Currently what we all hear about is debt restructuring; have you ever thought about what this actually means? Have you thought about what led to this debt crisis and what debt-restructuring means? Why do we need assistance from IMF? These are just a few questions at the tip of the iceberg. This article would dissect all the questions that you have been asking yourself for the past couple of months.
What is sovereign debt (government debt)?
Before we discuss debt restructuring, we need to know what sovereign debt is. Sovereign debt is also known as public debt in a way; governments use it to finance investments for growth and development.
However, it is also critical that governments are able to continue servicing their debt and that their debt burden remains sustainable. The government debt may be owed to residents of the country or to non-residents. The debt owed to residents are considered as domestic debt while debt owed to non-residents are considered as foreign debt. Debt can be denominated in local currency or in foreign currency and the domestic currency; value of foreign currency denominated debt is sensitive to exchange rate movements.
When a country fails to repay its debt, it is known as sovereign default. Typically, countries are hesitant to default, since doing so is likely to bar the country from accessing global capital markets again for years and make borrowing more expensive. However, many countries have defaulted; Russia and Ukraine in 1998, Argentina in 2014 and 2019, and Ecuador in 2008 and 2020, and Sri Lanka became the first Asia-Pacific country to default for this century.
What led to the Sri Lankan economic crisis?
During the post-war period, between 2010 and 2017 the economy grew at an average of 6.4%. Subsequently, the economy experienced many shocks including the constitutional crisis in 2018, Easter bombings and the pandemic in 2019. These factors accelerated the decline of the economy, which was weak to begin with and resulted in a contraction of 3.5% in 2020, the worst performance on record.
The Sri Lankan economy has historically been facing twin deficits, a persistent fiscal deficit and external current account deficit. Fiscal indiscipline and risky commercial borrowing caused the huge debt burden, which was built up over the years. Sri Lanka became one of the most highly indebted developing countries with public debt as a share of GDP rising from 77.9% in 2017 to 104.6% in 2021. Loose monetary policy along with monetisation of the fiscal deficit created further imbalances. Adding fuel to the fire, the Government engaged in tax cuts in 2019, which wiped out almost a third of government revenue and contributed to unsustainable debt and, as a result, Sri Lanka lost access to international financial markets in 2020 due to credit rating downgrades.
Furthermore, this led to severe foreign exchange shortages in the financial sector, as overseas creditor banks cut down swap lines to Sri Lankan banks and Central Bank’s foreign reserves reached a low point, affecting its capacity to provide forex liquidity to the banking sector. As a result, gross international reserves declined from $ 7.6 billion (end-2019) to $ 400 million (end-2021), a level equivalent to approximately a week of imports.
Moreover, the collapse of the tourism sector wielded significant pressure on the balance of payments while loss of market confidence made it difficult to bring back export earnings and remittances to Sri Lanka, mainly through formal channels, despite tighter foreign exchange controls, and mandatory repatriation and conversion rules imposed by Central Bank.
Meanwhile, export competitiveness has been hampering Sri Lanka’s export growth for two decades.
The sudden import ban of inorganic fertilisers and other chemical inputs from May to November 2021 substantially reduced the overall agriculture sector output during the first half of 2022 and devastated the tea industry, which was one of Sri Lanka’s main export crops. Supply chain disruptions and limited access to inputs severely affected the industrial activity, particularly food and beverage manufacturing and construction. Even though the fertiliser ban was reversed later, it was too late to minimise its impact. The war in Ukraine led to a rise in global commodity prices, added additional pressure on the import bill in 2022, and created a shortage in grains.
The Sri Lankan Government’s economic plan turned out to be a string of missteps that led to the collapse of a once vibrant and economically promising South Asian nation into the worst economic turmoil since independence in 1948.
There are disadvantages to getting IMF assistance as when they look into a country, in this case Sri Lanka, they will prescribe certain fiscal and policy adjustments that are politically unpopular for the governing party and that can cause some political problems. However, these prescriptions would help Sri Lanka in the end
What is debt restructuring?
