When none other than the Prime Minister says that the country’s economy has “completely collapsed,” you know things are really bad. With Sri Lanka’s Extraordinary high inflation (just over 60% as of July 2022), a near exhaustion of their foreign reserves, and a growing shortage of essentials, it can be easy to see why Ranil Wickremesinghe chose those particular words. In today’s article, we’re going to take a look at Sri Lanka’s ongoing economic crisis.
The Buildup
Some experts say that the disaster showed clear signs as early as 2014. The Institute of Policy Studies (IPS) described 2 main problems plaguing the Sri Lankan economy at the time. The first is what’s called hot money - capital that investors frequently move between different financial markets in order to profit off of the highest short-term interest rates available to them. Broadly speaking, the way it works is that a given country’s banks will offer short-term certificates of deposits (CDs, a kind of savings account that holds a fixed amount of money for a fixed amount of time in exchange for paid interest. This differs from regular savings accounts in that the depositor can’t touch their money for the agreed upon amount of time.) with generous interest rates in order to attract investors’ money - including money from other countries.
This in and of itself isn’t detrimental per se, but the problem was that Sri Lanka relied heavily on hot money as a means to build their foreign reserves. Do keep in mind, however, that all these foreign funds coming into Sri Lanka were being invested more so in Treasury bills and bonds rather than CDs. Regardless, the general principle of hot money remains. So then what happens if the central bank decides to lower interest rates in order to pursue an expansionary economic policy? Those funds are going to decrease and, in Sri Lanka’s case, so are the foreign reserves. To quote from an article written by the former Deputy Governor of the Central Bank:
…Sri Lanka has relied on foreign hot money to build its foreign reserves by permitting foreigners to invest in high yielding government paper. Such funds, amounting to $3.5 billion as at end October and accounting for about 40% of total official foreign reserves, have been attracted by Sri Lanka mainly by offering higher yields on government securities…This incentive will be narrowed and finally be negative if Sri Lanka reduces its interest rates to a low level.
But how does hot money help with the problem of foreign reserves? Simple - say you’re an investor with $1 million USD sitting in your bank account. The Sri Lankan government then increases the yield on their T-bills, and so you move those American funds to said T-bills; you now have yourself an asset with a higher-than-average return and the Sri Lankan central bank has a million dollars to deposit in their foreign reserves. Of course, this flow of money can be maintained only if the T-bill yield is kept abnormally higher.
The second point of concern the IPS highlighted was the government’s borrowing practices. Sri Lanka began issuing sovereign bonds (a government bond issued with the intent of financing government spending) at commercial interest rates. Let’s look at this arrangement for a minute: we have a government bond, an asset that’s generally thought of to be the safest out there, offering the same interest rates as riskier securities. In other words, lower risk and higher return.
Naturally, investors flocked to Sri Lankan government bonds and happily provided the sought-after funds. Exactly what is the problem then? There is a reason governments and/or public sector institutions, particularly that of developing and underdeveloped countries, refrain from borrowing private funds: the interest rates are almost always simply too high. That’s why they instead turn to international lending institutions that offer funds tailored to the nation’s tight economic circumstances. These are called concessionary loans - lower interest rates, longer payback period, etc.
As Sri Lanka moved from a low to middle-income country in 2010, however, it was no longer eligible for many of these generous loan terms. As a result, commercial loans as a percent of their foreign debt skyrocketed:
Now remember, the Sri Lankan economy hasn’t collapsed quite yet - all this is simply the groundwork for what’s coming.
