The treasury is empty: no more money for food, medicine, fuel – Sri Lanka is on the verge of bankruptcy. The bankruptcy of the island state could be a harbinger of further state bankruptcies. What happens when a country is no longer solvent?
Sri Lanka is bankrupt. The island state in the Indian Ocean is experiencing the worst economic crisis since its independence in 1948. The situation has not improved since the fall of Prime Minister Mahinda Rajapaksa around two weeks ago, which was preceded by bloody street fighting in the capital Colombo. The newly appointed “economic war cabinet” – which continues to operate without a finance minister – has so far not been able to get the country’s existential problems under control: the government is unable to finance essential food, medicine and fuel imports.
As a result of years of nepotism and government mismanagement, the country is facing economic ruin. Massively increased grain and fertilizer prices and inflation accelerated by the corona pandemic are also fueling the crisis in Sri Lanka (read the background here).
Not only the Southeast Asian island state is threatened with bankruptcy. Due to the pandemic, climate change and a world economy battered by the Ukraine war, numerous low-income nations are on the brink of economic collapse. But what does it actually mean when a country is bankrupt?
What is a national bankruptcy?
To put it simply: a state bankruptcy, also known as state insolvency, occurs when a state can no longer repay part or all of its debts. In this case one also speaks of a payment default. Exactly when this point is reached depends on the debt ratio. It is calculated from the ratio of national debt and gross domestic product.
As a rule, payments for government bonds and interest repayments have to be made on predetermined dates, explains economist Sjacco Schouten in a contribution for APG, the largest Dutch pension fund. If a state misses this point in time, a grace period follows – only when this has also expired does the country officially fall into arrears.
At first glance, a state is no different than a company or a private individual. If a state can no longer pay its debts, it is broke – at least in theory.
But that was about it for the similarities. Because, as it says in a 2014 “Wirtschaftsdienst” report, unlike a company, in the event of over-indebtedness, no state would be broken up in the course of insolvency proceedings to cover outstanding payments. “But that would mean that the over-indebtedness of the state determined in this way would be a non-event, so to speak,” says the journal.
In any case, according to the US financial magazine “Investopedia”, sovereign states often have the opportunity to evade their responsibility for payments. For example, countries that have accumulated debt in their own currency usually print more money simply to “pump” themselves out of bankruptcy and meet the demands of their creditors. That might work on paper. The result, however, is massive inflation, which usually triggers a catastrophic economic chain reaction, at the end of which the population suffers.
The power of rating agencies
If a state is heading towards insolvency, it can either try to offset its debt through higher taxes or take on new foreign debt. This turns out to be difficult, however, because even an impending state bankruptcy has serious effects on creditworthiness. The decisive factor here is their classification by rating agencies. The agencies Moody’s, Fitch and S
If the rating is bad, or if the agencies downgrade a country’s creditworthiness to junk status – as in the case of Russia and Sri Lanka – this makes borrowing extremely difficult and can result in significantly higher interest rates. What remains is a debt spiral that not only affects the state itself, but also its creditors. According to APG, in the worst case the latter would be forced to write off their bonds completely – they would be left with unpaid repayments and interest. In this context one speaks of the so-called haircut. However, the value of the bonds will never be zero – after all, in the long run there is always a chance that a state will pay off its debts.
According to Bloomberg, this is where aid programs usually kick in to maintain basic services in ailing states. One of them is the “Paris Club”, whose 22 members (wealthy creditor states, including Germany) are negotiating new terms for debt settlement. However, the Paris Club has increasingly lost its importance in recent years. The reason: China, itself not part of the club, has become one of the largest lenders to developing countries as part of its New Silk Road.
An economic vicious circle
If a state can no longer meet its payment demands, the population always suffers in the end. If a government takes out loans in foreign currency, it cannot offset the debt by inflating its own currency and will usually try to compensate for the impending bankruptcy with tax increases, among other things. However, this weakens the purchasing power of the population and often results in a recession – which in turn affects tax revenues. In such a situation, the population often panics: fearing for their savings, they try to withdraw as much money as possible from the banks and bring it to safety abroad – this is called capital flight. An economic vicious circle.
Since the state no longer receives loans from abroad, in extreme cases it can no longer pay public employees (hospitals, police, etc.), which further fuels the often violent political unrest that precedes the economic crisis.
As can be seen from the example of Sri Lanka, if emergency loans are not forthcoming, the ailing state can no longer even cover the basic needs of food, medicine or fuel.
Lack of transparency
In order to avoid the threat of national bankruptcies in the future, Bill Dudley, an economist at Princeton University, wrote in an opinion piece for the news portal Bloomberg at the beginning of the year that the debt system itself must become much more transparent – in many cases it is “impossible to assess how high the liabilities are, when they are due, what the interest costs are and what other conditions apply,” says the economist.
Because many governments cannot assess how high their own national debt actually is, poorer countries in particular find it difficult to take measures to avert impending bankruptcy in good time. This opacity is also a problem for the lenders themselves. Because they often don’t know how deeply in debt a country already is, investments would become a risk game – which they try to compensate with higher borrowing costs.
Sri Lanka – just the first domino?
2022 should prove to be a test, especially for low-income and already highly indebted countries, wrote Dudley. For one, interest rate hikes by the US Federal Reserve and other central banks would discourage investors from investing in low-income countries. In addition, these countries are recovering from the consequences of the corona pandemic much more slowly than industrialized nations. According to the International Monetary Fund, global debt reached the equivalent of more than 212 trillion euros at the end of the first year of the pandemic in 2020 – at more than 26 trillion euros, the highest increase in one year since the Second World War.
The effects of the Ukraine war on the global economy are a test of existence, especially for developing countries whose economies have already been weakened by a pandemic and massive crop failures as a result of climate change for more than two years (read here about the consequences of the exploding grain prices). As the “Economist” writes, global inflation threatens to spiral out of control as a result of rising interest rates. Countries in Africa, Southeast Asia and South America are enormously dependent on food and raw material imports – the prices of which are skyrocketing. According to the World Bank, almost 60 percent of the poorest economies are acutely threatened by a debt crisis. What is happening in Sri Lanka could therefore be a harbinger for many other poorer countries.
Sources: APG; “Economic Service”; “Investopedia”; “Bloomberg”; “The Economist”