The Sri Lankan economy is in meltdown, the political system is broken, and the population growing more desperate each day. In addition, the president was forced to flee the country earlier this week when protesters stormed his residence. So, how did Sri Lanka get into this situation and could this prompt financial contagion?


Worsening crisis


Inflation is currently running at 54.6%, the government can't afford to import food and petrol, and the economy has collapsed. In a calculated move, the country also recently stopped paying interest on sovereign debt. Even though many people saw the financial crisis fast approaching some months ago, the Sri Lankan government was reluctant to ask the IMF for help. Belatedly, they have now approached the IMF, but emergency funding is unlikely until the political situation is more stable.


Sovereign debt


While Sri Lanka was the first developing country, in recent times, to default on sovereign debt interest payments, there are serious concerns this could lead to financial contagion. Russia is also in default due to an ever-growing number of international sanctions, and Ukraine needs constant billion-dollar bailouts. However, recently we have also seen focus turning to El Salvador, Ghana, Egypt, Tunisia and Pakistan, countries described as "financially distressed" in the money markets.


It is important to remember that Pakistan is currently in the throes of negotiating a financial bailout from the IMF. While there are hopes this deal will be concluded relatively quickly, there needs to be structural change as well as financial assistance.


Rising interest rates aren’t helping


At the moment, emerging market sovereign debt now stands at around $1.4 trillion. A recent report by Bloomberg suggests that $237 billion worth of this debt is now distressed. This has prompted a surge in the cost of insuring emerging market debt from non-repayment. However, stopping contagion from spreading will be challenging until we see a long-term recovery plan emerge.


Many experts are comparing the ongoing financial challenges with the Latin American debt crisis of the 1980s. While Covid and the cost of living crisis have had an impact, the continued uptrend in US interest rates is a big issue. This has prompted a surge in the dollar, placing more pressure on developing nations already struggling to service their foreign bonds. 


Traditional international lenders are now reluctant to invest more capital in this market. Indeed, in June, we saw $4 billion pulled out of emerging market bonds and stocks.


Is there an end in sight?


The situation in Sri Lanka is worsening; while some observers are optimistic about Pakistan, overall, it isn't easy to see an end in sight. It is not a matter of will we see financial contagion, it has started, more how deep it will go and how long it will last. Moreover, inflationary pressures are forcing central banks across the board to increase interest rates. This is making debt more expensive and therefore reducing economic activity, chopping many recoveries off at the head.


Even though some sovereign bonds may offer good value at this moment in time, on an extended timescale, we are likely to see a flight to quality. Consequently, the IMF may be the only short-term solution for many countries currently teetering on the brink.

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