearly 25% of the external debt of emerging and developing countries is owed to China, although only China knows this for certain. So far, he’s been reluctant to restructure anything.
The Common Framework, an agreement by which G20 countries, so-called Paris Club sovereign creditors and private creditors agree to the same terms of a low-income country debt restructuring, has not yet come to such agreements. Many hoped the Common Framework would be extended to middle-income countries, but Sri Lanka suggests that will not happen.
Beyond Sri Lanka, the list of developing countries that appear vulnerable is long and varied. More than 20 emerging countries have foreign bond yields above 10%. Pakistan, Ghana, Egypt and Tunisia are all in bailout talks with the IMF. Relief could come to them in the form of a slowdown in the United States, dampening demand for energy, reducing global borrowing costs as the Fed cuts rates and pushes the dollar lower. But a recession in the world’s largest economy would not be good news overall. The IMF’s title for the World Economic Outlook could just as well be a commentary on the outlook for emerging markets: “Dark and more uncertain”.