Sri Lanka, Pakistan and Bangladesh: Weakened economies highly vulnerable to shocks

Black_cats · Jul 1, 2023

Sri Lanka, Pakistan and Bangladesh: Weakened economies highly vulnerable to shocks

06/29/2023 10:04:22 GMT | By BNP Paribas Team

Apart from being located in South Asia, Sri Lanka, Pakistan and Bangladesh have the common weakness of being very vulnerable to exogenous shocks, particularly those related to the commodity cycle and climate change. The Covid-19 epidemic and the very sharp rise in commodity prices in 2021 and 2022 have therefore exacerbated the macroeconomic imbalances of these countries, whose public finances and external accounts were already fragile. Consequently, Sri Lanka defaulted on its external debt in 2022. This is not yet the case in Pakistan, although the risk is very high. As for Bangladesh, it has been much more resilient to shocks than its two neighbours and should escape a default.

The causes of the crisis: Structural weaknesses accentuated by external shocks

Public finances and external accounts are structurally fragile in Sri Lanka and Pakistan, and to a lesser extent in Bangladesh. All three receive international financial support.

From an accelerated deterioration in public finances

The public finances of South Asian countries are fragile, especially those of Sri Lanka and Pakistan. The fiscal position in Bangladesh is much more comfortable, although it has deteriorated since 2018 due to higher capital expenditure.

Over the past five years, the average fiscal deficit has reached 9.3% of GDP in Sri Lanka, 7.7% of GDP in Pakistan and 4.5% of GDP in Bangladesh. Bangladesh’s government debt remains moderate (33.1% of GDP). However, it is high in Pakistan (71.4% of GDP) and even higher in Sri Lanka (113.8% of GDP). In addition, guarantees state owned companies reach 11% of GDP in Sri Lanka compared with 5% of GDP in Bangladesh and 2.6% in Pakistan.

Structurally, the governments of these three countries have very limited fiscal leeway to deal with domestic and external shocks. Their fiscal base is low: fiscal revenue is between 8.4% of GDP (in Bangladesh) and 12% of GDP (in Pakistan), and the share of rigid expenditure is high (all incompressible expenditure accounts for at least 58.2% of total expenditure in Bangladesh and up to 86.7% of total expenditure in Pakistan), mainly due to very high interest burden on government debt.

Pakistan's debt is particularly vulnerable to an interest rate shock as 64% of domestic debt is made up of floating-rate securities (27% in the case of Sri Lanka and less than 10% in the case of Bangladesh's debt).

Furthermore, Sri Lanka and Pakistan’s debt are particularly vulnerable to an exchange rate shock, as the proportion of their debt denominated in foreign currencies stands at 45% and 37% compared with less than 20% in Bangladesh. Prior to the start of the strong political tensions in 2022, Pakistan benefited from an advantage over its neighbours: its financial market was sufficiently developed to finance its fiscal deficit. Since 2022, the sharp rise in risk premiums on sovereign bonds and political instability have made debt issuance on the domestic market more difficult and costly.

Structurally fragile, public finances in Bangladesh and Sri Lanka weakened before the Covid-19 crisis.

Expansionary fiscal policies driving the deteriorating in public finances

In Sri Lanka, the deterioration began in 2019. Indeed, the fiscal deficit increased by 4 points of GDP, going from 5% of GDP in 2018 to 9% of GDP in 2019 due, on the one hand, to the drop in revenues caused by the contraction in economic activity following the attacks in April and, on the other hand, to the rise in government investments. In addition, the fiscal policy adopted by the elected government at the end of 2019 (lowering the VAT rate and reducing taxation on household income and corporate profits) generated a very significant reduction in fiscal revenues in 2020 already weakened by the Covid-19 epidemic (-3.5 points of GDP). The subsequent downgrading of the sovereign rating and the depreciation of the rupee increased the cost of debt servicing and accentuated the State’s difficulties in financing itself. From 2020, the Sri Lankan government could no longer issue debt on international markets. At the end of 2022, the fiscal deficit reached 10.2% of GDP.