During a presentation to external creditors on March 30, 2023, on restructuring debt, Sri Lanka’s government mentioned that rupee-denominated debt too will be ‘optimized’. It plans to extend maturities on treasury bonds and make longer-term treasury bill restructuring voluntary.

Three economic analysts, Udeeshan Jonas, Chief Strategist at CAL, Sanjeewa Fernando, Senior Vice President of Asia Securities and Vajirapanie Bandaranayake, Head of Research at NDB Securities joined a discussion on how Sri Lanka’s debt restructuring process may unfold, its impact on the economy and superannuation funds and banks that hold large portions of outstanding bonds.

We are looking at a picture that is still very unclear, we have very hazy details. What are, in your view, the likely scenarios on how Sri Lanka’s rupee-denominated debt restructuring is going to unfold?

Vajirapanie: In the IMF’s staff report, for the first time, we saw an indicative scenario and the investor presentation you referred to hosted by the government offered more clarity. We know what the Debt Sustainability Analysis targets are, and we also understand the perimeter of external debt restructuring or who is going to come under restructuring and the kind of debt relief that is expected from external bondholders.

I will begin from there and then come to domestic debt restructuring.

So in terms of DSA (IMF’s Debt Sustainability Analysis), the public debt to GDP expectation is 95% by 2032. This target is benign when compared to the IMF’s DSA targets given to countries like Ghana which has to achieve a public debtto-GDP ratio of 50%, from the very high level of debt that the country processes. By 2029 our public debt to GDP will be 100%.

The second DSA target is GFN, (Gross Financing Needs) as a percentage of GDP, of 13% during the IMF programme period of 2023 to 2027. And of that, 4.5% of the GDP is for foreign loan servicing and 8.5% for domestic loan financing.

What we didn’t know was the extent of the debt relief. The total debt relief we are expecting from the bondholders during the programme period is $16.8 billion. That’s $14.1 billion, plus the accumulation of the arrears in 2022 when we didn’t pay our loans of $2.8 billion.

We spoke to Sri Lanka-focused sovereign debt analysts to understand some assumptions they are making. When it comes to external debt restructuring, what is expected for private bondholders is a face value reduction and for amortization to begin after the IMF programme period, that’s in 2028. And for bilateral creditors, no face value reduction, but a longer maturity extension, and the amortization will begin in 2023. So that’s the expectation on maturity extension.

When it comes to coupon reductions; our Euro bond average coupon is 6.7%. What it infers is for a 6.7% average coupon, it will come down to 5% if we are not servicing the bilateral creditors during the IMF programme period. But it could come down to 2.5% if we are servicing bilateral bondholders.

And we are expecting at this point that we will only service the interest due to bilaterals?

Vajirapanie: We still don’t know. But if we are servicing bilateral bondholders, then the private bondholders, the Euro bondholders, will have to take a coupon reduction of up to 2.5%.

On face value reduction, there are two main assumptions. One is public debt to GDP, it’s a rather soft target we have and should be 95% of the GDP by 2032. Tellimer, a sovereign debt analyst, expects a 20% face value reduction for bonds. Now, the base value assumption is based on the IMF staff report’s expectation of a dollar-rupee exchange rate of Rs 396 annual average by the end of 2023. This means, around Rs420 year-end dollar rupee exchange rate. So this year-end exchange is used for all GDP calculations.

If we go by the Rs410 year-end target, then they are looking at about a 20% NPV reduction. But if the rupee strengthens to about Rs400 to the dollar, then a 15% or lower haircut. So it depends on how the rupee behaves.

One particular aspect of this is, the local banks have made a provision on their foreign currency commercial debt of about 35%. So if this comes to fruition, we might even see provision reversals coming from ISBs banks hold.

There is a lot to digest here. Let us start unpacking what you are talking about. Udeeshan what do you anticipate will happen with commercial creditors to Sri Lanka?

Udeeshan: The principal haircut is going to be between 20 to 30% on the commercial foreign currency debt. And that will correspond to coupon payments which will also fall by a similar amount. Because if the principal outstanding comes down from, let’s say 100 to 80, then your coupon is going to be on that 80. And we are looking at a maturity extension of five years. So until five years, there is no payment.

But obviously, when the ISB holders come to the negotiation, they will want a better deal. They might oppose a principal haircut because the other debt holders like the bilateral and even the local holders are not taking a principal haircut. But at the end of the day, there will have to be a level of principal haircut. And without that concession from the sovereign bondholders, the debt-to-GDP target of 95% might become difficult to achieve.

With a 30% principal haircut, there is an immediate 5% reduction in the debt to GDP percentage.

And the debt to GDP is now 120%?

Udeeshan: We are at about 127% right now. Automatically there is an improvement because this year’s inflation will be at 25%. In addition to that the haircut will reduce debt to GDP by a further 5% and from 2024 onwards, we are forecasting a primary surplus.

When the government is making more money, then its debt accumulation grows slower than your GDP growth rate. A combination of these will ideally allow us to hit this target of 95% before 2032.

