The IMF Trap

Massive demonstrations that swept Sri Lanka last year exposed the serious challenges at the heart of the global economy. In July 2022, former President Gotabaya Rajapaksa was forced to flee the country, only a few months after announcing a hasty default of Sri Lanka’s foreign debt obligations. He faced a wall of opposition as the nation suffered infamous kilometers-long fuel queues, power outages, and food and medicinal shortages, crippling everyday life. 

In the months since, the current government led by Ranil Wickremesinghe—allied with the party of the disgraced Rajapaksa family—has appeared savvier than its predecessor, implementing a quota system to manage fuel distribution and end the queues. However, the government has also tripled fuel prices, which has severely dampened demand. Fuel consumption is half of what it was a year ago, bringing economic activity to a grinding halt. Inflation has skyrocketed, with food inflation peaking at 94 percent in September 2022. A quarter of Sri Lankans are facing severe food insecurity; household incomes across the board have decreased. The Central Bank dramatically doubled interest rates, making access to credit for economic activity extraordinarily difficult. Rural livelihoods have been disrupted. Many small businesses are collapsing. 

The country’s default and its remaining pathways forward reveal the fault lines of a messy and intractable process. While the most visible aspects of the crisis that captured the attention of news media last year may have disappeared, the ongoing breakdown points to fundamental flaws in the global economy. These include the lack of a credible mechanism for resolving debt crises in peripheral countries like Sri Lanka, along with the possibility of a lost decade, if not longer, for development in many parts of the world.

Sri Lanka is already experiencing the unsustainable consequences of an International Monetary Fund (IMF) policy package, though it is yet to receive even the first infusion of IMF funds under a promised agreement of USD 2.9 billion, reached in September 2022. The IMF has demanded that Sri Lanka first obtain assurances from bilateral and private creditors, in addition to developing concrete plans to achieve a primary surplus by 2025 to conform with the IMF’s Debt Sustainability Analysis. 

The problems associated with the IMF’s policy package have been caught in geopolitical rhetoric. The US alleges that Sri Lanka is the victim of a Chinese debt trap. In fact, Sri Lanka is in an IMF trap. The structural consequences of over four decades of neoliberal policies have exploded into view with the receding welfare state, a ballooning import bill, and investment in infrastructure without returns, all of which relied on inflows of speculative capital. Framing Sri Lanka’s crisis within a narrative of geopolitical competition obscures the core dilemmas of the global economy. Will the evident breakdown force a reckoning with the present order, or will it be used as an excuse to inflict more suffering?

Foreshadowing the crisis

The current predicament seems to anticipate a wave of sovereign defaults with consequences as profound as the Latin American debt crisis of the 1980s. That moment signaled the beginning of “structural adjustment” as part of bailout agreements for countries in the periphery. The Bretton Woods institutions—the IMF and World Bank—originated in the aftermath of World War II as part of an attempt to coordinate global efforts to avoid another systemic breakdown. Intensifying debt crises in the 1980s forced a response from the US, which steered the creation of the Brady Plan to help Latin American countries undertake debt swaps. Bailouts from the IMF, however, came with strict fiscal conditionalities, complementing neoliberal policies in the core countries.

The counter-revolution of capital against labor during the economic crisis of the 1970s included the eponymous interest rate shock introduced by Federal Reserve Chairman Paul Volcker, which increased unemployment and helped break the back of organized labor. Giovanni Arrighi called it the signal crisis of US hegemony, with finance acquiring an increasing hegemonic role in the global economy.¹ The boom in financialized speculation occurred roughly over the same period and ended with the Covid-19 pandemic. It trapped more countries in new cycles of volatile financial inflows, encouraged by capital market liberalization, rating downgrades, and renewed austerity. Sri Lanka’s breakdown embodies the terminal crisis of this cycle. 

Sri Lanka was once celebrated for its high rates of economic growth. The ruling government’s pyrrhic victory against the Tamil Tigers in the North and East in May 2009 saw an expansion in financialization, with the government borrowing more in international capital markets. In response to the 2008 global financial crisis, the US and other Western countries adopted lower interest rates. Yield-hungry capital flowed into emerging markets, including Sri Lanka, eager to cash out on its post-war dividends. The government was led by Mahinda Rajapaksa, Gotabaya’s older brother, whose popularity in the predominantly Sinhala South had soared with the war victory. The Rajapaksa government obtained an IMF deal in July 2009 and promoted a development model that fueled economic growth by investing in large-scale infrastructure, including ports and highways, real estate, and urban development projects. This model was continued by the Sirisena-Wickremesinghe government that came to power in 2015. 

