As in the the case of Pakistan, which we reviewed last month, Sri Lanka’s debt crisis and financial problems have been augmented by the rise of oil and gas prices in 2021 and more dramatically since the Ukraine crisis started in February 2022. The difference between the two countries is that the government of Sri Lanka defaulted on its debt repayments in May this year while Pakistan is still managing the crisis.

The Western (and some Indian) mainstream media, think tanks and research centers, and even many government officials have made the Sri Lankan Hambantota Port a globally known name and the main example of “China’s debt trap diplomacy”, although this was entirely proven to be a false story. Some American “researchers” with background not in economics or finance but security matters, who were commissioned by the U.S. State Department to write a report about “Debt-book Diplomacy” in 2018, even stated that they will make Hambantota Port the “template” for this narrative.

The best-documented debunking of this fake story of Hambantota Port is the study published in 2020 by Dr. Deborah Brautigam and associates in the School of Advanced International Studies in Johns Hopkins University (USA) reviewing thousands of pages of official documents and interviews with officials and experts. The irony is that what the study discovered is that China’s deal with Sri Lanka was a bail out and debt relief which saved the day for Sri Lanka’s finances in 2017.

As our own research and interviews with experts will show here, the entire story of China being the source of Sri Lanka’s debt is fake through and through.

Who own’s Sri Lanka’s External Debt?

Two essential facts are ignored when the media in the West deal with the external debt of Sri Lank: the composition of the debt, and the real causes of the debt. Exactly as in the case of Pakistan, China’s share of the external public debt of Sri Lanka is only 10%. Western financial institutions (including the private credit markets) and their ally, Japan, hold the lion’s share of the debt.

According to a press release by the Sri Lankan Department of Foreign Resources, the composition (in percentage) of the foreign debt of Sri Lanka in April 2021 was as follows:

International capital markets borrowing: 16,383 US$ millions (47%)

Asian Development Bank: 4,415 US$ millions (13%)

China: 3,388 US$ millions (10%)

Japan: 3,360 US$ millions (10%)

World Bank: 3,230 US$ millions (9%)

Others: 3,038 US$ millions (9%)

India: 859 US$ millions (2%)

Despite what the name suggests, the Asian Development Bank’s major donors include, besides tha largest ones Japan and the USA, also Australia, Canada, France, Germany, Britain and a few Asian countries such as China, India, and Indonesia. Its policies are similar to those of the World Bank and IMF.

Thus, a simple look at the facts that are usually ignored or blacked out shows that China is not what is being portrayed to be. The real culprits, as shown here in this article, are from the same Western countries where the “China debt-trap” narrative was concocted.

How big is the debt

1. External Debt

The total external debt of the country (of both government and private sectors) increased to US dollars 50.7 billion at the end of 2021 from US dollars 49.0 billion by end 2020. But it is lower than 2019 (55,0 billion) and 2018 (52,0 billion). As percentage of gross domestic product (GDP), it stood at 60% in 2021 compared to 58% in 2020.

A key reason for the reduction of the outstanding government external debt in 2021 was due to reduction of new borrowings from international markets, while repayment of some external debt obligations of the Government had to be met by utilizing Central Bank’s reserves.

2. Internal Debt

The total domestic debt of the government increased by 2,032.2 Rupees billion from end 2020, reaching 11,097.2 billion (11 trillion rupees) by end 2021. This means that the share of domestic debt increased to 63.1 per cent of the total outstanding debt of the Central Government. The foreign debt as a share of total outstanding central government debt declined to 36.9 per cent by end 2021 compared to 40.0 per cent recorded at end 2020. The share of domestic debt as a percentage of GDP increased to 66.0 per cent by end 2021 from 60.3 per cent at end 2020.

The reason for the increase in domestic debt is due to the government’s resorting to financing budget deficit through domestic sources, while settling foreign debt obligations maturing in 2021 using foreign currency reserves.

