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By Zichen Wang,

Published on Pekingnology, Aug 15, 2022:

You’ve probably read an awful lot about the so-called “Debt Trap” by China. The Chinese have decried that as nonsense but nobody in China has been able to paint a full picture of the rising debt problems facing poor countries – until now… Professor Tang Xiaoyang, chair of the Department of International Relations at Tsinghua University, recently unveiled a detailed, 68-page report in English examining the impacts of Eurobonds on developing countries.
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You’ve probably read an awful lot about the so-called “Debt Trap” by China. The Chinese have decried that as nonsense but nobody in China has been able to paint a full picture of the rising debt problems facing poor countries – until now.

Prof. Tang Xiaoyang, chair of the Department of International Relations at Tsinghua University, recently unveiled a detailed, 68-page report in English examining the impacts of Eurobonds on developing countries.

Eurobonds do not mean bonds denominated in Euro/the Eurozone’s currency or bonds issued/bought by the EU, but an international bond that is denominated in a currency not native to the country where it is issued. The bonds are named Eurobonds because they originated in Europe, and are also called external bonds. They are commercial in nature and differ from bilateral or multilateral preferential loans.

Takeaways:

  1. Traditional bilateral and multilateral loans have grown relatively slowly and their shares in developing countries’ overall debt are actually decreasing. Meanwhile, the issuance of Eurobonds rocketed.
  2. Repayment periods of Eurobonds are significantly shorter than those of preferential loans. And the commercial contracts for Eurobonds are restricted from extending the repayment period.
  3. The interest rate of Eurobonds is much higher than that of preferential loans. For example, the coupon rates on 10-year Eurobonds issued by African countries in 2013-2019 are around 4% to 10%, while bilateral and multilateral debt rates are much lower. As a result, the financial cost of Eurobonds debt service accounts for a higher percentage of the cost of debt. Low and middle-income countries paid 63.2% of their total interest payments on international bonds in 2020 while only paying 9.8% for bilateral debt.
  4. Procyclical commercial behavior is not conducive to small and medium-sized economies. The issuance of Eurobonds by developing countries is market behavior. Pricing, subscription, and rating of Eurobonds by Western financial institutions are procyclical. When a recession hits, new bonds need higher coupon rates and lower issuance prices to attract investors, which exacerbates the situation.
  5. The timeliness of Eurobonds is not in tune with the economic development rhythm of developing countriesand is not helpful to maintain stable economic performance. Eurobonds are not only short-term, but their maturity also concentrates. Infrastructure construction and production projects in developing countries usually take a long time to complete. Some of them take more than 10 years to yield benefits, and the prospect of revenue is hard to guarantee. This means that bond-issuing countries have to frequently look for other valuable foreign exchange or issue bonds with higher interest rates to repay their maturing debts, further squeezing the limited liquidity and disturbing the normal economic order. If the issuing country fails to find money to repay the matured debt, it will default, and its future financing will become extremely difficult. The timing of international financial capital is mainly based on the mature economic activities of developed countries and is not flexible and tolerant enough to the liquidity challenges faced by developing countries.
  6. Eurobonds lack supervision over usage and neglect to cultivate long-term capacity of generating revenue. Eurobonds do not limit the purpose of use, and funds can be used for non-productive expenditure. The investors do not care about the use of funds. They only measure the investment risk by the overall macroeconomic situation of the country and seek to benefit from high price and high interest rates, without supervising and paying attention to the usage of funding. In the bond issuance documents of Eurobonds by many developing countries, the use of bond proceeds is simply written as “… the net proceeds of this issuance will be used for general budget purposes”,without including any substantial usage.
  7. However, for developing countries with unstable political and economic conditions, such freedom allows for bonds to be used for filling fiscal gaps or to serve as a funding source for short-term political goals, resulting in the situation of “living beyond their means”, while neglecting investment in productive and profitable projects, thus causing unsustainable long-term development.
  8. Market activities tend to add icing on the cake but rarely act as a lifeboat in a storm. Small and inexperienced developing countries lack the power to influence complex and huge international financial markets. Although these countries have more financing channels than before, they are also more likely to fall into the trap of debt repayment pressure driven by capital. If the issuer is not prepared to use the funds obtained when the financing costs are low to improve productivity and generate returns higher than interest, it is likely to fall into a vicious circle of borrowing new debts with higher interest rates to repay old debts under the market rules.
  9. The top 10 underwriters of developing country sovereign bonds are investment banks from the U.S., U.K., Switzerland, and the EU, with the market power of large underwriters becoming stronger.The top 15 subscribers in terms of holdings are also all from developed countries, mainly including well-known investment institutions from the US, Germany, France, and Italy. Investment companies from the U.S. subscribed the most number and amount of securities covered by sovereign bonds, with BlackRock topping the list of subscribers. Other major investors included fund managers, insurance and pension funds, hedge funds, and commercial banks.