Sanjeewa, comment on what you anticipate will happen with the commercial creditors, the holders of the sovereign bonds. And contrast for us, what is the likely outcome with Sri Lanka’s bilateral creditors, that is the Paris Club plus India and China?

Sanjeewa: ISB bondholders will probably have to take a principal haircut. Whereas expectations on the currency by year-end will obviously be determined by the inflows and how quickly we open the market for imports. Remittances are on the rise perhaps to $5 billion as opposed to 3.8 billion in 2022. Tourism inflows are rising too and will probably be more than $3 billion this year. Add to all this the external debt relief, resulting in maybe having above $4 billion of foreign reserves by the end of 2023. The IMF requires us to have around $14 billion worth of reserves by 2027.

If we discuss the outcomes you anticipate with the bilaterals and the holders of the commercial debt. What do you think?

Sanjeewa: So the commercial banks have gone with the assumption there will be a 40% adjustment on the sovereign bonds. But the elephant in the room for banks is not sovereign bond adjustment or Sri Lanka Development Bonds (SLDBs) but it’s the upcoming NPA (non-performing advances) shock. Because stage 2 plus 3 loans, according to the IMF report, have risen 32% year-on-year by 30th September 2022.

Just to jargon bust; stage 2 and 3 loans are classified under IFRS 9 of expected loan losses?

Sanjeewa: Stage 3 is default loans, and stage 2 loans are at high risk. But since we are not expecting interest rates to decline significantly until the end of June 2023, we are expecting these high-risk loans to come into your stage 3.

So I will bring you back to bilaterals, what do you think the position on bilaterals is like?

Sanjeewa: With NPA impact coming in with impairments if we have a lower ISB’s haircut then some of the NPA shock could be neutralized. Some manual reports indicated that in the December quarter of 2022 growth of stage 3 loans were 50%.

 Our discussion here is on the 20th of April 2023 and we do not have March quarter 2023 financial results yet.

Vajirapanie: The other issue is the longer the officials take to reach a decision, you have these vulture funds lurking like the Hamilton Bank. In April 2022, no sooner than the government defaulted, they went to the US district courts and filed a case against us saying all bondholders should be treated equally. And once that bond matured, they dropped the case. So what happens is, if a judgment is given before we arrive at a decision for debt restructuring, they will be actually paid. They have a modest holding, only $250 million.

Let us switch to the potential restructuring of Sri Lankan rupee denominated debt. Can you lay out for us what the landscape is like as far as domestic debt restructuring, who are the players and what are the likely big impacts?

Udeeshan: In terms of the presentation that the Central Bank Governor and the Treasury made to the creditors on the 30th of March 2023, they clearly mentioned only the Treasury bills held by the Central Bank will undergo restructuring where their tenure will be extended. So the T-bills will be converted to 10 to 15-year bonds. And any other T-bills are not going to be restructured in any way. 62% of outstanding T-bills are held by the Central Bank.

In terms of Treasury bonds, what they have said is that a selected pool of investors will be subject to what they call voluntary debt optimization. They have clearly mentioned they won’t coerce bondholders into a programme, it’s entirely voluntary.

After an external debt haircut and extending maturities on T-bills held by the Central Bank, your requirement for further adjustment is rather small. To meet gross financing needs targets the tenors will have to be extended. The debt maturities and the budget deficit as a percentage of GDP, will have to meet a target of 13% from about 34% in 2022.

Before restructuring, this 34% (debt maturities and the budget deficit as a percentage of GDP) is forecast to fall to 19.8% by 2027. This 19.8% has to come down to 13%. It is to bring down that 19.8% to 13%, we are extending the maturity of the Central Bank holdings of T- bills, which accounts for about 2.5 trillion rupees. Even after those actions and the relief coming from the external holders, there will still be a component that you need to manage from the other Rupee debt holders.

Within the debt T-bond holders, 45% is held by deposit-taking institutions and about 43% by the superannuation funds, which are the EPF and ETF.

So the banks and EPF hold 90% of the T-bonds outstanding?

Udeeshan: Some component of that has to be touched to make a material difference in your equation. The remaining portion (held outside of the pension funds and the banks) is a small component and it may not make sense to go behind each of those individual holders to make a difference in the equation.

One more thing the Central Bank Governor mentioned, during the presentation to external creditors, is an institution with a significant asset-liability mismatch, they do not want to touch.

So I am a little confused, what does voluntary mean? If you give somebody the choice, they will say “No, do not touch my holdings”?

Udeeshan: Correct. So voluntary can be in two ways. One is that you need to give some kind of sweetener to entice them into the programme.

There is another option which is the hard route where they say it is voluntary, but they will also put in regulatory clauses saying, if you do not exchange, we will treat the old bonds at higher risk ratios for your capital adequacy ratios and so on (in the case of financial institutions), effectively forcing you to convert.

In this kind of scenario facing Sri Lanka, we anticipate a completely voluntary programme. If the main requirement is extending the maturity, doing so for the debt held by the EPF and ETF is fine because EPF’s collections are more than its annual settlements. So you can afford to extend maturities.

