Sri Lanka Prime Minister Ranil Wickremesinghe declared the country "bankrupt" on 7 July this year.
If we take a quick look back, one can remember that Sri Lanka's economy began to deteriorate in late 2020. At the time, the authorities pinned the reason on the raging Covid-19 pandemic. However, one expert believed, it was primarily due to political incompetence and mounting debts with China.
Fast forward to 19 May 2022. Sri Lanka defaulted on its debt for the first time in its history as the country struggled with its worst financial crisis in more than 70 years. And since then, its foreign currency reserves have depleted.
What really transpired in Sri Lanka?
Because foreign exchange reserves are depleted, the prices of daily essentials, especially food, are set to skyrocket in the market. Due to inefficiency and electricity shortages, the economy's gears are grinding to a halt. Sri Lanka has reached the brink of a huge humanitarian calamity as a result of the financial crisis.
Experts believe that the main cause of the crisis in Sri Lanka is an increase in the money supply on unneeded large projects, which in turn, led to a rise in foreign debt. As the loan amount grows, so does the regular number of payments. Again, taxes have been decreased to keep the people calm, and the government's earnings have decreased.
Sri Lanka would have to pay almost $6 billion in foreign debt by 2022, despite having only $150 million in foreign exchange reserves, the lowest in its history. In addition, Sri Lanka will have to repay another $2.5 billion in foreign debt by 2023 to 2026.
There has been a long pandemic. The tourism industry, which is the country's main source of revenue, took a major hit. The Sri Lankan government tasked the army with ensuring that people could buy essentials such as rice and sugar at reasonable prices at the start of the year. That didn't help matters. In March, food inflation surpassed 30%.
According to the World Bank, more than 500,000 individuals in Sri Lanka have fallen below the poverty line since the pandemic began.
The country is never bankrupt
According to India Times it is incorrect to say that a country is going bankrupt. When a country fails to repay its debt, it does not declare bankruptcy, instead it defaults on loans. Another critical element to remember is that the "defaulter is the government, not the country."
Looking at the news coverage of the Sri Lankan tragedy, one may believe that it is unusual for a country's government to default; but that is not entirely true. At some point in history, most nations have defaulted or modified their obligations.
It was not Greece's first time, nor was it the first developed nation, to default on debt in 2015, owing the IMF $1.8 billion. In 377 BC, the country had its first debt default. Since the country's independence in 1829, Athens' governments have failed on loans for more than half of the national history.
Spain, on the other hand, has the highest rate of loan default in Europe. The country defaulted on its debts 15 times throughout the 18th and 19th centuries.
To avoid loan defaults, IMF member countries often enter into bailout or assistance arrangements with the institution. The IMF provides not just financial assistance, but also engineering skills to monitor the bailout package.
However, the bailout money does not come without restrictions. The government that accepted the bailout must adhere to a number of restrictions outlined in the Washington Consent Agreement. Cost-cutting measures, currency depreciation and trade liberalisation are a few examples, even if they are unpopular.
What factors contribute to default
The difficulty or inefficiencies of utilising it after taking out a loan pushes the government into default. When a country's government changes, the incoming government is nearly certain to default on the former government's financial burden. Then they must embark on the path of a bailout deal.
For example, Jamaica's $7.9 billion loan default in 2010 was blamed on government overspending and a decline in tourism, the country's most vital source of revenue.
A country may default for a variety of reasons. The government's coffers are strained if the flow of global liquidity fluctuates or tax collection is hindered for whatever reason.
What happens when a country declares bankruptcy?
When people or institutions go bankrupt, lenders acquire their assets. However, a country's assets cannot be purchased nor can foreign lenders be forced to pay the money owed to the government.
A point to keep in mind here is that if the defaulting country's government assets are located outside of the country, it is a different story. When Argentina defaulted in 2012, a naval training ship in Ghana was confiscated.
In most circumstances, the only way to have the debt paid by the defaulting countries is to renegotiate the loan terms. To reschedule the missed payments of treasury securities, which means that the bond's price will fall.
Argentina guaranteed its lenders one-third of the debt after defaulting on $8.1 billion in loans in 2011. From 2005 to 2010, 93% of their loans were converted into shares, and until 2016, the Argentine government was unable to refund 75% of the outstanding debt to the 'Valcher Fund' (fund for buying bonds that had defaulted).
What's the way forward?
Governments, in an ideal world, spend what they generate through taxes and investments to satisfy costs and responsibilities. When we have to borrow more than we can afford, the government can borrow in two different ways.
By issuing bonds, it collects money from inhabitants of the country in exchange for a promise to pay interest at a certain rate for a set length of time. The government can also obtain long-term loans from abroad and acquire funds from foreign investors by issuing foreign currency bonds. The government's debt is referred to as sovereign debt.
Loans within the country can be repaid in domestic currency, and the government can manage the debt by raising taxes, cutting interest rates, or creating fresh money if it is withheld. However, international debts must be repaid in foreign currency. As a result, the dollar must be removed from the income-generating investment sector, and the debt must be repaid if necessary.
The government has no power in this situation.
Bishal Basu is a student of Finance at North South University.