    These financial institutions, with capital strength and profit-seeking motivation, have actively helped African countries and others issue Eurobonds and purchased large amounts, which greatly contributed to the rapid growth of total debt of Lower Middle-Income Countries (LMCs).

  10. The interests and priorities of investors in developed countries, the most powerful in the global economy, are not the same as those of peasants and laborers in developing countries. Developing countries must be vigilant when entering the financial markets dominated by these investors, otherwise they will not be able to properly protect the priority interests of their own economies, people, and societies once a debt crisis erupts. The international community needs to provide developing countries with more precise information, in-depth analysis, and timely guidance to help them avoid these financial traps.

Read the full report in English via Google Drive

The Trap of Financial Capital: The Impact of International Bonds on the Debt Sustainability of Developing Countries.

About the author

Prof. Tang Xiaoyang is the chair of the Department of International Relations at Tsinghua University. He is the author of Coevolutionary Pragmatism: Approaches and Impacts of China-Africa Economic Cooperation (Cambridge University Press 2020) and has published extensively on international development.

Tang completed his Ph.D. in the philosophy department at the New School for Social Research in New York. Tang worked as a consultant for the World Bank, UNDP, USAID, and various research institutes and consulting companies. Before Tsinghua, he worked at International Food Policy Research Institute(IFPRI) in Washington, DC. Tang is also a resident scholar and the deputy director of Carnegie China.

Research Background

In the twenty-first century, international bonds have become an important financing tool for developing countries and have significantly changed the structure of their external debt. This trend has been particularly evident in the aftermath of the 2008 global financial crisis, with the stock of sovereign bonds of all low and middle-income countries rising from $484.3 billion in 2009 to $1,737.2 billion in 2020.

The share of sovereign bonds in the government-guaranteed external debt of low and middle-income countries correspondingly climbed from 30.7% in 2009 to 50.4% in 2020. At the same time, traditional bilateral and multilateral loans have grown relatively slowly and their shares in developing countries’ overall debt are actually decreasing.

Sub-Saharan African countries’ sovereign bonds have grown particularly fast, with their stocks quintupling from just $22.6 billion in 2009 to $136.6 billion in 2020. In contrast, the bilateral debt of African countries has only about doubled in the same period, amounting to $114.9 billion in 2020, and similar phenomena have been observed in other regions.

In addition, the coupon rates on 10-year Eurobonds issued by African countries in 2013-2019 are around 4% to 10%, while bilateral and multilateral debt rates are much lower. Considering the generally high-interest rates on international bonds, the financial cost of international bond debt service accounts for a higher percentage of the cost of debt for these countries.

Low and middle-income countries paid 63.2% of their total interest payments on international bonds in 2020 while only paying 9.8% for bilateral debt. It is important to note how the surging bond stock and high financial outlays affect low and middle-income countries that issue bonds.

Since 2016, developing countries have been facing steadily rising debt pressure due to a combination of multiple external factors, including severe fiscal deficits, falling commodity prices, declining international demand, the COVID-19 epidemic, etc.

However, international attention has largely focused on non-Western emerging lenders, for instance, China, and has put forward factually ungrounded arguments like “debt trap”, while seriously underestimating the impact of international bonds on sovereign debts.

With the peak of international bond repayments in the coming years and the volatility of capital markets caused by the new cycle of US dollar interest rate hikes, developing countries will face a more severe external debt burden.

