The day of reckoning
After years of gravitas, Sri Lanka now finds itself in a deep socio-economic crisis, after years of unbalanced fiscal and monetary policies and an over-reliance on tourism for foreign exchange inflows. The country has just announced this week that it will officially default on all its external debt service obligations (about $51 billion) (estimated at about $7 billion this year alone!) to contain the free fall of the Sri Lankan rupee and tame inflation. With the stock market falling by over -33% since the beginning of the year, the currency weakening by -54% since April 2017 and inflation reaching 18.7% in March this year, all the ingredients for an unprecedented socio-economic collapse are simmering. The following serves as a flexible case study. Mauritius is beginning to show similar macroeconomic indicator trends and so understanding the weaknesses, arrogance, intellectual blindness and their mistakes can be useful.
“Mistakes are priceless, if we learn from them.”
5 years of public financial mismanagement, a pandemic and the day of reckoning
In summary, this crisis has taken years to build up (especially over the last 4-5 years). With political instability and socio-cultural segregation, the ruling party has proven to be a ‘bad’ driver in the governmental ship (so fundamentally essential for a democratic country). Public policy-making, supported by powerful private sector lobbying, often defines the socio-economic trajectory of any nation, especially in the medium to long term. Poor public policy making, accentuated by political stubbornness, ultimately harms the voiceless, the people. The underlying impact of poor policy making is often even more pronounced for developing and frontier countries like Sri Lanka. Lack of fiscal discipline, over-leveraging of external debts to finance mostly unproductive domestic public spending (including less than intelligent waste), poor monetary policy and foreign exchange management frameworks all harmonised a perfect storm. As the pandemic hit and tourist inflows dried up, the government had decided to cut taxes (from 15% to 8%) without thinking intelligently (yes, arrogance and blindness precede falls); especially as to how it would compensate for the revenue lost in a global pandemic biosphere.
With lower tax revenues and no increase in tax revenues in sight, the rating agencies quickly downgraded Sri Lanka’s sovereign credit rating, making access to global capital markets extremely difficult (especially when a sovereign nation is considered ‘Junk’). Now, tapping into the central bank’s balance sheet may seem like a smart move for many policymakers, just like Sri Lanka.
Ring’s chart here clearly shows the madness that ensues. The government has continued to borrow for the past 5 years (worse, they have favoured external borrowing over domestic), with the country’s public debt to GDP rising from 91% of GDP in 2019 to around 120% of GDP in 2022. Foreign exchange reserves were first used to service external debt repayments (yes, which, in their right mind, get carried away by low interest rates on hard currency debt – in a currency that is not printed against higher rates but domestic debt that is viable and sustainable in the long term!?) and more recently, to buy basic commodities (fuel – oil and gas, commodities and health-related products) to keep the country running. While its total public debt is growing by +32% from already unsustainable levels, the central bank’s foreign exchange reserves are plunging by -73% to just $1.9 billion this year!
Now, when we reflect on net foreign exchange reserves (i.e. gross international reserves minus central bank liabilities – again hard currency), our readers can easily see a massive deficit and a weakened central bank (no wonder the governors are resigning); facing enormous difficulties in meeting the hard currency demands of the economic machine (does this sound familiar?). Adding fuel to the fire already lit, as commodity prices soared, first, due to disruptions in the global supply chain and recently, due to the Russo-Ukrainian conflict; the Central Bank decided to float the Sri Lankan rupee (and then they wonder why it’s raining on them!); thus causing a devaluation with the currency free falling and aggravating the already velocity inflationary environment. While monetary policy tightening should have been proactive, it was only recently that the Central Bank of Sri Lanka took aggressive steps to increase interest rates on its standing lending facilities from 7% to 14.50%, which naturally failed to support the Sri Lankan currency.
Bitter solutions for Sri Lanka
Despite new lines of credit from the Chinese and Indian behemoths (the latter even sending oil and gas), the country is in default on its external debt, whose main creditors are China, India and Japan. Defaulting before an IMF bailout may not be the most optimal cash flow strategy, but it was either that or allow the central bank to fail.
They have no choice. In this case (many countries have faced and continue to face this problem), a full debt restructuring is inevitable. In general, creditors are likely to take a hit and, more importantly, longer-term confidence and faith in Sri Lanka as a borrower but also as a much sought-after tourist destination (especially now that the lasting impact of such a crisis probably translates into greater income/wealth disparities, impoverishment of the country’s most vulnerable – thus reinforcing the risks of social instability). It is easy to blame the COVID-19 pandemic as the builder of all sins, but when you leave a hole in your house, the rain comes in because the water always finds its way in.
