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Can broke Sri Lanka avoid a ‘disorderly default’ and reach an IMF deal in time?

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Anti-government demonstrators take part in a protest near the President’s office in Colombo on May 15, 2022. Photo: AFP

New Delhi : Amid ongoing political turmoil over the economic crisis engulfing Sri Lanka, the International Monetary Fund (IMF) has been holding “technical talks” with government officials on a rescue plan.

The IMF says the aim is to ensure the two sides are “fully prepared” to begin official negotiations on a bailout package as soon as the situation stabilises.

Right now, though, Sri Lanka’s new Prime Minister Ranil Wickremesinghe, a veteran opposition lawmaker and former premier, is struggling to forge a unity government while opponents are demanding fresh elections.

Opposition politicians want to boot out strongman President Gotabaya Rajapaksa, whose populist economic management is blamed for the country’s financial mess and who is stubbornly clinging to power.

Once the political uncertainty ends – and that may be some time – working out an IMF package will take as long as six months, government officials have said.

Before it can extend help, the IMF says it will need “adequate assurances” that Sri Lanka can achieve “debt sustainability” which means restructuring the nation’s huge external debt.

To tide over the country while it sorts out its loans, Colombo needs further lines of credit to import essential goods.

“The country owes money to a myriad of international creditors, which will make coming to a settlement harder,” said Capital Economics’ Emerging Markets analyst Alex Holmes, adding that “disorderly default remains a clear risk”. Sri Lanka’s credit rating stands just one notch above default.

Read Also: Sri Lankan situation is fraught with danger

Also, the IMF says Sri Lanka must agree to “a credible and coherent macroeconomic strategy” which will involve hiking taxes, cutting state spending, selling some public-sector assets as well as keeping monetary policy tight and following a floating exchange-rate policy.

The question is whether the new government would have the credibility and popular support to strike a deal with the IMF and implement painful fiscal austerity, economists say.

Another question is whether Sri Lanka would stick with a deal once the immediate crisis has blown over. Colombo has an unreliable track record, having abandoned seven of 16 previous IMF programmes.

How bad is the economic situation? “The outlook was dreadful and continues to worsen,” Holmes said. Sri Lanka suspended foreign debt payments in April to conserve dwindling foreign reserves to pay for essential food, fuel and medicine imports and in a policy U-turn declared it would seek IMF help after insisting for months it could work out a “home-grown” solution.

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People in Colombo sit on empty LPG cylinders as they block a road to protest against a shortage of fuel and cooking gas. Photo: AFP

The country, once seen as a South Asian economic success story, has been reeling from 12-hour blackouts and petrol, food and medicine shortages. Wickremesinghe said his goal was to create a country “where people can eat three meals a day again”, as many Sri Lankans say they can now only afford to eat one.

Wickremesinghe was on Monday afternoon due to address the nation to give a “full explanation” of the financial crisis. “There is a lot to be done and undone. We are prioritising matters, rest assured they shall be addressed as early as possible,” he said in a series of tweets on Sunday.

Despite suspending the repayments, foreign exchange reserves crashed to US$50 million this month. Newly appointed central bank chief Nandala Weerasinghe, a career central banker and an old IMF hand, has warned the economy faces “collapse beyond redemption” unless the political situation steadies.

The new prime minister is aiming to prove his parliamentary majority this week, although the main opposition party is refusing to join the new government as long as Rajapaksa remains president.

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Sri Lanka’s Prime Minister Ranil Wickremesinghe. Photo: AFP

Aside from government policy blunders, another blow has been the pandemic which has crippled the tourism industry, a key foreign exchange earner. Meanwhile, migrant workers remittances have slid 61 per cent year-on-year.

The rupee has slumped by 45 per cent against the US dollar since the central bank stopped defending it in March, causing import costs to skyrocket. Food inflation is nearly 50 per cent while overall inflation is 30 per cent. The final straw has been Russia’s invasion of Ukraine which has sent prices of oil and other commodities soaring.

“Sri Lanka desperately needs an IMF deal,” Holmes said. To get IMF assistance, Sri Lanka must urgently work out restructuring agreements with its creditors that include China, which extended loans to fund many of the white-elephant infrastructure projects in the Hambantota district, home to the powerful Rajapaksa clan which has dominated Sri Lanka’s politics for decades.

China has criticised Colombo’s decision to approach the IMF. Sri Lanka sought to renegotiate its repayment schedule with Beijing, but the Chinese offered instead more loans to repay existing borrowings.

But a statement from the new prime minister’s office has said the envoys of India, Japan and China have promised their governments will help in stabilising the economy.

Sri Lanka’s external debt was US$35 billion at the end of 2021, according to central bank data. Colombo owes US$20 billion to other nations as well as international lending institutions like the IMF.

A big chunk is also owed to international bondholders. China holds Sri Lankan debt of US$3.5 billion or 10 per cent of the external debt. Japan holds another 10 per cent. All creditors will likely have to forgive some debt, analysts say. They predict bondholders could face a haircut one-third to half their investment.

The IMF says it’s aware of the hardship austerity measures could place on ordinary Sri Lankans who are already suffering economic pain.

“Fiscal policy has to be formulated in a way that protects the livelihood of the most vulnerable,” said Anne-Marie Gulde-Wolf, the IMF’s acting Asia-Pacific director. Wherever possible, higher taxes “should be paid more by those that are well-off. The adjustment should not be forced on the most vulnerable”, she said.

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A street vegetable vendor pushes his cart in Colombo. Photo: Bloomberg

Wickremsinghe is regarded as pro-West and a free-market reformer, and so if his administration survives, his leadership could facilitate bailout negotiations with the IMF. Until an agreement with the lender can be clinched, Sri Lanka says it will need bridging finance of US$3-4 billion in bilateral credit to see it through the next few months.

Colombo is seeking the money from India and China, as well as from Japan, Oman, Qatar and the Gulf Cooperation Council countries.

The crisis has given India, which had been sidelined by the Rajapaksas in recent years in favour of China, a chance to regain its traditional influence in the country and push back against Beijing’s clout.

New Delhi has stepped in, extending nearly US$3 billion to Sri Lanka since January via currency swaps, credit lines for essentials and loan payment deferments. The reward for New Delhi has been a string of investment agreements.

India also has a keen interest in seeing an end to the economic crisis as Sri Lankans, calling themselves “economic refugees”, have already been arriving on its shores and New Delhi fears an influx.

Could there be light at the end of the tunnel? Assuming Sri Lanka agrees to an IMF deal by the end of the year, Holmes said the economy was likely to “contract by 5 per cent this year and stage only a gradual recovery in 2023-24”.

“Firm measures should eventually put the economy on a more sustainable footing” so long as Sri Lanka sticks with the programme, he said.