Systematic Reflections on the Impacts of Eurobonds on Developing Countries

The issuance of Eurobonds by developing countries is a market behavior, but its main driving force comes from the need of international financial capital to pursue high returns. Admittedly, developing countries have demand of funding, as a result of expansionary fiscal policies. However, they reduced the proportion of bilateral and multilateral preferential loans, which have low interest rates and long repayment cycles, mainly because the international financial market has offered convenient and abundant funds for these countries to issue Eurobonds.

Nevertheless, institutional investors from the advanced economies respond enthusiastically to bonds issued by developing countries completely out of their own commercial interests. Their operations mainly follow the practices of mature markets in the world, which meet the needs of investors to obtain high returns in the short term but neglect the vulnerability of the economic structures and the particularity of the long-term development of developing countries. Specifically, commercial international bonds have the following three systematic risks to the debt sustainability of developing countries, which call for special attention and improvement measures to be taken as soon as possible in order to avoid further expansion of debt default crises and more serious consequences for global development.

Procyclical commercial behavior is not conducive to small and medium-sized economies

Pricing, subscription, and rating of Western financial institutions are procyclical. In the period of high global liquidity and commercial prices, developing countries that mainly rely on mineral and energy export are in a period of economic prosperity, so they are more likely to issue sovereign bonds and have high ratings while the cost of issuing bonds is relatively low.

However, if the global economy is in recession and the prices of resources decline, these countries may need to finance more to maintain economic stability, but at this time, rating agencies would downgrade their credit ratings. Meanwhile, new bonds need higher coupon rates and lower issuance prices to attract investors, which exacerbates the situation.

Although developed countries also face similar superimposed market fluctuation, developing countries usually have less revenue sources and smaller economic volume, so they are more likely to face crisis or default. In addition, as the issuance of Eurobonds is mainly denominated in the U.S. dollar, when the liquidity of the dollar is loose and the exchange rate is low, it is easy to issue Eurobonds, but when the U.S. dollar has higher interest rates and the exchange rates rise, a large amount of funds flows out of developing countries, which makes bond-issuing countries have to borrow money and repay debts at high interest rates and exchange rates during a period of tightest liquidity, forming another superimposed impact.

The timeliness of Eurobonds is not in tune with the economic development rhythm of developing countries 

Eurobonds are not only short-term, but their maturity also concentrates. Infrastructure construction and production projects in developing countries usually take a long time to complete. Some of them take more than 10 years to yield benefits, and the prospect of revenue is hard to guarantee. This means that bond-issuing countries have to frequently look for other valuable foreign exchange or issue bonds with higher interest rates to repay their maturing debts, further squeezing the limited liquidity and disturbing the normal economic order. If the issuing country fails to find money to repay the matured debt, it will default, and its future financing will become extremely difficult. The timing of international financial capital is mainly based on the mature economic activities of developed countries and is not flexible and tolerant enough to the liquidity challenge faced by developing countries.

Due to market factors such as low ratings and high risks, the maturity of Eurobonds issued by developing countries is mostly shorter than the bilateral or multilateral loans provided by governments, multilateral banks, and international organizations. Before African countries issued sovereignty guaranteed Eurobonds, their debts were mainly composed of bilateral and multilateral preferential loans with an average interest rate of 1.6% and maturity of 28.7 years.

In contrast, the repayment periods of Eurobonds issued by African countries are significantly shorter than those of preferential loans. The interest rate is much higher than that of preferential loans, and commercial contracts are restricted from extending the repayment period.

According to the IMF, from 2004 to 2013, the maturity of Eurobonds issued by African countries ranged from 5 to 10 years, of which 5 to 7-year bonds account for 50% and 10-year bonds account for 50%.

The large stock of commercial bonds in developing countries has led to higher debt servicing costs and reduced financial sustainability. Especially the reduction of available liquidity threatens macroeconomic stability.

At the peak of debt repayment, if emerging market debtor countries cannot manage to refinance, they will be forced to spend a large amount of foreign exchange reserves to repay the debt, which may lead to a sudden reduction in the public expenditure and cause devastating consequences to national development.

