After China, India aid, is IMF help Sri Lanka's best hope as Rajapaksa battles worst economic crisis since independence?

As anger in Sri Lanka mounts over massive food and fuel shortages, the government is hoping to negotiate a financial lifeline from the International Monetary Fund to end the country's spiralling economic crisis.

Finance Minister Basil Rajapaksa will head to Washington this month to discuss bailout terms for the island nation of 22 million that is saddled with huge debts, a junk credit rating and depleted foreign exchange reserves.

Gotabaya Rajapaksa, Sri Lanka's strongman populist president and Basil's older brother, made a policy U-turn last month and agreed to seek an IMF rescue as demonstrators took to the streets.

Do you have questions about the biggest topics and trends from around the world? Get the answers with SCMP Knowledge, our new platform of curated content with explainers, FAQs, analyses and infographics brought to you by our award-winning team.

"Seeking IMF help is the way forward to stabilise our finances," said Nimal Sanderatne, an ex-senior central bank economist. But the fiscal and monetary reforms required will be "extremely painful and politically challenging," he added.

Sri Lanka was once South Asia's best-performing economy even as it binged on debt - first to pay for a long civil war against Tamil insurgents that ended in 2009, then to fund post-war construction.

But the government is quickly running out of options to resolve the country's worst economic crisis in living memory. Massive debt-servicing costs and a pandemic-induced tourism slump have led to a shortage of foreign currency in the import-dependent nation which buys everything from baby milk, rice and cooking gas to medicines and cement from abroad.

The IMF has already sketched the broad outlines of a "credible and coherent strategy" for the government to seek "macroeconomic stability and debt sustainability" and avert a sovereign debt default. The plan would mean stringent fiscal consolidation - in short: more taxes, hefty government spending cuts and higher interest rates.

Sri Lanka's challenges include public debt at "unsustainable levels, low international reserves, and persistently large financing needs" the IMF said bluntly in a report, adding that the island is facing a "clear solvency problem".

The reforms required for an IMF rescue would mean "a sharp economic slowdown in the near term but [that would] then put the economy on a more secure footing," said Alex Holmes, an emerging-markets economist at Capital Economics. Some debt restructuring would also be needed and Sri Lanka would have to adopt a permanently floating exchange rate, he said in a note to investors.

Shilah Shah, senior economist at the same London-based research consultancy, cautioned in a separate note that there's "no guarantee" the government can work out an IMF programme, or if it would even stick to one. Sri Lanka has completed only nine of 16 previous IMF deals and there's a "significant chance" it might default over the next couple of years, Shah said.

Sri Lanka's problems have deepened over the last few days with 10-hour daily power cuts - even street lights are being turned off - as the government does not have the foreign currency to pay for fuel imports. Hospitals are cancelling surgeries due to anaesthetic and other drug shortages. Skyrocketing food prices mean families are only eating one or two meals a day.

Rajapaksa, known as "The Terminator" when he was defence minister during the civil war, swept to power in 2019 on an election manifesto grandly titled "Vistas of Prosperity and Splendour".

He ditched an ongoing IMF financial stabilisation programme. Instead, in a move reflecting his ultranationalism, he promoted a "home-grown solution" to jump-start the tourism-dependent economy which was reeling from the deadly 2019 Easter Sunday bombings. But his remedy, involving slashing corporate taxes and nearly halving a value-added tax, only exacerbated the island's woes. Tax revenues slid and the budget deficit soared. The central bank has been printing money to pay state salaries, repay bonds, finance the deficit and keep interest rates down.

Rajapaksa's "reforms" inevitably stoked inflation, now at 15 per cent, while the rupee plunged in black market trade. Credit-rating downgrades shut access to global capital markets, making Sri Lanka unable to refinance its debt, while Covid-19 wiped out tourism foreign-exchange earnings. To retain enough foreign currency to service the debt, Rajapaksa curbed imports of cars, air conditioners, TVs, cosmetics and other goods. Then, he banned chemical fertiliser imports until shrinking harvests made him abandon his plans to make the island an "organic Utopia".

Now, a tougher global credit environment due to tighter US monetary policy and rising fuel costs aggravated by Russia's Ukraine invasion have piled on more financial pressure. The war also stalled the tourism sector's post-pandemic recovery by halting arrivals of Russian and Ukrainian tourists who were flocking to Sri Lanka's beaches. Tourism accounted for more than 12 per cent of the country's total economic output before Covid-19.

As public protests spread, the president abandoned his rigid opposition to an IMF rescue he previously insisted would mean unacceptably harsh austerity measures and asked for help to alleviate the economy's slide.

Rajapaksa has traditionally favoured "all-weather friend" China for the support it gave during the civil war. Lately, though, he has also been energetically recultivating ties with nearest neighbour India. Both countries have extended significant financial aid. China, whose influence has grown in the strategic Indian Ocean island which is part of the Belt and Road Initiative, is mulling giving an extra US$2.5 billion in credit support. India, seeking to regain clout on an island it regards as its diplomatic backyard, is considering extending another US$1.5 billion credit line.

But economists say government-to-government help just kicks the can of financial reckoning down the road, and only an IMF programme can provide the rigorous fiscal and monetary framework to restore Sri Lanka's economic health and foreign investor confidence.

Fulfilling one of the expected IMF conditions, the central bank has already abandoned its artificially high rupee-US dollar peg and allowed the currency to weaken. But a softer currency brings its own problems for the net-importing nation. While higher import prices help balance the trade deficit, they erode living standards. Also, a weaker rupee makes repaying foreign debt tougher.

Sri Lanka has US$7 billion in foreign currency debt repayments to make this year alone, including US$2 billion in principal repayments. The next big deadline is a US$1-billion 10-year bond maturing in July that economists believe Colombo may need to restructure to repay. Sri Lanka's debt obligations over the next five years are an estimated US$26 billion.

An IMF rescue would be nowhere near enough to cover Sri Lanka's debt obligations, economists stress. An IMF programme's real value would be as an "anchor of credibility" that could unlock other financing sources, said Deshal de Mel, an economist at Verite Research, a Colombo think tank. Once an IMF plan has been agreed, other multilateral agencies, such as the World Bank, might provide support and bilateral partners would follow. "It would be a mistake, however, to expect the IMF to solve all the country's macroeconomic problems," de Mel said.

Then, there is the crucial question of "whether Sri Lanka would stick to the deal once the immediate crisis had passed," said Holmes. "As recently as 2020, the IMF cut short a lending facility" after Rajapaksa "flouted the conditions of the deal," he said. The president ramped up public spending, slashed taxes and drastically expanded money supply to finance government outlays.

There is always the option of an outright default to free up resources to tackle the food and energy crisis. But there is a downside, Holmes said.

"It would lock the country out of global capital markets for a time and see it pay a defaulters' premium for years thereafter. Having never defaulted on its debts before, Sri Lanka appears keen to avoid this option," he said.

This article originally appeared on the South China Morning Post (SCMP).

Copyright (c) 2022. South China Morning Post Publishers Ltd. All rights reserved.