Author: Editorial Board, ANU Courtesy East Asia Forum

If you think your New Year hangover was bad, spare a thought for Sri Lanka. In 2022 what was once a dynamic economy on its way to high middle-income status became a cautionary tale of how rotten politics, and the bad policy it produces, can trump otherwise promising economic prospects.

As Dushni Weerakoon writes in this week’s lead article, a continuation of our Year in Review series on the major developments of the year across the region, Sri Lanka has set out on a hard road to recovery in a political environment not conducive to the structural reforms the country needs to achieve its potential.

In the short term, ‘Sri Lanka is banking on an IMF bailout to facilitate access to bilateral and multilateral financial support to get the economy back on track.’ Progress is being made in securing a deal, with the IMF agreeing access to US$2.9 billion under its Extended Fund Facility and the World Bank confirming Sri Lanka has ‘reverse graduated’ to be eligible for concessional finance under the International Development Association. But with Sri Lanka having an unwieldy mix of private and official creditors, the IMF program will require financing assurances and a good faith effort from creditors to restore debt sustainability before Sri Lanka is able to get the support it seeks.

Further bad news, Weerakoon says, is that ‘the standard IMF policy prescription that demands stringent financial discipline means that adjustment costs will be front-loaded, preventing the government from spending its way out of recession. Accordingly, taxes are being hiked and expenditures are being cut’ to get the Fund’s money in the door.

From the IMF’s perspective, this is a feature of the Extended Fund Facility, rather than a bug. The IMF program is intended to help Sri Lanka restore macroeconomic stability and implement necessary reforms, including anti-corruption reforms, to address medium-term balance of payments challenges — rather than subsidising the government’s day-to-day expenses. ‘Even if everything goes according to plan, it will be another two or three years before the Sri Lankan public feels any real improvement in economic conditions.’

That timeframe could be of great importance. As Weerakoon notes, ‘[w]ith all the uncertainties, next year will be crucial for Sri Lanka as it gears up for the all-important presidential elections in 2024.’ Until then President Ranil Wickremasinghe — an ally of the ousted Rajapaksa brothers who was installed by parliament after they fled the country in July 2022 — will navigate both the international debt restructuring negotiations and the domestic policies they entail without any electoral mandate.

For this reason, as Weerakoon says, ‘[a]n economic crisis can sometimes be the catalyst of a major economic overhaul, but in the absence of political stability the downside risks are significant. Governments have far fewer resources in hand to compensate those who are bound to lose out from reforms.’

The Sri Lanka situation occurs against the backdrop of the need for new modes of global debt governance as the international landscape of sovereign creditors becomes more diverse, with China, the Gulf states and India, and private and state-owned creditors based in these countries, all claiming larger roles as development financiers abroad.

As the role of non-traditional creditors grows, governance frameworks for global debt need to change. Recent controversies over the role that Chinese lenders have played in the debt crises afflicting Tonga and Tanzania haven’t substantiated the ‘debt trap’ narrative — nor has China’s role in Sri Lanka’s current problems. Rather, they’ve obscured a more mundane but equally concerning reality: that Chinese lenders got out over their skis in extending loans abroad, driven by a complex mixture of domestic commercial and bureaucratic interests. It’s in everybody’s interest, including China’s, that its overseas lending practices are guided by more clearly-articulated policy principles and are executed with more transparency that has been the case so far.

The impulse to make the developing-world’s debt problem the object of geopolitical rivalry shouldn’t distract from a more worthwhile goal: to fold China, as well as the other emerging non-traditional leaders into fit-for-the times coordination — and, if necessary, adapting those frameworks to the reality that business as usual is increasingly an anachronism. As the World Bank’s chief economist warned in a recent interview, ‘we are applying a restructuring model that was devised for another time’, when Western governments or multilateral lenders were dominant. The Paris Club creditors’ coordination group no longer reflects the creditor mix in emerging economies.

Change is in the interests of all the stakeholders in this mix. The need for multilateral economic coordination through bodies like the G20 couldn’t be clearer. The beleaguered G20 Common Framework for Debt Treatments beyond the DSSI has had only one country achieve debt restructuring in two years. One significant improvement could be expanding eligibility to middle-income countries: until its December ‘reverse graduation’ under the World Bank, Sri Lanka was ineligible — as alluded to in the 2022 Bali G20 Leaders Declaration which noted that members were ‘concerned about the deteriorating debt situation in some vulnerable middle-income countries’.

Sri Lanka will likely face economic pressures for much of the decade ahead, but it would do well to take inspiration from the experience of the region in moving past the Asian Financial Crisis. Indonesia was forced to ‘reverse graduate’ in 1999 in order to access concessional finance but proceeded to graduate again in 2008 and is now a powerhouse economy in the region, whose sustained run of sound macroeconomic management can in no small part be put down to the memories of the traumas of the crisis and its aftermath.

If there’s a silver lining to the hard years ahead for Sri Lanka, it is to be found in the hope that its elites will never allow a repeat of the abysmal policymaking that its people are now paying for with their economic livelihoods.

The EAF Editorial Board is located in the Crawford School of Public Policy, College of Asia and the Pacific, The Australian National University.