CHOICE IS AN ILLUSION : SRI LANKA’S DEBT RESTRUCTURING

In the 21st century, no sovereign be they rich or poor, expects to repay its debt. That is by repaying it is assumed they will use current resources to retire the liability. Instead, every sovereign borrows with the expectation that when the debt matures, they will borrow from someone else to repay it and when that matures, they will borrow yet again from someone to repay, and so on and so forth endlessly into perpetuity.

This is a self-evident truth and is called the assumption of refinancing. It’s is for this reason that sovereign debt stocks normally grow by a process of relentless, remorseless accretion. They may sometimes decline, in debt to GDP terms because GDP goes up, but sovereign debt stocks rarely go gown.

Broadly, sovereign debt is of two types, those issued in local currency and ones owed in foreign currency. Because governments, or sovereigns, directly and indirectly, control the supply of local currency, repaying local currency debt is never an issue. This article deals with foreign currency sovereign borrowings, where the debt issues cannot be settled by printing money.

Forty years ago, the principal lenders to emerging markets were commercial banks. No commercial bank manager would go to her credit committee with a proposal for sovereign lending knowing that the first question the committee will ask is, ‘what makes you so sure they will repay this loan?

There are a couple of implied predicates to that question, the first is that the country will in fact repay the loan with its own resources and the second, and this is important, is that the bank would be there on the maturity date and would be holding the liability and would hold the risk of repayment.

No banker would therefore accept the risk that on a certain day in the future the county would be able to borrow at a tolerable interest rate from some other source to repay them.

The difference between today and 40 years ago reflects the depth and the liquidity of the capital market. Compared to 40 years ago it has become perfectly plausible for people to say that sovereigns will have access to capital markets.

Sri Lanka grew its debt at a blistering pace financing productive assets like roads and powerplants and questionable ones. For some of the debt it now has tangible assets. However, unlike in the past, it was also possible to finance budget deficits by issuing sovereign bonds.

Sri Lanka’s debt saw explosive growth. From a little over Rs1 trillion in the year 2000, the outstanding debt stock rose to nearly Rs14 trillion. Sri Lanka’s debt is also high relative to the size of its economy and the quantum of annual government revenue. In 2019, government debt was almost 700% of government revenue, whereas, in the Philippines, Thailand and Vietnam debt was the equivalent of 190% to 220% of revenue.

Over the next four years, Sri Lanka’s foreign currency debt and interest repayments top $21 billion (See Chart 1).

The problem is that the refinancing option occasionally proves to be fragile. Sometimes, like in Sri Lanka’s case, it is the country’s own economic management that causes the markets to turn skittish. At other times, the causes are quite outside the ability of the sovereign debtor to effect. An unexpected geopolitical crisis, a Lehman moment, interest rates in the developed world rising, can all trigger markets.

It can be a misfortune or the malfeasance of a sovereign somewhere else in the world that reminds investors that there are risks in sovereign lending and all of a sudden, they begin to pull back.

Sri Lanka’s bond spreads are among the highest in emerging markets according to a Goldman Sachs report in July 2021 titled, “Sri Lanka’s debt sustainability challenges to keep spreads wide.”

Political uncertainty and Covid’s impact led to a worsening of the country’s external vulnerabilities, Goldman Sachs points out. This led to multiple-notch credit rating downgrades. In the nine years to 2030, Sri Lanka must repay ISBs’ (International sovereign bonds) of over 10 billion dollars (See chart 2).

“Shorter-dated bonds are priced significantly higher than longer-dated bonds, with the Jan 2022 bonds at 94, the July 2022 bonds at 83.5 and the April 2023 bonds at 74. Maturities from June 2024 onward are all priced in the mid-60s. This pricing suggests that markets are assigning a much higher probability to near-term maturities being met, but are unclear on the longer-term prospects. In other words, markets are assuming that Sri Lanka has a reasonable chance of muddling through in the near term,” the report says about market conditions.

But the problem is when a country for whatever reason finds that it cannot refinance its maturing debt, and at that point, the choices become quite grisly.

As the spreads indicate the market’s view of Sri Lanka’s bond prospects is gristly.

One option is to get through the period of market interruption using one’s reserves. However, that is almost always a bad idea. For one thing, the reserves of most countries would not last long when they are cut off entirely from credit markets.

The second option, if available, is some official source, like the IMF, to lend the money to continue to repay maturing bonds. In effect, bond liabilities will shift from commercial lenders to the shoulders of the official lenders and their taxpayer-funded sources.

Typically, however, the IMF will not start a program until a country has restructured their debt. Essentially the fund will not lend money to settle private-sector creditors in full.

The third option is to restructure debt.

If there is a constant theme in sovereign debt crises over the last 40 years is that counties have put off that decision as long as possible.

The IMF will provide a degree of financing and that is never without strings. That conditionally, for the local politicians, is both good news and bad news. The bad news is the fund will ask for a fiscal adjustment that is politically unpopular. The good news is that the politicians realise fiscal adjustment is necessary and it’s so much easier to blame it on the IMF.

From the standpoint of commercial lenders, the IMF plays an important role. In the world of bond finance, there are tens of thousands of bondholders. It is fatuous to believe that any portion of them are going to be able to study the condition of the country and form a view on debt restructuring and if the proposed debt restructuring is proportionate to what the county needs. Once a debt restructuring is announced, the politicians think the more they can extract from the creditors the less fiscal adjustment at home. The foreign creditors don’t vote in Sri Lankan elections.

At base, every sovereign debt restructuring comes down to a burden-sharing decision. How much of the discomfort of the adjustment should be put on the citizens in the form of fiscal adjustment, reduce the public sector workforce, raise taxes, strip-off subsidies, cut pensions and how much of the burden is to be borne by creditors in the form of debt relief. Only one institution has the political legitimacy to contribute to that decision making and the competence to do so, and that is the IMF.

From the standpoint of a commercial creditor invited to join a debt restructuring, the fact that there is a third party will provide a false sense of security.

When commercial creditors enter a room with a sovereign to negotiate the terms of a debt restructuring, what they fail to apricate, is that the outcome is pre-ordained. In sovereign debt restricting it is useful to nurture the illusion of free will.

No minister can agree to pay the creditors more than the IMF has already told them, they can’t pay more without risking the entire programme. This is why for Sri Lanka it’s enormously advantageous to engage the IMF quickly and be pragmatic about the next steps.

If there is a constant theme in sovereign debt crises is that counties have put off restructuring their debt for as long as possible