Like people and companies, sovereigns can also struggle to repay their debt. This could be because they borrowed too much or in a way that was too risky or because they were hit by an unexpected shock, such as a deep recession or a natural disaster.
In these circumstances, the sovereign needs to restructure its debt. But, unlike people and companies, there is no bankruptcy court for sovereigns that can compel the debtor and its creditors to resolve the issue. Instead, it becomes a negotiation: creditors want to recover as much of their money as possible, while the sovereign wants to regain “normal” status in financial markets, without paying out too much.
Debt restructuring is possibly the most discussed term that an average person will use at least once a day in Sri Lanka. Having said that, debt restructuring is the process of renegotiating the terms of debt so the payments are more manageable. This can include extending the repayment period, lowering the interest rate, or reducing the overall balance owed. This can be done by using different instruments such as adjust the interest rate of the bonds also known as coupon, reducing the principal of the debt (capital portion of the debt) also known as a haircut and extend the maturity of the debt. Whereas, reprofiling is where a transaction in which maturities are extended but there is no principal haircut and typically not even an adjustment to the coupon.
One could ask if IMF is Sri Lanka’s only option. On the other hand, are there any other options available?
So typically, in a debt, restructuring creditors do get new terms and it is called an exchange offer. Normally they do not amend the bond within its four corners, rather issue a new instrument to replace it.
The IMF Article IV consultation report, published on 26 March 2022 (IMF 2022a), concluded, “Sri Lanka’s public debt is unsustainable. China, India and Japan are notably the countries that hold most of Sri Lanka’s sovereign debt. China accounting for about 10% of its debt and often taken as an example for the “debt trap diplomacy”. However, having said, that commercial institutions hold the largest portion of Sri Lanka’s debt. In 2019, commercial lenders held Sri Lankan debt of 56% compared to only 2.5% in 2004. Most of the debt that was obtained for large infrastructure projects that did not yield the returns that was expected.
In April 2022, Sri Lanka defaulted on its foreign debt, as it was unable to meet the 30-day grace period and missed interest payments on two of its sovereign bonds. According to the credit rating agency, Moody’s, this was the first default by an Asia-Pacific nation in this century. As the Government borrowed most of the external debt, the private sector was less exposed than the other Asian crisis hit countries. However, the Sri Lankan banks have a large holding of foreign currency-denominated government debt, which have led to severe liquidity issues since the default.
Due to this unsustainable debt, whoever takes control of the government will have to implement reforms to restructure loans. Moreover, a nation would be excluded from accessing international credit markets due to its irresponsible handing of public finances, no sensible lender would agree to lend and reduce their claim against a country.
Sri Lanka is a resilient nation that has overcome years of challenges from the time of independence. It is imperative that Sri Lanka takes the right policy decisions and explores different paths that would secure the best outcome to the citizens of this nation, to build a better tomorrow
Sri Lanka’s debt restructuring and IMF
This is when the IMF gets involved. IMF is the International Monetary Fund that works to achieve international monetary cooperation, encouraging the expansion of trade and economic policies. So for countries that are looking for debt restructuring would find themselves getting IMF assistance as the IMF program, implicitly say to the bondholders that the debt relief the sovereign seeks is both necessary to achieve sustainability and relative to the contribution that the country’s authorities are offering through their fiscal adjustments. This is crucial factor that the commercial creditors will look for in the debt restructuring process.
In Sri Lanka, IMF has reached a staff level agreement initially, this is where a group of IMF economists determine the plausible fiscal measures, that would stop producing a revolution and what measures not to take in order to damage the country’s economy permanently. In accordance to the staff level agreement under the Extended Fund Facility (EFF) for $ 2.9 billion conditional on financial backing from its multilateral creditors, this includes India and China, in the early parts of September 2022. Where IMF introduced a bailout package. Sri Lanka is required to implement economic policy adjustments and reach a final consensus among all its stakeholders. Although, China had certain differences over the loan moratorium period and other terms of debt restructuring. China has agreed to support Sri Lanka in securing the IMF bailout package and support the debt restructuring process.