Things Go South
Tourism is Sri Lanka’s 3rd largest foreign income sector and accounts for 12% of GDP. So when the 2019 Easter bombings (wherein 269 people were killed) and COVID-19 pandemic hit, travellers grew more reluctant to visit Sri Lanka (or anywhere for that matter). When the tourist industry sharply declined, as did all the much-needed government tax revenue associated with it. Gotabaya Rajapaksa, the newly-elected President, also enacted massive tax breaks at the beginning of his term in 2019 in an attempt to stimulate the economy (less taxes means more money people have to spend), but these cuts only further worsened the country’s growing deficit:
These huge hits in government revenue prompted international rating agencies (a company that assesses the financial strength of other companies and/or government entities, principally in regards to their ability to pay off debt) to downgrade their evaluation of Sri Lanka, effectively blocking off the country’s ties to international markets, as no one wants to lend to a borrower that’s on default levels. So in terms of paying debt, government revenue clearly is no longer an option; what else can be done? Foreign exchange reserves are an option, especially when dealing with foreign creditors (an entity that provides credit, in that they’re lending money to another entity that’s to be repaid in the future). Governments can simply open up their “forex vaults” and withdraw the money necessary to pay off an investor based in, say, the United States, which is precisely what Sri Lanka did, shrinking its foreign reserves from $6.9 billion in 2018 to around $2 billion in 2022:
Now what does all this mean for the national currency, the Sri Lankan rupee? More than anything, it ensues in a fatal imbalance between foreign currency imports and exports (which also results in high inflation). Sri Lanka is simply unable to import adequate amounts of foreign currency in order to replenish their reserves; the devastated tourism industry and international reluctance to purchase any of the central bank’s bonds are the key culprits in this regard. On the other side of things, foreign currency outflows are increasing due to not only the higher debt payments, but also Sri Lank’s widening trade deficit.
As explained in our article on the currency markets, importing a product requires the outflow of the exporting country’s currency, since the customer must pay in the exporter’s currency. The trade deficit is also further depleting the Sri Lankan rupee; importing a foreign product requires the currency of the exporting country, which decreases the former’s demand and increases that of the latter’s.
The Politics
Sri Lanka’s current struggles are by no means solely economic in nature - there’s an entire political story that played a major role in how everything came to be. Although SoBasically is indeed an economics newsletter, it is nevertheless imperative to at least touch upon these sorts of events.
In 2018, before many of the economic ills grew prevalent, President Maithripala Sirisena dismissed Prime Minister Ranil Wickremesinghe and replaced him with Mahinda Rajapaksa, a leader with a long history of human rights abuses and nepotism. Sri Lanka has 3 branches of government; the President is the most powerful government official and belongs to the executive branch whereas the PM, being the most senior member of Parliament, belongs to the legislative branch and is second in command to the President.
However, this new PM’s nomination caused a constitutional crisis wherein various ministers and members of Parliament called it illegal. Fast forward to March 2022, and now citizens are becoming fed up with the inflation and lack of essential supplies, eventually taking their anger to the streets. Things got really bad at the end of the month when protestors threw bricks and started fires outside the President's private residence.
A 36-hour curfew, nationwide social media blackout, and heightened law enforcement powers were all subsequently implemented. None of that stopped demonstrators, and the protests continued. After a series of mass resignations of top ministers, the country’s cabinet (a body of government advisors who also serve as heads of government departments) dissolved.
Then, in early July, President Rajapaksa fled the country after rioters stormed the president's official residence and set fire to the prime minister's home. People had been demanding his resignation for months, and it seemed like he finally caved in. Sri Lanka's constitution says that if the President resigns, the PM will assume the role, so the country’s future now lies in the hands of Ranil Wickremesinghe, the new President.
As for what’s next, Sri Lanka has been seeking aid from its neighbors, with India being notably supportive in providing over $3.5 billion in relief funds as of early July. Talks with the IMF also commenced, with a bailout mandating serious economic reforms that will hopefully not only alleviate the nation’s woes, but pave the way for a better future going forward.
Econ IRL
A convenience yield is the return someone gets for holding an underlying asset or good such as oil or gold, rather than a derivative associated with it. But what about the convenience yield of holding government debt? This kind of asset is generally considered to be so safe that simply having it can be thought to provide a convenience yield. This week’s paper approaches the question by comparing government yields to a risk-free rate (the interest an investor would expect from an absolutely risk-free investment over a specified period of time) in the options markets.
The authors first find that the convenience yield in the US is, on average, 35 basis points (0.35%), but this is also strongly correlated to the level of interest rates; every 1% rise in interest rates causes a 15 basis points increase in the convenience yield. The second finding has to do in the case of a financial crisis: when such events occur in a given country, its respective convenience rate spikes relative to that of others. But when comparing US vs foreign option rates, US rates always fell more during a crisis.
This all suggests a special demand for dollar-denominated assets in general, and said demand spikes during a financial crisis.
‘Till next time,
SoBasically