These policies were the outcome of Sri Lanka’s long experience with economic liberalization. The IMF and World Bank gave the country room to maneuver with populist measures by supporting investment in large-scale infrastructure projects even after liberalization in 1978. However, the emphasis shifted to austerity by the early 1980s. Meanwhile, export industries such as garments did not transition to investment in more capital-intensive industries, becoming yet another export enclave, one of many dating back to the colonial plantation systems. 

The post-war regime of Mahinda Rajapaksa capitalized on the desire for investment in the rural south. It promoted infrastructure development, which was ultimately predicated on deeper financial integration into the global economy. The model of funding large infrastructure projects by relying on domestic and international capital markets was further endorsed by major multilateral institutions, particularly the IMF, World Bank, and Asian Development Bank. However, the expectations of a post-war economic boom did not last long. By 2016, Sri Lanka was yet again in economic distress, which led it to enter another IMF agreement.

Indeed, early signs of economic trouble had already emerged by 2014, and provoked rising discontent among ordinary people, contributing to the electoral defeat of Rajapaksa in 2015. A drought in the interim years of the Sirisena-Wickremesinghe government further weakened the rural economy. Finally, the 2019 Easter bombings led to a deterioration in Sri Lanka’s current account, as tourism experienced a significant drop. The final blow to Sri Lanka’s economy came with the Covid-19 pandemic and the tremendous global price hikes caused by the war in Ukraine. The proposed IMF agreement with Sri Lanka would be the country’s seventeenth since 1965. However, the new IMF policy package now prefigures a dramatic change in relations between state and society, greater than any IMF agreement preceding it.

The IMF path of devastation

Since the IMF’s initial Article IV Staff Report release early last year, Sri Lanka’s policymakers have already carried out its main recommendations. These measures include raising indirect and direct taxes, implementing cost-recovery energy pricing, imposing fiscal consolidation, hiking interest rates, and devaluing the rupee. Although the IMF also recommended robust measures of targeted social protection, they have yet to be implemented. 

The evasive rhetoric about social protection raises questions about the IMF’s commitment and the interest of the local economic establishment—including the nation’s central bankers, prominent expert voices, and think tanks—in addressing the tremendous suffering across the nation. Meanwhile, the Wickremesinghe-Rajapaksa government went so far as to criticize the very idea of a food subsidy and relief in the Budget for 2023 presented late last year.² As a result, the government has abetted what has become a full-on assault on working people’s livelihoods, during an economic depression unseen in the country since the 1930s.

Sri Lanka’s pro-IMF contingent has argued that raising value-added taxes on goods is crucial, which means increasing costs for items that have already skyrocketed in price. They insist that the tax cuts of the Gotabaya Rajapaksa government in 2019 triggered Sri Lanka’s crisis, an explanation that is part of the justification for reducing the country’s fiscal deficit by rescinding the cuts and increasing taxes in other areas. However, the return to the revenue question overlooks the fact that liberalization had hollowed out Sri Lanka’s tax structure long before Gotabaya Rajapaksa’s rule. For years, indirect taxes have comprised roughly 80 percent of total tax revenue.

The explosion of imports from the late 1970s onwards had brought in additional revenues from duties, but these have been reduced by the restrictions necessary to conserve foreign exchange during the recent crisis. While prioritizing imports is essential, the desperate lack of other revenue sources has exposed how Sri Lanka’s upper classes have long disproportionately benefited from taxation policies. Indeed, redistributive taxation has all but collapsed. The government has now increased direct taxes on all people earning over Rs. 100,000 per month, but this new policy, focused on income, is a far cry from efforts to redistribute wealth. A truly redistributive approach requires a wealth tax on existing property and assets as well as on conspicuous consumption, such as luxury cars and high-end properties. Such wealth was accumulated through decades of exploitation and extraction by the elite. Sri Lanka’s post-war development model, for example, directly led to the boom in luxury real estate development and the luring of speculative investment, which has now fled the country. 