The impacts of sudden reductions in government expenditure include: the infrastructure constructions and the public projects stagnate and will be unable to recover existing investment; the government’s means of stimulating economic growth are further limited, the overall social output decreases, and the unemployment rate increases; the normal economic order is seriously disturbed, and bankruptcy and default spread.

For emerging countries that urgently need to develop infrastructure and lack a sound industrial system, the sudden reduction of public expenditure caused by the debt repayment peak and the difficulties in refinancing might bring an abrupt end to the economic structural transformation efforts of the past few years or even more. It will take a long time to recover the pre-crisis results after the liquidity crisis. Such a huge impact of cyclical repayment has already caused several developing countries, including Argentina and Ecuador, to fall into the vicious cycle of unsustainable economic growth in modern history.

Eurobonds lack supervision over usage and neglect to cultivate long-term capacity of generating revenue

Eurobonds do not limit the purpose of use, and funds can be used for non-productive expenditure. The investors do not care about the use of funds. They only measure the investment risk by the overall macroeconomic situation of the country and seek to benefit from high price and high interest rates, without supervising and paying attention to the usage of funding. However, for developing countries with unstable political and economic conditions, such freedom allows for bonds to be used for filling fiscal gaps or to serve as a funding source for short-term political goals, resulting in the situation of “living beyond their means”, while neglecting investment in productive and profitable projects, thus causing unsustainable long-term development.

The proceeds of Eurobonds guaranteed by sovereignty usually do not have specific purposes, which is different from bilateral or multilateral preferential loans and general commercial bonds. For general commercial bonds, enterprises are required to clearly state the investment usage of the financing funds and explain how to bring future output. Accordingly, investors will pay attention to the future profitability of the bond issuers.

However, because sovereign bonds have lower default risk and higher credibility compared with corporate bonds, countries are not required to promise the use of bond proceeds when issuing Eurobonds. In the bond issuance documents of Eurobonds by many developing countries, the use of bond proceeds is simply written as “… the net proceeds of this issuance will be used for general budget purposes”, without including any substantial usage.

For buyers in the bond market, they are prone to measure investment risk based on indicators, such as outstanding debts, resource reserves, and overall macroeconomic prospects; they seek high returns, without paying attention to and supervising the use of funds raised through bonds, and seldom considering the specific contribution or risk of bond issuance to the development of bond-issuing countries.

Bond-issuing countries can freely invest and use the funds raised from Eurobonds, and they have more freedom in debt management. But under the surface of freedom, the use and management of such a large amount of fund that arrives suddenly is a great challenge for developing countries without stable and sound political and economic systems.

Sometimes, funds are used for filling fiscal gaps or serving short-term political goals, while neglecting investment in projects which improve productivity and generate revenue, thus causing unsustainable long-term development.

In 2019, Edward Ouko, the auditor general of Kenya, submitted a special audit report to the National Assembly of Kenya, stating that although his office could confirm that $2.15 billion Eurobond proceeds had entered into Kenya’s National Exchequer Account, as the National Treasury failed to disclose the specific purpose of the money, the audit office could not determine which development projects the money was specifically used for, or whether it is really used for development projects as stated in the bond issuance.

The National Treasury responded that the proceeds had been deposited into the National Exchequer Accounts in the Central Bank of Kenya (CBK), so it was impossible to confirm whether it was used for any specific infrastructure projects. The auditor general dismissed the explanation of the National Treasury and believed that funds raised through international sovereign bonds should be earmarked and traced to specific development projects.

Before the COVID-19 pandemic, some developing countries chose to use the funds raised through issuing Eurobonds for large-scale infrastructure construction projects. However, infrastructure construction takes a long time, and the return time is also very long. Sometimes infrastructure projects need long-term, large, and stable investment to meet the need of public welfare and may even suffer from long-term losses, rendering Eurobonds, with short maturity and high interest rates, unsuitable for infrastructure projects.

For example, in 2014, Ethiopia issued Eurobonds to finance the construction of 10 state-owned sugar manufacturing projects, but the development of the sugar industry was not smooth. The planting areas of sugarcane, including Kuraz, decreased. The decline of sugar output made the Ethiopian government unable to repay the debt and interest, putting a heavy debt burden on the government.

