Sri Lanka’s economic crisis is a wakeup call for Nepal

Nepal is not in a comfortable position to take the whole debt distress scenario lightly given that our outstanding debt is increasing.

Ranjan Sapkota

  • Read Time 5 min.

Sri Lanka’s public debt-to-GDP ratio has skyrocketed over the past few years. The International Monetary Fund (IMF) projected its public debt-to-GDP to reach 119.9 percent in 2022. Nepal, on the other hand, is operating at a public debt-to-GDP ratio of 38.1 percent. Studies show that a public debt-to-GDP ratio above 64 percent among emerging markets amounts for a loss of real GDP growth by 0.02 percent points with each additional percentage point increase in public debt. 

While the number might seem small, the cumulative effect with each percentage point increase can be devastating. Given the case, Sri Lanka’s public debt-to-GDP ratio is very concerning. Sri Lanka is operating at almost double the public debt-to-GDP threshold. Countries with excessively high levels of public debt are more likely to lose their output during a crisis and are more prone to spillover effects. That’s exactly what happened in Sri Lanka. 

In 2019, before the Covid pandemic, Sri Lanka’s public debt was already very high at 93.6 percent. After the Covid in 2020, its ability to cope with the crisis became weaker. It became even worse when the spillover effects of the Russia-Ukraine war hit the economy with massive inflation, food shortages and weak exchange rates. 

Not to forget, the 2019 tax cut and its impact on revenue, with an estimated revenue loss crossing two percent of GDP. With rising expenditures and low revenue, fiscal deficits widened by 12.8 percent of GDP in 2020 and 11.4 percent in 2021. Owing to increasing fiscal deficits inter alia, public debt was pushed up massively. To give a context, by the third quarter of 2020, Sri Lanka’s public debt was already operating at 114 percent, unsustainable for the country.

Thus Sri Lanka’s debt crisis was a long time coming. It started to take an upward shift a decade ago. Given that Sri Lanka was upgraded to a middle-income country in the early 2000s, Sri Lanka’s access to concessional loans with low interest and high repayment periods from multilateral and bilateral organizations declined which pushed Sri Lanka to pursue commercial loans. 

Back in 2007, Sri Lanka issued its first International Sovereign Bond (ISB) of $500 million. In 2009, Sri Lanka’s commercial loans consisted of only 2.5 percent of external debt. By 2019, commercial borrowings consisted of 56 percent of total external debt and most of it were ISBs. Unlike the concessional loans, ISBs have higher interest rates and shorter repayment periods. 

Case of Nepal

Nepal hasn’t taken a commercial foreign loan yet, although the International Development Cooperation Policy (2019) allows it. While Nepal’s debt to GDP ratio is gradually increasing, Nepal is still at a safe debt to GDP position. However, jumping to take heavy commercial loans or getting comfortable with taking any loans with high interest can easily shift the tide towards debt distress. 

Unlike Sri Lanka, Nepal’s bilateral and multilateral deals largely push for grants and if it must be a loan, then it should be concessional loans or loans at low interest rate as is the case with loans from multilateral donor agencies which are less than two percent with high repayment period. Having said that, it’s pertinent to understand that Nepal is also not in a comfortable position to take the whole debt distress scenario lightly especially given that the outstanding debt has shown a consistent increasing pattern over the past few years.

Government banned imports of luxurious goods on a temporary basis. But such moves hardly bring sustainable solutions. 

 Foreign exchange reserves of both countries are critically low. Although the reserves have improved over the past few months, Sri Lanka is still at a very critical stage whereby they cannot pay for their imports largely reflecting pre-existing debt vulnerabilities, policy failures and the effects of exogenous shocks like pandemic and the ongoing war. Nepal Rastra Bank (NRB) aims to maintain foreign exchange reserves at a level that can sustain imports for at least seven months. However, that target was compromised lately, for the first time in the last six years. 