Inflation problem

Reflecting the global crisis, inflation, as measured by the year-on-year (Y-o-Y) change in the Colombo Consumer Price Index (CCPI) increased to 39.1% in May 2022 from 29.8% in April 2022. This increase in Y-o-Y inflation was driven by the monthly increases of both Food and Non-Food categories, such as petroleum products and fertilizers. Subsequently, food inflation (Y-o-Y) increased to 57.4% in May 2022 from 46.6% in April 2022, while Non-Food inflation (Y-o-Y) increased to 30.6% in May 2022 from 22.0% in April 2022.

Accordingly, prices of items in the Non-Food category recorded increases mainly due to price increases observed in the Transport (Petrol, diesel and bus fare), Housing, Water, Electricity, Gas and Other Fuel (LP gas and Materials for maintenance/reconstruction) Further, within the Food category, increases were observed in prices of vegetables, fresh fish, rice, bread, dried fish and dhal during the month.

Foreign Currency Reserves

Gross official reserves declined by US dollars 2.5 billion during the year due to sizeable foreign debt service payments of the Government, honoring of maturing liabilities of the Central Bank as well as the significant supply of foreign exchange by the Central Bank to facilitate imports of essential items including fuel, LP gas, coal, medicine and essential food items, particularly during the latter part of 2021.

Decline of value of local currency

While the Sri Lankan Rupee has been in steady decline for several years (Rs to US$ 181 in December 2019, 186 in December 2020, 200 in December 2021) it suddenly dipped to a historical low level of 360 Rupees to the US$ in early March 2022. This was triggered by the global crisis and the imminent default on payment of 78 million US$ in matured foreign bonds in April. A 30-day grace period expired and on May 18, and the Central Bank of Sri Lanka declared that the country was in a preemptive default status.

Political unrest followed as the government failed to provide fuel and imported food which prices have dramatically increased while the government ability to provide foreign currency to support continued imports dried up.

Causes of the Debt Crisis

Contrary to the usual narrative in Western mainstream media, think tanks and statements made by political leaders of a “China debt-trap”, Sri Lanka’s debt crisis has entirely other reasons.

These are:

1. Borrowing in international capital markets: After a devastating civil war ending in 2009, the government resorted to expensive borrowing from international bond markets for the reconstruction process. These sovereign loans, from mostly Western financial investors like the American and British giants BlackRock and Ashmore, constitute the greatest part of the external debt of the country (47%). It was the scramble to repay some of this debt, that matured in 2017, that pushed the Sri Lankan government to offer the Hambantota Port for leasing. China accepted the offer in return for ca US$ 790 million that were used to repay the debt to the international markets, not to China.

The bond market is a brutal, profit-seeking force which has a secondary market where investors sell the sovereign debt of troubled countries to so-called “vulture funds” that buy the debt with big discount from the investors, to later demand full payment from the debtor nations. They do not renegotiate, reschedule, nor cancel their debt. Payments must be made on time, otherwise the country will be shut down from lending sources and rating agencies downgrade it to the bottom. What is worse is that the vulture funds sue sovereign debtors in British and American courts where, under the threat of seizing the assets of those nations abroad, the courts usually judge in favor of the vulture funds.

2. The trade deficit: In an identical manner to the case of Pakistan, Sri Lanka has a major dependency on imports of oil and gas their refined products for transport and power generation. In recent years the global prices have increase but exploded in 2021-2022. These items, in addition to fertilizers constitute the most part of the imports of the country. In 2020 total exports were US$ 10 billion while imports stood at US$ 16 (US$ 6 billion deficit). In 2021 the deficit increased to US$ 8 billion as exports amounted to US$ 12 billion and imports US$ 20 billion. Consequently, the current account deficit widened significantly to 4.0 per cent of the Gross Domestic Product (GDP) in 2021, compared to 1.5 per cent of GDP registered in 2020.

