The International Monetary Fund (IMF) confirmed a $3 billion bailout plan for Sri Lanka’s struggling economy.
What is a bailout?
- Bailout is a general term for extending financial support to a company or a country facing a potential bankruptcy threat.
- It can take the form of loans, cash, bonds, or stock purchases.
- A bailout may or may not require reimbursement and is often accompanied by greater government oversee and regulations.
Why do nations seek an IMF bailout?
- Countries seek help from the IMF usually when their economies face a major macroeconomic risk, mostly in the form of a currency crisis.
- For instance in the case of Sri Lanka and Pakistan, both countries have witnessed domestic prices rise rapidly and the exchange value of their currencies drop steeply against the U.S. dollar.
- Such currency crises are generally the result of gross mismanagement of the nation’s currency by its central bank.
- Central banks may be forced by governments to create fresh money out of thin air to fund populist spending.
- Such spending eventually results in a rapid rise of the overall money supply, which in turn causes prices to rise across the economy and the exchange value of the currency to drop.
- A rapid, unpredictable fall in the value of a currency can destroy confidence in said currency and affect economic activity as people may turn hesitant to accept the currency in exchange for goods and services.
- Foreigners may also be unwilling to invest in an economy where the value of its currency gyrates in an unpredictable manner.
- A country’s domestic economic policies can also have an adverse impact on its currency’s exchange rate and foreign exchange reserves.
- In the case of Sri Lanka, a decrease in foreign tourists visiting the country led to a steep fall in the flow of U.S. dollars into the nation.
Need for a bailout:
In such a scenario, many countries are forced to seek help from the IMF to:
- meet their external debt and other obligations,
- to purchase essential imports, and
- to prop up the exchange value of their currencies.
How does the IMF help countries?
- The IMF basically lends money, often in the form of special drawing rights (SDRs) to troubled economies.
- SDRs simply represent a basket of five currencies, namely the U.S. dollar, the euro, the Chinese yuan, the Japanese yen, and the British pound.
The IMF carries out its lending to troubled economies through a number of lending programs such as:
- the extended credit facility,
- the flexible credit line,
- the stand-by agreement, etc.
What the countries do with the money?
- Countries receiving the bailout can use the SDRs for various purposes.
- Currently, both Sri Lanka and Pakistan are in urgent need for U.S. dollars to import essential items and also to pay their foreign debt.
- So any money that they receive from the IMF is likely to go towards addressing these urgent issues.
Conditions to an IMF bailout
- The IMF usually imposes conditions on countries before it lends any money to them.
- Acountry may have to agree to implement certain structural reforms as a condition to receive IMF loans.
- The IMF may demand a country affected by high price inflation to ensure the independence of its central bank
SOURCE: THE HINDU, THE ECONOMIC TIMES, PIB