Currently, the country is in deep distress, the cabinet is non-existent and therefore dysfunctional and yet the political leadership has not wavered! Therefore, Sri Lanka desperately needs a new political and central bank leadership and a restructuring of its external debt; otherwise, the party would only be starting! For this to happen, its fiscal policy must reflect its international trade competitiveness, debt profile and national productivity. An 8% corporate tax with a 15% personal income tax and you have a sad disconnect between your fiscal policy and your socio-economic priorities.
With tourism (an important source of foreign exchange) officially at about 12.6% of GDP (estimated multiplier effect of 26% of its GDP of about $81 billion); economic diversification is a key element of the restructuring plan. New alliances with Washington to bail out the IMF are essential (but they cannot continue to adopt bad self-inflicted policies against the institution’s own recommendations), but a stronger geopolitical relationship with their current saviours; China and India will be critical (in a world where these 2 countries are themselves facing geopolitical alliance problems with the US over Russia and more).
Hard-learned lessons for the island paradise – Mauritius
Now, all of these are critically important, especially for a small tourist destination and economy like Mauritius. Many of these leading macroeconomic indicators are similar to those of our country. If history serves our nation well, we must avoid a Sri Lankan socio-economic path, AT ALL COSTS!
Ultimately, in such crises, it is ALWAYS the most vulnerable, the voiceless masses who pay the highest price. Where we humbly ask to differ from Sri Lanka as an economic system is the official levels of the country’s external debt (which should, unless otherwise stated, be kept to a bare minimum, especially at times like these). The management of a country’s external (but also domestic) debt is therefore extremely important; where worst-case scenarios must always be considered. Already with the opening of our borders, we see that the country is facing an unprecedented foreign exchange crisis and that the central bank has unfortunately been clearly unable to supply the market effectively.
If a third world war between the Americans and the Chinese/Russians were to hit us, resulting in a complete seizure of long-haul tourist travel to Mauritius, our foreign exchange inflows could dry up completely, forcing our dear rupee into an abyss. To that extent, please consider another deadly pandemic or natural disaster, for that matter.
Fiscal consolidation (as mandated by the IMF in Sri Lanka for years now!) and discipline are very important as we live in an increasingly complex geo-political world in which socio-economic supremacy is changing hands from the West to the East and really ‘anything’ is plausible from here.
Central banks are there to ensure financial and price stability in a country’s socio-economic system, not to always bail out everyone under the sun. When you have mismanaged and all the negative macroeconomic variables come into play at the same time, you cannot run and so Sri Lanka today wisely provides us with several wrong paths, which our dear country should avoid taking.
Arrogance precedes the fall of empires
Time and again, the world has presented empires in rise and decline and the common (rather sad) denominator of declining empires is intellectual and military arrogance and profligacy, coupled with fiscal indiscipline. We are currently in the midst of one and therefore reiterate that the next 2-3 decades will increasingly be one of transition; and as wisely and empirically demonstrated /every time a new world order takes over, the world becomes a highly unstable and extremely volatile place. In these times, as a country, we need to focus on our own house, strengthening it to ensure its robustness and sustainability over time, but also, solidifying our global geopolitical alliances, especially and most closely with the rising powers (and less so with the declining ones, for more than obvious reasons).
Yes, buy into the Sri Lankan, Russian and Chinese dips and take the long view
From an investment point of view, both Sri Lanka and Russia, but also China, represent interesting long-term opportunities, which currently seem to be lagging their valuation levels.
As a result, we at Anneau are increasingly positioning ourselves in relation to these multi-generational capital market opportunities. With interest rates tightening after decades of low to negative interest rates, we expect increased volatility but with attractive return potential in various asset classes; especially in these battered geographies.
Furthermore, with global commodity prices at clearly unsustainable levels, it makes increasing sense to short a number of these commodities; especially if one takes a medium to long term view. We are already beginning to notice that some leading indicators of consumption in the developed world are beginning to fade. Naturally, these abnormally high freight and commodity prices eventually kill off aggregate demand and consumption and, as a result, our expectations that inflation will start to ease in the third/fourth quarter of this year are becoming increasingly rational. As a result, we clearly expect some slowdown in global price levels from a high 2022 base next year.
Coupled with the global reopening of economies, overheating was rightly anticipated, but excessive overheating can also eventually lead to a period of stagflation in which underlying price growth exceeds GDP growth; ultimately leading to economic recessions.
Therefore, while many investors may have ‘mixed feelings’ in these times, it is, in all humility, essential to maintain a longer-term perspective, particularly when investing, notwithstanding the unique opportunity for shorter-term gains.
Sri Lanka’s “misfortune” serves Mauritius well, especially in these volatile times.
“If we think long term, we can accomplish things we couldn’t otherwise…” Jeff Bezos
Amit Bakhirta, MBA
FOUNDER & CEO,
Anneau is a financial services company licensed and regulated by the Financial Services Commission (‘FSC’) in Mauritius.
Note: *The views expressed are personal.