In addition, the current government’s attempt to target a fiscal surplus presupposes unprecedented austerity, while an economic crisis is immiserating people. The new income tax initiative is not part of a broader effort to restructure Sri Lanka’s economy along more egalitarian lines, including ensuring relief and investing in a new, self-sufficient development model. Instead, it is part of a misguided attempt to double down on austerity. Finally, the Wickremesinghe-Rajapaksa government lacks the legitimacy to carry out new tax measures in the absence of parliamentary elections. In this context, tax increases are politically explosive, evidenced by growing discontent manifested in new protests.

While the predominantly urban, professional middle classes are starting to stir, the government has made things worse by trying to implement the IMF recommendation of cost-recovery energy pricing. The resulting increase in prices on fuel and utilities, detailed above, has led to economic distress for various demographic sectors, including farmers, fishers, and electricity consumers. 

During an economic crisis of this scale, as pointed out by Keynes and other economists, governments must engage in counter-cyclical spending to help sustain aggregate demand when the private sector withdraws. Instead, following the IMF’s recommendation, the Wickremesinghe-Rajapaksa government has decided to freeze state sector projects as part of the pro-cyclical fiscal consolidation. This has further eroded the incomes of day wage laborers and those involved in seasonal livelihoods, who often depend on construction work. As a result, a UN report recently noted that incomes of unskilled labor had declined by roughly 50 percent.³ The increase in unemployment is occurring at a time when food prices alone have nearly doubled and even tripled in the case of some essential items. Wages relative to the increased cost of living have not changed, and in fact, real wages have fallen. Even nominal incomes are declining. Malnutrition, resulting in wasting and stunting among children, threatens an entire generation.

Although inflation calculated year-on-year appears to be receding, the one-time price hikes that occurred because of the shock policies of devaluation and rising prices of commodities in the global markets last year continue to be a grueling burden. While the entire population has access to electricity, working people now fear being disconnected from the electricity grid because of the tremendous increase in prices; current measures are forcing households to ration or restrict the most basic aspects of their consumption. The government has also quadrupled the price of kerosene, with a severe impact on food production. Farmers have withdrawn from cultivating their fields, and fishers are increasingly unable to go out to sea. The price hikes have compounded the crisis of Sri Lanka’s food system that began when the previous government led by Gotabaya Rajapaksa banned chemical fertilizers overnight in April 2021. 

Finally, the IMF’s recommendations to hike interest rates and devalue the rupee have also legitimized the Central Bank’s policy rate increase from 6 percent to 15.5 percent and the depreciation of the rupee from Rs. 200 to Rs. 360 to a dollar. The government is supposedly maintaining high interest rates to address skyrocketing inflation, even though inflation is largely the effect of import-induced price hikes sparked by the devaluation of the rupee and rising prices in global commodity markets.

In the absence of relief, many people have been forced to pawn assets such as family heirlooms at market rates of 24 to 30 percent. Working people are in danger of losing their emergency liquid assets. Small and medium enterprises have experienced extraordinary difficulty and even collapsed because borrowing rates are too high, while consumer demand is simultaneously contracting. All these effects add up to what is best described as an IMF trap.

The unraveling order

Unlike past IMF agreements, Sri Lanka has effectively zero bargaining power in the current negotiations, a result of the premature decision to default in April 2022. Gotabaya Rajapaksa’s government relied on foreign currency swap lines while insisting an economic revival was right around the corner. The wasted years in the aftermath of the Covid-19 pandemic meant that Sri Lanka’s foreign exchange reserves quickly disappeared. Parliamentary opposition and prominent think tanks singularly focused on demanding an IMF agreement, believing it was the silver bullet to solve the crisis, even as they carefully avoided calling for prioritizing imports, given their commitment to the free trade regime. Eventually, they began a campaign calling for an early default, believing it would lock Sri Lanka into an IMF agreement along with rapid restructuring of its debt. The government then declared a default in April, the first in the country’s history, even when the much larger USD 1 billion in international sovereign bond payments was due months later in July. Sri Lanka is now at the mercy of its creditors, and the IMF claims an agreement is predicated on a satisfactory debt restructuring package.

