Sri Lanka Defaults

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The sovereign debt crisis is starting.

The credit markets have been tightening over the past few months. This has been done intentionally by the Federal Reserve in an attempt to fight the high consumer inflation at home in the United States. Unfortunately, the consequences of these actions have ripple effects which are beginning to be felt overseas.

Debt is broadly denominated in dollars. Dollars are created by being lent into existence by institutions with the power to do so. But when this credit supply, or the broad money supply, starts to contract, things get very dicy for those who owe money in dollars. With less dollars circulating and less new dollars coming into existence compared to the amount of debt which needs to be serviced and repaid, the cost of acquiring dollars to service the debt starts to increase rapidly. Any individual, institution, or country which was already struggling to pay bills and service debt will start to have an even harder time, as the amount of debt relative to the money supply or amount of new credit becomes increasingly unsustainable.

Today, for the first time ever, the country of Sri Lanka has fallen into default. The nation missed their grace period payments on bonds worth $78 million. It also has Asia’s fastest inflation forecast, which is expected to worsen to 40% from 30%. It has gotten to the point where the country claims they have just days left worth of money for fuel, and that servicing the debt was out of the question.

Sri Lanka is a relatively small country, but still significant. It is densly populated and home to over 21 million citizens, putting it on a similar scale to Canada in terms of population. It has a GDP of roughly 81 billion. With more than $50 billion in external debt and a shortage of foreign exchange reserves, the country is currently struggling to pay for essential imports. It is important to remember that all the debt Sri Lanka owed is someone else's asset under the debt based monetary system we have today. So if 50 billion in ‘assets’ suddenly disappears through default, it begins to trickle through other economies and damages any institutions or governments which were holding this debt themselves.

Sri Lanka is likely the first of several countries that will begin defaulting in emerging markets. These countries are metaphorically far away from the money printer located at the Federal Reserve, and when tightening begins as it has for the past few months, they are the first to have their currency reserves dry up. This domino effect of countries defaulting will start to unwind until the Federal Reserve has seen enough, reverses course, and re-injects credit into the economy. A pyramid scheme always needs more new members joining from the bottom than are leaving at the top. When new money isn’t flowing in, our debt based economy begins crashing down as all the over-leveraged and over-indebted parties begin to default. The biggest borrowers in the world are the billionaires, countries, and companies. I would be shocked if they allowed the deflationary cascade of defaults to continue and destroy all the fake wealth they have been able to accumulate from the hard working citizens which provide the real value.

Be on the lookout for more stories like Sri Lanka. Many more will be coming out soon, and it will be very interesting to see what the supposedly hawkish Fed can do to inflation in the face of a global recession and debt crisis. I believe they will try to give this rusty, destroyed can one more good kick down the road before all faith is lost in these institutions and sound money makes its triumphant return.

But who knows.