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Tuesday, December 5, 2023

Beyond Sri Lanka, an economic cyclone bears down on South Asia – The Morning

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For over a decade, Mattias Martinsson has been investing in frontier economies, including Pakistan, Bangladesh, and Sri Lanka. Now, he says, South Asia is “in the eye of the storm”.

“The next couple of months will be painful for the South Asian markets,” predicted Martinsson, Chief Investment Officer (CIO) at $ 220 million Swedish fund Tundra Fonder. “There is a high possibility that we will see both inflation and interest rates rising and currencies depreciating.”

Sri Lanka’s rapid descent into an economic abyss has shocked the world. As the country’s accessible foreign reserves dwindled to next-to-nothing and citizens suffered under acute shortages of fuel, food, and medicine, the Government last month “preemptively” defaulted on its international debt for the first time.

But while the Indian Ocean island is the most desperate country, it is not alone. From the beaches of the Maldives, to the mountains of Nepal, to the bustling streets of Pakistan, much of South Asia faces similar risks from shrinking forex coffers and surging global inflation. While countries around the world are feeling similar headwinds, South Asia is home to a particularly vulnerable cluster – one that is in focus this week as India’s Central Bank meets, a Maldivian bond matures, and Pakistan prepares its budget.

South Asian nations have also rung up relatively hefty foreign debt, including significant amounts to China, which has courted them under what Indian and American foreign policy wonks refer to as the “string of pearls” strategy. Over the years, Beijing pumped in cheap loans in exchange for strategic assets through long-term leasing programmes, giving itself a strategic hedge against India. Sri Lanka owes an estimated 10% of its debt to China, while Pakistan’s figure has been reported at 27.4%.

As the pressure builds, countries are eyeing escape routes.

The woes stem partly from factors beyond governments’ control, experts say. First, Covid-19 severely strained public finances. Then rising commodity prices amid the Ukraine war slammed South Asia’s net importers.

Rohan Gunaratna, a leading South Asian scholar who has written several books on Sri Lanka, described the country as the “first domino to fall”, adding that its “weak economy was crippled by the loss of tourism, loss of foreign workers’ remittances, and rising energy prices”. Sri Lanka’s inflation rate for May hit a record 39.1%, its statistics office said last week.

But observers also say Sri Lanka lacked foresight. After President Gotabaya Rajapaksa won the 2019 election, Martinsson said that “the new Government’s idea was to stimulate the country out of the debt trap by lowering taxes. It could have worked, but when Covid-19 hit, Sri Lanka’s tourism revenue was impacted, along with its ability to service its foreign debt”.

Rather than negotiating with foreign lenders and the International Monetary Fund (IMF) early on, Sri Lanka continued to pay as its reserves evaporated. “They did not want to go to (the IMF) because this would require stringent fiscal discipline,” Martinsson said. “Instead, they took a bet on the tourism industry recovering in time.”

That did not happen. Panicked officials resorted to capital controls, limiting the withdrawal of foreign currency by citizens, companies, and foreign investors, further discouraging outside investors. Making matters worse, the Government banned fertiliser imports last year in an ill-fated attempt to conserve foreign currency. Partly as a result, the country’s vital tea exports hit their lowest level in more than two decades in the first quarter of this year, according to reports.

In April, Sri Lanka’s usable liquid reserves were said to be just $ 50 million, enough for only days’ worth of imports. “It is one of the worst crisis management that I’ve seen, if not the worst,” Martinsson said. “I can’t explain it as anything else but a gamble, which they lost.”

Pakistan is another economy on the precipice.

While conditions are not as dire as in Sri Lanka, Pakistan’s total foreign reserves plunged to $ 16.4 billion at the end of April, down from $ 24 billion last fall, according to the State Bank of Pakistan. Its ratio of external debt to gross domestic product (GDP) stood at nearly 35% as of the beginning of the year, versus Sri Lanka’s 58%.

“Sri Lanka and Pakistan are stressed due to high external debt to GDP levels, plus current-account deficits, caused by too much previous optimism (and) borrowing,” said Mike Gallagher, Research Director at Continuum Economics, a macroeconomic research specialist that counts BlackRock and the IMF as clients. “Now their central banks are faced with a crisis at the worst possible time – when the (dollar) is strong and the Fed is pushing interest rates to 2.5% to 3.0%.”

Tightening by the US Federal Reserve affects emerging markets by increasing their debt burdens and sucking capital out of their economies.

Like Sri Lanka, where protestors have raged against Rajapaksa, Pakistan has been rocked by political instability. Former Prime Minister Imran Khan’s Government was ousted in a no-confidence vote in April, prompting massive protests. The new Government of Shehbaz Sharif is attempting to right the economic ship, starting with an unpopular decision to slash fuel subsidies in a push to unlock IMF funding.

(This article first appeared on Nikkei Asia on 7 June 2022)

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