Joshua Lohka
Argentina, Ghana, Ecuador, and Lebanon, each nation adds to a growing list of states who have come to default on their debt since 2019 (Nicholas and Illanperuma 2023, fig.3). Each of the aforementioned nations shares a key principal, high levels of debt accounted for by international sovereign bonds (ISBs) (Nicholas and Illanperuma 2023, fig. 3). With the island nation of Sri Lanka in the midst of a debt crisis and at risk of debt default, there lies increasing evidence to demonstrate a link between the risks ISBs pose to low-middle-income countries (LMICs) and the current debt crisis facing Sri Lanka. This paper will proceed to develop an understanding of why ISBs are to blame for the current debt crisis in Sri Lanka—focusing on the lack of foreign currency reserves, debt to GDP ratios and ISB maturation timelines—continuing then to expose how ISBs might offer increased risk to low-income countries and LMICs alike, due to relatively large interest rates as well as the risk of legal action that may be imposed by vulture funds, when ISB creditors fail to received an ISBs full yield.
To understand the role ISBs play in the Sri Lankan debt crisis it is first imperative to understand how ISBs function. Implemented by national governments, ISBs are fixed-rate short-term bonds issued by government to finance national budgets (News First 2022), as ISBs are bought they collect interest—paid monthly or annually—over the principal which is paid out at the bond’s maturation date.
Sri Lanka exists currently in what can be competently deemed a debt crisis, facing extended levels of inflation, (Chughtai, Thowfeek, and Ali 2022) increased levels of foreign debt (De Zilwa and Illanperuma 2021) and a high debt to GDP (gross domestic product) ratio (Nicholas and Illanperuma 2023). The nation, now measuring a gross debt to GDP ratio of 83% sits notably lower from a 2003 peak of 96% (International Monetary Fund 2020), untangling the difference between the exceedingly high debt levels of 2003 that failed to risk a default and the current 2023 situation is found within the amount of foreign debt in the form of ISBs faced by the island nation today. Previous to 2005 the level of ISB indebtedness remained minuscule, this would change with ISB debt, then 3% in 2007, rising upwards to 31% in 2019 (De Zilwa and Illanperuma 2021, 6), then 48% in that same year (De Zilwa and Illanperuma 2021, 20). Contrasting the levels of ISB borrowing between the current debt crisis and previous peaks of indebtedness, it becomes clear that ISBs play a role in the default risk Sri Lanka is currently facing. The debt trap Sri Lanka finds itself in due in part to borrowing in ISBs can be understood as being brought on by unsustainable interest payments developed from the fixed yield of the issued ISBs, having issued over $17 billion worth of ISBs, 70% of all Sri Lankan government interest payments are made to service ISB interest (Nicholas and Illanperuma 2023). Furthermore the interest issue remains compounded by future ISBs set to mature early 2024 (Ada Derana 2019) leaving both interest and principal to be paid, as well as declining foreign currency reserves (The World Bank 2022a, viii). With Sri Lankan foreign reserves having declined from $10 billion USD down to less than $3 billion USD, (The World Bank 2022a, viii) there is a severe lack of currency to pay off the $12.5 billion USD in ISB debt. This inability to pay off debt has developed into an exponential increase in inflation (measuring average consumer prices), sitting at 48%, an increase of 800% over a one-year period (2021-2022) (International Monetary Fund 2020). With inflation devaluing the Sri Lankan Rupee from an exchange rate of 119 LKR/USD to 310 LKR/USD (Chughtai, Thowfeek, and Ali 2022), there is exceedingly little the Sri Lankan government holds to add into their foreign reserves without monetary grants, such as those set to be received from The World Bank in the form of IDA concessional lending (The World Bank 2022b), or what can be collected by the Sri Lankan government through the divestment of its parastatal entities (Kotelawala 2023).
Through the comparison of pre 2007 high debt levels to current debt distress faced by Sri Lanka, it is apparent that ISBs have had an effect in promoting the distress faced by the island nation. As a result of high interest payments marked with principal expenses from maturing bonds (Chughtai, Thowfeek, and Ali 2022), coupled with a lack foreign reserves (The World Bank 2022a, viii) unable to service the debt or gain in value due to the increasing inflation, ISBs have created a debt cycle with external aid – such as IDA – being one of very few solutions out.
Aside from the debt cycle imposed onto Sri Lanka by the ISBs issued by the Sri Lankan government, there are multiple key risks associated with ISBs that can be particularly scathing to LICs and LMICs. Mismanagement, interest rates, foreign currency volatility, and legal suits fall as the primary risks LIC/LMICs face exposing themselves to the ISB market. Fiscal in-discipline, on the part of ISB borrowing nations is the catalyst that brings about all issues surrounding the ISB market. With Sri Lanka as a backdrop, it can be interpreted that without a weak revenue collection and greater fiscal discipline the service of ISB interest would not hold the burden that has developed into the debt crisis seen today (The World Bank 2022a). Moreover with ISBs not being tied to traditional structural adjustment programs (SAPs) there is little keeping the money gained through ISBs from being invested into non-revenue generating facilities, further crippling any nation’s ability to pay ISB interest (Mecagni et al. 2014, 23). Along with risks associated with relatively high interest rates associated with ISBs (News First 2022), their also exists an inherent risk for LIC/LMIC nations dealing in ISBs as the each ISB transaction is primarily made with developed global-north currencies such as the USD or EURO (Hanlon and Jones 2021), any amount of currency devaluation by the borrowing state, such as the devaluation recommended by traditional SAPs during times of debt distress, would hamstring the borrowing nations ability to fund foreign reserves used to service ISB interest as is the case in Sri Lanka (Chughtai, Thowfeek, and Ali 2022). Following an inability to service ISB creditors, LICs and LMICs face the risk of legal action pursued through international lenders and vulture funds alike. As outlined by Gohil (2020, 26) vulture fund actors might enter into ISB markets, seeking bond repayments through litigation against the issuing nation, such as the 2006 ICSID (International Centre for Settlement of Investment Disputes) Italian arbitration against Argentina (Michael 2007). This is the consequence faced currently in Sri Lanka with Hamilton Reserve suing the near-defaulting state (Nicholas and Illanperuma 2023). The risk litigation poses to states who fail to service ISB debt is but a compounding risk associated with ISBs. One that creates greater hardship on states that, through fiscal mismanagement, currency devaluation, and volatility – as well as high interest rates – have little ability to pay off increasing debt pressures from maturing bonds.
International Sovereign Bonds act as an easy means for a government to access funds, simpler and without the conditionality that IMF or World Bank IDA grants impose (News First 2022), making ISBs particularly attractive. This attraction however is not without risk, especially to low-income and low-middle-income nations. With nations dealing in global-north currencies when issuing ISBs (Hanlon and Jones 2021, 274) there exists an inherent risk to foreign reserve shortages, when ISB investments fail to return on their investments or the local currencies of a nation face devaluation. Likewise, the risks continue with legal litigation hanging over governments who are unable to meet interest payment. These risks as outlined above have each found their way into the debt crisis in effect in Sri Lanka (Nicholas and Illanperuma 2023), begging the question of whether low-income countries and their low-middle-income counterparts should continue to view ISBs within the foreign market as a safe and sound investment.
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