Sri Lanka crisis sends inflation warning worldwide

(Reuters Breakingviews) – Sri Lanka’s collapse is front of mind for many. Protesters fed up with crippling shortages of essential food and fuel items are on the streets, prompting multiple members of Prime Minister Mahinda Rajapaksa’s cabinet to offer to resign late on Sunday. Social unrest will probably accelerate a restructuring of some $44 billion of international sovereign debt. Though Sri Lanka’s problems follow years of mismanagement, its speedy unravelling is a warning to sturdier economies from Europe to Asia suddenly grappling with a spike in the cost of living.

A current account crisis has intensified after the West fired its sanctions bazooka at Russia as punishment for its invasion of Ukraine. Rolling blackouts and a state of emergency are frightening away remaining tourists, a crucial source of foreign exchange. Food inflation hit an eye-watering 30.2% in March. The currency’s 40% depreciation against the U.S. dollar in one month, including a central bank managed devaluation, is blowing out leverage ratios: Public debt estimated by the International Monetary Fund at 120% of GDP is perhaps some 40 percentage points more than might be deemed sustainable, guesses Citi.

A worsening crisis mutes the impact of disjointed financial lifelines, including a $1.5 billion currency swap from China in December and rice and diesel shipments from India. The IMF notes that policies required to reduce debt to sustainable levels are neither economically nor politically feasible. Hence, Sri Lanka’s $1 billion bond maturing in July trades at 67 cents on the U.S. dollar, compared to about 74 cents at the start of February. Haircuts will stretch from China to Wall Street, where market borrowings accounted for 47% of Sri Lanka’s foreign government debt as of April last year.

It’s a reminder of the political implications of high prices. Prior to Russia’s invasion of Ukraine, few Asian countries had consumer inflation in double digits. The standouts were Sri Lanka and Pakistan, whose Prime Minister Imran Khan on Sunday dodged a no-confidence vote and called fresh elections. Poorer countries are more vulnerable to surging global food prices because their populations spend more on food than discretionary items. But pandemic dislocations to supply chains and trade meant advanced economies overall were facing a jump in prices three times bigger than emerging markets between 2019 to 2022, per IMF estimates in January.

Whether countries rush to deal with surging prices with tax cuts, or ramping up subsidies, Sri Lanka’s speedy unravelling offers a warning of the political risks of complacency.