In the past three years, African countries have been plagued by debt crises. Especially after the COVID-19 pandemic, almost all newly issued Eurobonds have been used for supporting non-productive short-term expenditure and repaying maturing bonds. Bonds issued by Benin, Côte d’Ivoire, Kenya, Morocco, Gabon, Ghana, and Egypt are all used for raising funds to support budget deficits and bond refinancing.

This practice of African debtor countries has made Eurobonds into an expensive source of disposable income, which is often used to fill fiscal deficits and finance short-term political goals. Priorities of longer terms, such as crucial infrastructure and economic diversity, have been shelved. Therefore, the income from Eurobonds is only filling the fiscal gap and cannot bring more fiscal revenue, leading African countries to fall into a vicious cycle.

Surging Eurobond Issue and Its Consequences

The main component of international bonds for developing countries is Eurobonds, which are bonds issued by a government, financial institution, business enterprise, or international organization in foreign bond markets in the denomination of a third country’s denominated currency (usually U.S. dollars or euros). Eurobonds provide a means for developing countries to quickly raise a significant amount of capital. They are flexible, easy to issue, inexpensive, not subject to official approval, and not subject to any national interest rate control or limit on the amount of issuance. As the bondholders can stay anonymous and can keep the bonds overseas, they may avoid the income tax on their interest income, which attracts many investors.

Generally speaking, countries with high credit mainly finance through Eurobonds, while countries with low credit mainly finance through bilateral and multilateral borrowing with sovereign guarantees. Low-income developing countries have difficulties accessing financing in international capital markets due to their mediocre economic performance, investment environment, and credit ratings. Because of the remarkable economic surge of developing countries in the early twenty-first century, coupled with the tepid economic situation in developed countries in Europe and the United States, financial institutions hoped to find high returns in emerging economies, and Eurobonds have seen a quick surge in Asia, Africa, and Latin America in the last decade.

Although most African countries have only been issuing sovereign bonds in international capital markets since 2007, this financial instrument has become a more common choice for African countries as of 2021. More than 20 African countries hold one or more outstanding Eurobonds, and in 2021 alone, African countries issued $11.8 billion worth of Eurobonds. Eurobond issuance in Asia and Latin America have also shown an upward trend.

The top 10 underwriters of developing country sovereign bonds are investment banks from the U.S., U.K., Switzerland, and the EU, with the market power of large underwriters becoming stronger.

The top 15 subscribers in terms of holdings are also all from developed countries, mainly including well-known investment institutions from the US, Germany, France, and Italy. Investment companies from the U.S. subscribed the most number and amount of securities covered by sovereign bonds, with BlackRock topping the list of subscribers. Other major investors included fund managers, insurance and pension funds, hedge funds, and commercial banks.

These financial institutions, with capital strength and profit-seeking motivation, have actively helped African countries and others issue Eurobonds and purchased large amounts, which greatly contributed to the rapid growth of total debt of LMCs. Although the favor of capital allows developing countries to easily obtain financing in a short period, the accumulation of debt will become a long-term uncertainty in the international debt market.

Usually the rating of B- is considered the lowest acceptable rating for issuances in international capital market. However, investors driven by yields have been increasing their acceptance of credit risk and pricing in the risk of default in a low interest rate environment. A number of low-income countries have successfully issued sovereign bonds despite having sovereign ratings below B-, and the low sovereign ratings at the time of issuance do not appear to have been a significant impediment to these countries issuing Eurobonds. Moreover, many countries continue to issue Eurobonds even though their credit ratings have been downgraded since the initial Eurobond issuance.

The demand for investment by international financial capital, in defiance of traditional risk management rules, has led to a surge in sovereign bond issues in developing country markets. In addition, many investors actively or passively track market indices or benchmark their investments against them. Some “automatic” purchase demand is generated if a bond qualifies for inclusion in an index.

Most Eurobond coupon rates in developed countries are below 2%; in contrast, 10-year Eurobond coupon rates for African countries issued in 2013-2019 were between 4% and 10%, with a slow upward trend, indicating that the sovereign bond coupon rates for African economies are higher than usual. Against the backdrop of the global capital market downturn, high-interest rate Eurobonds offered by developing countries show unprecedented attractiveness.