From mid-July 2021 to mid-May 2022, Nepal’s gross exchange reserves tumbled down by 21.1 percent. Although there has been a slight improvement by 2.5 percent in the last four months ending November, it’s pertinent to comprehend that Nepal is still at a vulnerable position. 

Likewise, Sri Lanka’s foreign reserves tumbled down by 44.58 percent from 2020 to 2021 and has only seen a consistent downfall each month. From May 2021 to May 2022, reserves went down by 53.21 percent. IMF estimates that Sri Lanka’s gross reserves over 2022-26 will remain extremely low. Sri Lanka’s catastrophic state of currency reserves can be a wake-up call for Nepal given that Nepal still has time to boost its reserves. 

Likewise, inflation has gone rampant all over the world, but tends to be much better when compared to Sri Lanka. Sri Lanka’s inflation rate has shown a consistent increase every month over the past year. Nepal and Sri Lanka were standing at a fairly good inflation position during August 2021. However, by April 2022, Nepal and Sri Lanka had a difference in inflation of 22.52 percent approximately. Year on year inflation rate has only worsened with Sri Lanka operating at 61 percent and given the consistent economic debacle, it is not expected to improve anytime soon.

Food and non-alcoholic beverages in Sri Lanka saw its Consumers Price Index (CPI) reach 90.9 percent in June 2022 which has improved mildly over the past few months with CPI at 73.7 in November. The transport sector crossed a century mark with a whopping 133 percent. Largely due to fuel shortages and inability of purchasing fuel with its worsening foreign exchange reserves, Sri Lanka was forced to call for a fuel lockdown. Nepal, on the other hand, is operating at a fairly comfortable position in this regard. The situation in Nepal also needs urgent attention when it comes to inflation of daily necessities. Mid-Oct/Nov comparison shows a 7.38percent CPI on food and beverage. 

Like in Sri Lanka, Nepal is also embracing the impacts of war with the rising fuel prices creating the largest inflationary pressure on the transportation sector with about 17.71 percent though there has been some progress compared to 25.79 percent in mid-May/June 2022.

What should be done? 

Matters went multifold worse due to back-to-back exogenous shocks. Nepal’s high imports in 2022 is largely accommodated by inflated fuel prices, which subsequently hampered the country’s reserves. Government has taken steps to ban a few products considered as luxurious goods on a temporary basis in order to avoid an outsource of dollars from the country. 

However, such moves hardly bring sustainable solutions. Instead of focusing on restricting imports, focusing on encouraging exports would be a welcome move for the medium or long-term recovery. In fact, for the short term, Nepal can try increasing taxes on luxurious goods or goods that are imported in heavy amounts like the austerity policy initiated by Bangladesh. 

Nepal’s export scenario is considerably vulnerable given that a significant chunk of our export is largely boosted by soybean oil and palm oil imported from third countries which are exported to India with a minor value addition. Between 2020-21 and 2021-22, approximately 29 percent of Nepal’s total export was covered by Soybean oil and palm oil accounting for NRS 97.34 billion worth out of the total export of NRS 335.94 billion. The fear factor here is that the strength of Nepal’s export of palm oil and soybean oil is largely in the hands of India. If India applies quota or issues import ban of these products like they did earlier in a temporary manner, Nepal’s export scenario will get worse, and it will hit harder than before with the current reserves already in a very fickle state. Hence, there is a strong need for Nepal to avoid heavy dependence on few products that aren’t even produced in the country. We need a concrete pathway to pursue a sustainable and long-term export ease. 

Likewise, the government of Nepal needs to refrain from consistent political fiasco and multiple controversies. The conflict between the Finance Ministry and Nepal Rastra Bank (NRB) is a fresh case in point. The Finance Ministry is the fiscal body and NRB is the monetary body of the nation. Conflict between the two is not something that any economy would expect from the two most important bodies of the nation. Friendly and effective collaboration is a must between the two especially in times like these when macroeconomic crisis is looming.