The Sri Lankan Rupee has been marked as the best performing currency in the world this year amidst the hope of getting the IMF bailout. The IMF executive board has confirmed on the sign off and the immediate disbursement of about $ 333 million. Which would make way for the release of the funds to start-off the four-year program designed to support Sri Lanka’s economy.
However, Kristalina Georgieva, Managing Director of IMF has advised Sri Lanka, to keep up “the momentum of ongoing progressive tax reforms should be maintained, and social safety nets should be strengthened and better targeted to the poor”. She also added that, “a more comprehensive anti-corruption reform agenda should be guided by the ongoing IMF governance diagnostic mission that conducts an assessment of Sri Lanka’s anti-corruption and governance framework.”
However, there are disadvantages to getting IMF assistance as when they look into a country, in this case Sri Lanka, they will prescribe certain fiscal and policy adjustments that are politically unpopular for the governing party and that can cause some political problems. However, these prescriptions would help Sri Lanka in the end.
One could ask if IMF is Sri Lanka’s only option. On the other hand, are there any other options available?
Debt restructuring is possibly the most discussed term that an average person will use at least once a day in Sri Lanka. Debt restructuring is the process of renegotiating the terms of debt so the payments are more manageable. This can include extending the repayment period, lowering the interest rate, or reducing the overall balance owed. This can be done by using different instruments such as adjust the interest rate of the bonds also known as coupon, reducing the principal of the debt (capital portion of the debt) also known as a haircut and extend the maturity of the debt. Whereas, reprofiling is where a transaction in which maturities are extended but there is no principal haircut and typically not even an adjustment to the coupon
Is IMF Sri Lanka’s only option?
Well, there are countries that did not seek the IMF program but opted for a different path; for instance, Belize is doing that right now. What is Belize doing different, it’s “a debt for nature swap”. If you are wondering, what it is? A debt for climate swap or debt for nature swap seeks to free up fiscal resources so that the government can improve resilience without triggering a fiscal crisis or sacrificing spending on other development priorities. Simply it is when creditors provide debt relief in return for government commitment to an environmental cause like decarbonise the economy, invest in climate-resilient infrastructure, or protect biodiverse forests or reefs.
Belize is home to the longest barrier reef in the Western Hemisphere that is a habitat to some 1,400 species, from endangered hawksbill turtles and manatees to several threatened types of sharks. Due to climate change and ocean warming, excessive fishing and mangrove felling and unchecked coastal development all pose risks to the ecosystem.
The Nature Conservancy (TNC), an environmental organisation (as part of their Blue Bond for Ocean Conservation project), reduced the country’s external debt by a remarkable 10% of GDP. Perhaps more significantly it greatly improved the prospects for marine protection.
Based on this agreement, TNC has lent funds to Belize to buy back $ 553 million in “Superbond” that accounts for the government’s entire stock of external commercial debt, equivalent to 30% of GDP at a discounted price of 55 cents per dollar. It financed this by issuing 364 million in blue bonds. This allowed the loan to have a low interest rate and a 10-year grace period, where no principal is paid and a maturity of 19 years.
In return, the Belize government has to spend $ 4 million a year on marine conservation until 2041. They will double their marine protection parks from 15.9% to 30% by 2026. An endowment fund of 23.5 million will finance conservation after 2040. These instruments have existed in various forms for decades, and more countries are considering them following recent agreements in Belize, Barbados and Seychelles.
This looks like a brilliant option for Sri Lanka, as Sri Lanka is home to over 21 species of mangroves, one-third of global true mangrove species, and 208 species of hard corals of 71 genera representing 19 families. These innovative debt swaps can help the Sri Lankan Government to have access to debt reliefs and grants when they have limited access to traditional grant or debt reliefs.
Sri Lanka is a resilient nation that has overcome years of challenges from the time of independence. It is imperative that Sri Lanka takes the right policy decisions and explores different paths that would secure the best outcome to the citizens of this nation, to build a better tomorrow.
(The writer holds a BA (Hons) International Business Management and is currently attached to the Securities and Exchange Commission as an Assistant Manager.)