But the reality is that even in the absence of an IMF agreement, many of the recommendations in the staff level agreement have already been implemented—to disastrous effect. The IMF policy package is being used by the Wickremesinghe government to legitimize shock policies that harm the lives of working people. In addition, one of the two official conditions of an IMF agreement include targeting a primary surplus, which is the exact opposite of what Sri Lanka needs to overcome the economic depression.      

Meanwhile, the details of further conditions imposed by the IMF for the staff level agreement have not been made public. The government, desperate to prove itself as an exemplary debtor before the IMF, claims to have implemented all the proposed recommendations, even as the IMF plays hard to get, having already missed several expected deadlines to sign the agreement. But its rhetoric deflects from a focus on the ways in which the crisis has insinuated itself into every aspect of people’s lives, including those who are forced to give up on sending their children to school, and who have yet to see any tangible relief. 

Will the IMF face any pressure to reverse the measures that have turned the crisis into a slow-moving social, economic, and potentially even political disaster? Amidst threats of financial contagion for the global South, Sri Lanka could be the forerunner of a wave of defaults with unpredictable consequences. But two factors distinguish the current crisis from its previous IMF bailouts. First, there is no clear, global coordinated package to bailout Sri Lanka. Second, domestic political factors—including a government ruling without parliamentary elections amidst massive instability and popular discontent—will likely make the continued implementation of the current IMF policies unfeasible.

Unlike during earlier debt crises, there is growing division between major global powers, which in the past sought to address debt resolution, albeit in their own interests. The failure of the G20 to come up with a solution at its forum of Finance Ministers held in India in February this year is a clear example of this. The cycle of global financialization appears to have reached its limits, with countries like Sri Lanka bearing the costs. A recent UNDP Briefing highlighted that fifty-two developing countries are suffering from severe debt problems.⁴ Several scholars are warning against the dangers of debt overhang and the need for a different architecture of development finance, advocating for a new growth path linked to debt adjustment for countries at risk of a debt crisis.⁵

Some countries have obtained debt relief under specialized initiatives over the past several decades, depending on their status as low-income. This includes those part of the Heavily-Indebted Poor Countries initiative created during the late 1990s. But many more middle-income countries, or emerging markets, have been drawn into the financial vortex, a trend which became clearer during the East Asian financial crisis of 1997–1998. Prior to the current crisis, Sri Lanka had been upgraded to middle-income country status. The government’s current appeal to reassess the country’s income-status is narrowly focused on unlocking provisions afforded to low-income countries, such as concessionary rates or debt suspension provisions. It precludes discussion of what a low-income status means for the overall economy and its people, in terms of incomes, food security, and social welfare. 

What next?

Once a market success story, Sri Lanka is now under immense strain. Creditors are likely to attempt to extract their pound of flesh from the country, evident by the growing presence of vulture funds trying to buy collapsing debt. In addition, threats of legal action are ever-present. For example, the Hamilton Reserve Bank, which holds more than USD 250 million of Sri Lanka’s sovereign bonds, has initiated legal action, anticipating a messy, drawn-out process. It echoes creditor hold-outs for bailout agreements in other countries, including the most infamous example of Argentina. 

Sri Lanka’s economic establishment nevertheless proclaimed a path to quick debt restructuring and a recovery through further integration with global markets and a return to commercial borrowing in the international capital markets—the very strategy that led to the crisis in the first place. Insensitive to the tremendous suffering experienced by the working people with the implementation of the IMF policy package, Sri Lanka’s elites believe in the prospect of an eventual return to the status quo after a period of severe wage repression and dispossession. Greece after its lost decade appears to be the model. 

Compared to its sixteen previous IMF agreements, Sri Lanka’s adjustment this time around will cause an entirely different scale of suffering. The country is now at the whims of its creditors, while the elites counsel “bitter medicine” to people who are nearing an economic cliff. After a contraction during 2022 on the order of a tenth of its GDP, the economy could shrink on a similar scale in 2023. This so-called solution will have dire political consequences. 

There is now a growing recognition that the battle over debt reflects distributional issues in a world characterized by dramatic inequality. Imposing large haircuts on debt owed to international creditors and even the possibility of debt cancellation are part of a range of alternatives.⁶ The Sri Lankan disaster reveals that the ailing global economic system and its prescribed solutions are itself the problem. The question is whether Sri Lanka’s working people, through a powerful refusal to bear these conditions, will help the world envision a new path of development.