At the same time, compared to the secondary market prices of developed country sovereign bonds, the prices of developing country sovereign bonds in the secondary market are generally lower, showing an overall trend of significant deviation from the issue price. Although low secondary market prices and low trading frequency do not directly affect the current financing costs of issuing countries in terms of outstanding sovereign bond, the change in the market’s risk judgment of their sovereign bond may lead to the need for issuing countries to use higher coupon rates and lower issue prices to attract investors when issuing new bonds. From this perspective, the cost of financing for developing countries may face indirect pressures to rise in the future.

Surging bond stocks in developing countries have led to higher debt service costs, shrinking fiscal resources, and macroeconomic instability. Sub-Saharan Africa’s debt grew from 35% of GDP in 2014 to 55% in 2019, with interest payments becoming the highest spending component of fiscal budgets and debt service consuming on average more than 20% of government revenues in African countries as the fastest growing expense. The maturity of Eurobonds issued by African countries is also significantly shorter than bilateral or multilateral borrowing, with the average maturity of bilateral and multilateral concessional loans received by African countries reaching 28.7 years. In contrast, the repayment terms of Eurobonds issued by African countries are significantly shorter than those of concessional loans and are not easily rolled over due to commercial contractual constraints. The maturity of Eurobonds issued in the early years ranged from 5 to 10 years, and even though the maturity of Eurobonds issued after 2014 has been extended, long-term bonds account for a relatively small share. Under the dual impact of concentrated debt issues and short bond maturities, African countries are expected to experience their first debt service peak in 2023-2025. According to statistics, African countries will need to repay a total amount of over $106 billion Eurobonds by 2025, and the reduction in available financial liquidity could jeopardize macroeconomic stability. By the time debt service peaks, emerging market debtor countries that are unable to successfully refinance their debt will be forced to spend large amounts of foreign reserves on debt service, which is likely to lead to a sudden reduction in public spending with devastating consequences for national development.

The severe debt situation and the impending debt service peaks are likely to cause developing countries to experience credit rating downgrades and reduced access to international capital markets. With lowered credit ratings, these countries will have to obtain future financing at higher costs and may even be excluded from international capital markets altogether. At the same time, as the Federal Reserve in the US raises interest rates and shrinks its balance sheet, the U.S. dollar experiences a significant appreciation, and international investors’ capital will flow back from emerging economies to developed economies such as the United States. A massive sell-off of bonds issued by emerging economies will lead to a decline in their bond prices and a rise in bond yields, increasing the size of foreign debt. The massive capital flight itself will in turn trigger currency depreciation in developing countries, making the size of bonds denominated in foreign currency bigger.

Combined with the COVID-19 epidemic further reducing government revenues in developing countries, many countries may not have the necessary capital to repay their bonds as they are due. If payments are overdue, a large-scale emergence of defaults and restructuring agreements may occur. The disposition of defaults on international bonds may also be more complex than bilateral and multilateral debt, even with the emergence of “vulture hedge funds” that acquire distressed assets and seek high profits through malicious litigation, which can cause lasting and substantial economic damage to the issuing countries.

Overview of Sri Lanka

Sri Lanka is an island country in the southern Indian Ocean. Its economy is dominated by plantation economy, and its main crops include tea, rubber, coconut, and rice. Its industrial base is weak while agricultural production and the garment manufacturing industry play an important role. Sri Lanka has a low level of technological development and insufficient economic growth impetus. From 2013 to 2019, its GDP growth rates hovered between 2%-4%, which was lower than the average level of its neighbors in South Asia.

