September 1, 2022 by Dymphna

Could a debt crisis happen here?

Sri Lanka is in real trouble. It can’t happen here.

So a student asked me the other day if I thought that the economic crisis playing out in Sri Lanka right now could happen here.

The very short answer is no. Zero chance.

Things are tough in Sri Lanka right now. The economy is collapsing. The currency is collapsing, and the price of energy and food is going through the roof.

It’s a nightmare scenario. You can’t feed people. You can’t power your hospitals. Its terrible stuff.

The causes of every crisis are complex, but a lot of it has to do with Covid, which killed tourism revenue and sent the price of energy soaring.

But this is really where the crisis comes from.

Australia is in a better position. In fact, I saw that we’re extending more aid money Sri Lanka’s way. Bravo.

But why are we immune to a crisis like this?

Our politiicans do stupid things too on a regular basis. Energy prices here are going through the roof.

What makes us different?

The key difference is the denomination of our debt.

So when Sri Lanka borrows money from international markets, like most developing economies, it receives that money in US dollars, and commits to pay everyone back in US dollars.

International lenders don’t want the risk, or just the inconvenience associated in dealing with smaller currencies.

The currencies of developing countries tend to be more choppy and volatile, and there’s a non-zero chance they could just collapse.

And so for Sri Lanka, when we say that they owe international lenders a lot of money, what we’re really saying is that they owe international lenders a lot of US dollars.

But this is how the debt trap is set.

Because as the economy collapses, the currency starts to fall. Just the absence of tourism alone probably had a big impact.

Tourists never bought the Sri Lankan rupee, which reduced demand for the rupee, which, thanks to supply and demand, pushed down the price of the rupee.

But Sri Lanka still has to pay its US dollar debts. Only those US dollar debts now cost a lot more rupees than they used to.

Their finances go from bad to worse, which puts more pressure on the rupee, which makes the debt servicing even more expensive, and before you know it, you have a hole that is almost impossible to climb out of.

That’s the bind that Sri Lanka is in right now.

But this is exactly the reason why something like this could never happen to Australia.

As a large, open and modern economy, we have the luxury of issuing debt in Aussie dollars.

Take a look at the chart (left-hand panel). 95% of our debt is in AUD.

That means that the RBA can always just print money to pay off the debt, since the debt is in Aussie dollars.

And that means that there’s no way we’ll get pincered like Sri Lanka is right now.

I mean, sure, maybe in the distant future things will change and people lending to Australia will want to be paid back in US dollars.

But for now, it’s just not an issue.

Another reason to count your blessings. We’re the lucky country for sure.