Sri Lankas main export items are textiles and garments (accounted for US$ 5.4 billion in 2021), tea (US$ 1.3 billion) and rubber products (US$ 1.1). Imports include fuel (accounting for US$ 3.7 billion in 2021), textile materials, since Sri Lanka does not produce the raw materials and machinery (US$ 3.1 billion), machinery and equipment (US$ 2.8 billion), and food and beverages (US$ 1.7 billion). Chemical fertilizers constitute another important item of imports, but in 2021 the government issued a ban on chemical fertilizer imports in order to promote organic agricultural practice. The result was that the food production dropped by 20% in the country. The ban was relaxed later in the year.

It is clear that while the exports are relatively stable or stagnant in value, imports fluctuate dramatically from year to year, mostly in upward direction in the past two years.

3. Collapse of tourism sector due to terrorism and COVID-19 pandemic. According to the Sri Lankan Tourism Authority, earnings from tourism have been the major contributor to the surplus in the services account for many years. The income, in foreign currency, and level of employment were substantial until its collapse. First, in April 2019 on Easter Sunday, Islamic State terrorists launched simultaneous suicide bombings on a church and known hotel in Colombo killing a large number of locals and foreign tourists. This was a major setback for the tourism industry. A second wave of disaster hit with the 2020 outbreak of the COVID-19 pandemic which reduced the number of tourists visiting the country to a trickle.

A look at the numbers gives a clear picture:

Foreign Tourist entries to the country and income generated:

– 2017: 2,116,407 tourists. Income generated: US$ 3,9 billion. Employment generated: 156,369 direct jobs (and 202,846 indirect jobs).

– 2018: 2,333,796 tourists. Income generated: US$ 4,4 billion. Employment generated: 169,000 direct jobs (219,484 indirect jobs).

– 2019: 1,913,702 tourists. Income generated: US$ 3,6 billion.

– 2020: 507,704 tourists. Income generated: US$ 682 million.

2021: 194,495 tourists. Income generated: US$ 507 million.

The government supported the industry to compensate for the losses and avoid social and political unrest. The price the government paid was that borrowing increased internally and externally. It is important to note that the tourism sector has a large share of the labor force of Sri Lanka of 8 million workers (total population is 20 million).

4. Decline of Remittances: Over the past two decades, annual remittances from Sri Lankan national abroad have represented nearly one fourth of the total credits to the external current account, on average, and exceptionally, this share exceeded more than one third (35 per cent) in 2020. But as a result of the effects of the COVID-19 on the global service sector, where Sri Lankan foreign workers are generally employed, the remittances declined from US$ 7 billion in 2020 to US$ 5 billion in 2021.

The government of Sri Lanka has been plagued by persistent fiscal deficits for decades, compelling the Government to continually borrow from both domestic and foreign markets and accumulate public debt. As a result, a large fraction of government revenue and foreign currency inflows to the country are required to be channeled for debt service payments, permitting little leeway for productive investments. Increasing the productivity of the Sri Lankan economy hold the key to the solution. But this requires great investments in infrastructure, industrialization, and the modernization of the agricultural sector.  Finding alternatives for the very expensive imports of petroleum products is one other very important elements of the solution for Sri Lanka.

China’s role and the BRI

China’s does not have a magical rod to change the conditions of nations. The reason China managed to eliminate extreme poverty and build the world’s most productive economy is through hard work and massive investments in infrastructure labor force through education. China’s role in Sri Lanka is considered positive since it focusses on developing the productive aspects of the economy such as modernizing the infrastructure. Although contrary to the debt-trap narrative China is not Sri Lanka’s largest creditor, it is the largest foreign direct investor in the country. For China, Sri Lanka will play a key role in the Maritime Silk Road of the 21^st century. China’s investments in Sri Lanka are long-term projects that gradually increase the productivity of the economy. But they do not represent a quick fix.

What is needs to be done by the U.S. and Europe, rather than pushing the thoroughly debunked debt-trap narrative against China, is to join hands with China and the Belt and Road Initiative to assist in rapidly raising the productive capabilities of Sri Lanka through investments and long-term, low interest credits for infrastructure projects, industries, and modern agricultural production.