The Sovereign Debt Crisis in Sri Lanka: Anatomy and Policy Options

Abstract

During the COVID-19 pandemic, there was a dramatic increase in national debt levels across the world, with reported cases of downgrading sovereign debt ratings and difficulty of fulfilling debt obligations (“debt distress”), heavily concentrated in low-and middle-income countries. In this context, the unfolding sovereign debt crisis in Sri Lanka has attracted worldwide attention as the canary in the coal mine for what could become a global “development” crisis. This paper examines the Sri Lankan crisis encompassing both the sources of vulnerability to the COVD-19 shock, and stabilization and structural adjustment reforms after the debt default, with emphasis on the systemic “solvency” challenge of dealing with the massive debt overhang evolved over the previous two decades. The prime focus of the Extended Fund Facility (EFF) program that Sri Lanka signed with the IMF in March 2023 is on economic stabilization through fiscal consolidation. This paper makes a strong case for combining economic stabilization with coherent structural adjustment policies to redress the long-standing antitradable bias in the incentive structure that underpinned vulnerability of the economy to external shocks.