Sri Lanka’s large debt will work against the country if the global recession deepens, according to the South Asia section of the World Bank’s Global Economics Prospects report. The country’s interest payments on debts could increase and the large external debt will get larger, if the dollar peg is removed and the rupee is allowed to depreciate.
The report notes that there is a risk of a deeper global recession, stemming from the current global credit crunch. “Given the synchronized and widespread nature of the current crisis, downside risks to the baseline are pronounced. A more prolonged and pervasive credit crunch than envisioned in the baseline would lead to a deeper global recession,” said the report.
A deepening recession will make it harder for Sri Lanka to sustain the exchange rate peg against the dollar, as foreign exchange reserves are “relatively low.”
“The Sri Lankan currency peg against the dollar could come under pressure, because the foreign reserve cover is relatively low,” said the report.
Even without the recession deepening, over the medium term, exports and private remittances are expected to slow down, slowing the inflow of foreign exchange.
Others in the region, like India, Pakistan and Nepal have already allowed their currencies to depreciate against the dollar, to boost export competitiveness and sustain foreign exchange inflows.
“Additionally, the recent sharp depreciation of local currencies against the dollar for India, Pakistan, and Nepal will help boost export competitiveness. This should help offset partially the negative effects of the coming contraction in world trade,” said the report.
But Sri Lanka’s high external debt will make it difficult to drop the currency peg and allow the rupee to depreciate, because the rupee depreciation will make the external debt balloon. The country could also be hit by increased interest rate payments on debts, if the global credit crunch gets worse.
“Sri Lanka has a large public debt (equivalent to 83 % of GDP in 2007), with 44 % of the debt external, albeit primarily concessional; the country’s fiscal position is thus vulnerable to higher interest rates and exchange rate depreciation,” noted the report.
In the South Asian region, only India is seen to have large enough foreign exchange reserves to withstand a deeper global recession.
“Whereas India holds sizable foreign exchange reserves (despite recent draw-downs) to help weather more negative than expected growth dynamics, other countries in the region have seen widening trade deficits and capital outflows reduce their reserve holdings, increasing their vulnerability to sustained pressure on currencies. Countries holding substantial short-term debt obligations would be more vulnerable,” said the report.