A tragedy is unfolding in Sri Lanka. The economy is paralysed, and because the country's debts are unsustainable, it cannot borrow. The country is suffering the world's worst economic crisis since World War II.
The situation is so dire that millions of people have taken to the streets. The president has fled the country, and now parliament has elected a new, but unpopular, replacement. If all goes smoothly, the International Monetary Fund can come to Sri Lanka's aid with a rescue loan package and a programme to achieve sustainable fiscal, monetary and exchange-rate policies.
Sri Lanka's plight serves as a lesson to other governments. When a country's economic problems are obviously becoming insurmountable, postponing a reckoning through various piecemeal measures will only make matters worse in the end.
For years, Sri Lanka was a "donor darling", owing to its relatively high standard of living, good social services and robust economic growth. In the first half of the last decade, it boasted a 6.5% average annual growth rate -- one of the world's highest -- and very low population growth. Though economic growth slowed after 2015, it still averaged well over 3% through 2019.
But at the end of that year, a new government came to power and immediately announced a large tax cut. In both 2020 and 2021, the government ran a fiscal deficit of more than 10% of GDP. The annual inflation rate rose from an average of under 5% in previous years to 39.1% in May, and then to 54.6% in June.
Worse, with inflation already accelerating, the government announced in the spring of 2021 that it was banning all chemical-fertiliser imports. Predictably, rice production fell by 20%, tea exports fell to their lowest level in more than two decades, and more than a third of the country's farmland was left fallow.
The Covid-19 pandemic came on top of these self-inflicted wounds, causing a sharp decline in tourist revenues, which then deepened Sri Lanka's foreign-exchange shortage and further curtailed its ability to purchase imports. By late 2021, the situation was spinning out of control; in May, the government defaulted on its foreign debt.
Now, Sri Lanka cannot obtain essential inputs to restart the economy until it has restructured its debt and installed a working government. Restructuring the country's debt will be unusually complicated because a significant portion is owed to China, which does not participate in the multilateral Western-led restructuring exercises for overly indebted sovereign borrowers.
Again, the lesson for other debt-distressed countries is clear. While a country's economic authorities can delay some of the consequences of ill-advised policies for a while through import rationing and prohibitions, price controls, fiscal deficits, foreign borrowing and printing money, the music eventually will stop.
Had Sri Lanka approached the IMF late in 2021 (or even earlier) and implemented the painful reforms needed to rein in inflation and reduce its current-account and fiscal deficits, at least six months of suffering could have been avoided. More to the point, the country's descent into complete political chaos might have been avoided altogether.
Since the start of the pandemic, the international community has appropriately been directing more attention to the plight of heavily indebted developing countries, with the G20 rolling out a Debt Service Suspension Initiative that extended some US$13 billion (478 billion baht) of relief to 48 countries in 2020-21, but that was a drop in the bucket relative to needs.
Worse, there has been very little differentiation between countries whose underlying economic policies were sustainable and those whose policies would have become unsustainable without reform, even in the absence of Covid-19. Lending to a country in the latter category without ensuring that it has or will implement sustainable economic policies is not doing it any favours. On the contrary, such "support" merely postpones the day of reckoning and leaves it with an even higher debt-service burden when the time comes.
Policymakers in other economically struggling countries should take heed of Sri Lanka's tale. The lessons can be paired with those from Brazil, which, following its 2002 debt crisis, quickly adopted the necessary policy reforms and went on to enjoy years of sustained growth. Brazil, too, had a choice between swift painful action to create the conditions for recovery, and denial and delay to put off the inevitable. Its leaders proved wiser than those who have since high-tailed it out of Sri Lanka. ©2022 Project Syndicate
Anne O Krueger, a former World Bank chief economist and former first deputy managing director of the IMF, is Senior Research Professor of International Economics at the Johns Hopkins University School of Advanced International Studies.