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

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.

On Monday, Sri Lanka's new Prime Minister Ranil Wickremesinghe, a veteran opposition lawmaker and former premier, appeared to make progress in forging a unity government after winning support from the opposition.

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Opposition politicians had earlier hoped 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.

In the latest development, the main opposition SJB party dropped its demands that Rajapaksa step down. It declined to join a unity government helmed by Wickremesinghe but said it would "unconditionally support the positive efforts to revive the economy".

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.

In a televised national address late on Monday, Wickremesinghe said the country had run out of petrol and was unable to find dollars to finance essential imports. The government needed to secure US$75 million in foreign exchange in the next few days to pay for essential imports, he said.

"The next couple of months will be the most difficult ones of our lives," Wickremesinghe said. "I have no desire to hide the truth and to lie to the public."

However, he urged people to "patiently bear the next couple of months" and vowed he could overcome the crisis.

"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.

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.

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.

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.

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.

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.

Additional reporting by AFP, Reuters

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

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