Sri Lanka’s foreign exchange income mainly comes from primary product export, immigrant remittance, and tourism, and its exports fluctuate greatly. Since 2010, Sri Lanka’s export has stagnated for a long time and even registered negative growth sometimes, putting the country in a trade deficit for many years (See figure 4-3). Sri Lanka’s foreign exchange reserves also showed a corresponding downward trend. The country’s foreign reserves fell from $7.5 billion in November 2019, when the new government took office, to less than $2 billion at the beginning of 2022, which could only sustain the import expenditure of the following months. Meanwhile, its public budget deficit has been widening. Sri Lanka has long been implementing a wide range of social welfare subsidy policies, causing great expenditure pressure, which can only be alleviated by long-term financial overdraft. According to the statistics of the World Bank, the overall budget deficit of Sri Lanka increased by 160% from 2007 to 2017, and the total debt owed by the government increased by 209%.

Background and Causes of Sri Lanka’s Bond Default

In recent years, Sri Lanka fell into a debt crisis mainly because its foreign exchange reserves are almost entirely composed of commercial loans and the investment income is lower than the interest on loans. From 2007 to 2017, Sri Lanka’s non-project loans increased by 605%, and the growth rate of project loans was only about 117%. Non-project loans increased too fast, and they could not generate income to repay the principal and interest.

In addition, since the issuance of international sovereign bonds in 2007, the proportion of multilateral and bilateral preferential loans in Sri Lanka’s external debt has declined rapidly. In 2017, commercial loans accounted for 42.98% of its total debt, with an average interest rate reaching 6.29% and a maturity of about 7 years. The government was forced to borrow new debt to repay the existing debt in a short amount of time. Sri Lanka issued 14 international bonds between 2017 and 2019, with a total amount of $16.55 billion, and the coupon rate rose to 7.85% in 2019.

With the strong dollar and the recovery of capital markets in developed countries, heavily indebted Sri Lanka became particularly vulnerable to a refinancing crisis. Sri Lanka’s external debt accounted for about 42% of its GDP in 2019 but has risen to 119% of GDP in 2021.

From the perspective of liquidity, the proportion of foreign exchange reserves to foreign debt in Sri Lanka has fell from 24.2% in 2011 to 5.48% in 2021, which indicates that its foreign exchange reserves will face serious challenges in response to emergencies in the future, exacerbated by the fact that 2019-2022 and 2025-2027 are the two peak periods of foreign debt repayment in Sri Lanka.

The COVID-19 pandemic and the Russia-Ukraine conflict hit Sri Lanka’s economy severely. First, tourism used to account for more than one-tenth of Sri Lanka’s GDP. In 2018, tourism earned $4.4 billion for Sri Lanka and contributed 5.6% to GDP, but due to the pandemic, the figure fell to 0.8%. According to the data provided by the Sri Lankan Tourism Development Authority in the Monthly Tourism Arrivals Report of February 2022, Russia and Ukraine are Sri Lanka’s two largest source countries of tourists. In the first two months of 2022, there were nearly 28,000 tourists from Russia and 13,062 tourists from Ukraine arriving in Sri Lanka. With the outbreak of the Russia-Ukraine conflict, the tourists from the two countries have declined sharply.

The conflict also takes tolls on the tea export of Sri Lanka, which is another source of foreign exchange reserves because Russia is the largest importer of Sri Lanka’s tea. Under the Western sanctions, the ruble collapsed, making it difficult for Russians to continue to import Sri Lanka’s tea. At the same time, global commodity prices soared due to the influence of the pandemic and the Russia-Ukraine conflict, leading to a surge in the prices of crude oil and food which are in short supply in Sri Lanka.

By March 2022, Sri Lanka’s national inflation rate climbed to 17.5% and foreign exchange reserves fell to $1.9 billion. It was nearly impossible to repay the dollar debt due in 2022, of which the maturing Eurobonds amounted to $2 billion. In this situation, on April 12, 2022, Sri Lanka announced that it would default on its external debt, which was its first debt default since its founding.

In the past decade, Sri Lanka has failed to effectively promote industrial transformation and find new sources of income generation at home and abroad. Instead, it has issued large amounts of commercial bonds, which increased the fiscal deficit and made the country fall into the dilemma of borrowing new debt to repay the old debt with rising interest rates. Under the superimposed impacts of the pandemic, the Russia-Ukraine conflict and international financial fluctuations, the vulnerable Sri Lankan economy could no longer bear pressure and collapsed rapidly. Other developing countries should seek to learn from Sri Lanka’s painful lessons.

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