So let us discuss the banks and the EPF separately because the circumstances surrounding the two are completely different. What are the likely scenarios as far as voluntary restructuring is concerned for the EPF because it’s unlikely that individual EPF members are likely to have a say?

Sanjeewa: There is a political aspect to manage in this kind of scenario. There could be politically motivated parties trying to gain mileage. At the end of the day, it’s about managing expectations and meeting the objectives of the programme.

Are there any other areas in the economy that will be impacted?

Sanjeewa: Next in line for impacts are the life insurance companies. If you look at other countries, it was chaotic.

If there are impacts on life insurance companies, then you are impacting market confidence. There can be significant negative impacts of doing so.

You mentioned the Paris Club may agree to give us a 10-year extension of maturities

Vajirapanie: The IMF staff-level agreement mentions a 10-year maturity extension for bilateral bondholders.

If you look at the indicative scenario in the IMF staff report, what they said was, the Central Bank’s balance sheet will be restructured and part of the pool of remaining bondholders will be re-profiled via domestic debt operations without coercion. They indicated a re-profiling. The best-case scenario would be a maturity extension, but we will get to know the details in the weeks to come.

If there is some kind of loss at the EPF that goes on to impact their capital, we may be able to get solvency support through international financial organizations like ADB, World Bank and maybe even the IMF.

Usually, when a banking sector in a country is in crisis, a liquidity support fund will be established by these institutes. At banks, there could be pressure on deposits or external funding, for that purpose.

There have been instances where the financial system stability fund has been used for solvency purposes. I think Jamaica, in 2010, used it to support their pension fund and in 2012, Saint Kitts and Nevis also used it.

I am confused, how can a pension fund have a solvency crisis because they can sell assets in the market?

Vajirapanie: That is from the liquidity point of view, but if capital is affected, even capital support could be provided. There can also be some temporary adjustments. There have been instances where for newer employees, their earliest eligible age for benefits has been extended. There could be temporary adjustments like these to come out of the situation.

Before we get to talking about the banks and the impact of all this, one big assumption we are all working with is where the Sri Lankan rupee will be trading at. The IMF has forecast that it could go beyond 400 rupees to the dollar by yearend 2023. So far the Rupee has defied those odds. But there are so many controls in place that we cannot say with confidence what the real value of the rupee will be. What are your views on this?

Udeeshan: So in terms of the currency, I think the IMF is using a very pessimistic scenario. They are looking at about Rs415 to the dollar at the end of 2023 and by the end of the programme period, they are looking at Rs 515 to the dollar, which is a 10% annual depreciation.

We are looking at a new scenario now. So in that context, I would only look at a 5-6% depreciation annually. But this year the currency will be more stable. We expect the Rupee to settle at about 320 to 330 range, given that there is a lot of money yet to come in from the ADB and other financing. And the confidence has to build up after the domestic debt restructuring programme.

This year the currency should be relatively stable. We have seen in other countries, which have gone through a programme like this, that the initial year after a programme is agreed there is currency appreciation.

Explain to us what are the consequences or what are the impacts, should the currency not depreciate as steeply as forecast by the IMF, you are saying 10% a year till the end of the programme. What are the implications of it not depreciating so steeply?

Udeeshan: To be honest, my view is that it doesn’t matter where it goes in a year’s time or in two years or three years’ time. Why I say this is the domestic debt exchange and the external exchange are going to happen in the next few months.

The debt exchange will be based on the IMF numbers. The IMF’s forecast must be used for all calculations, including their GDP, inflation, and other forecasts because exchanges must take place immediately and cannot wait for events that may occur in three to four years.

What matters now is the numbers we are using and that’s how their DSA (Debt Sustainability Analysis) will be making projections that will determine the debt relief that is required.

The fiscal assumption is a major assumption; we are planning to go from a primary deficit to a large primary surplus in two years. In all these assumptions we have to go with what the IMF is saying and the debt exchange will be based on that. It doesn’t really mean that you have to look at right now whether Sri Lanka can hit those primary surplus or the fiscal deficit numbers as such.

So in terms of the currency, I think the IMF is using a very pessimistic scenario. They are looking at about Rs415 to the dollar at the end of 2023 and by the end of the programme period, they are looking at Rs 515 to the dollar, which is a 10% annual depreciation.

What’s happened in the primary and secondary market for government debt, since a little bit more clarity was shed following the March 30th presentation to creditors?

Sanjeeva: The secondary market has been showing mixed signals with T-bill and bond yields coming down and then later going up. But what we need to understand is when the IMF made these forecasts on currency and inflation the visibility was poor.

If you recall during the monetary policy review when they increased policy rates in early March the governor said there were differences between the IMF’s inflation forecast and the central bank’s inflation forecast.

Because the IMF had wanted a 250 basis point upward adjustment in rates versus the central bank doing a 100 basis point rise. When you look at that evidence, maybe the market is probably overreacting.

What do you think? Markets make assumptions and try to price those assumptions today. What’s your reading on how Sri Lanka’s fixed income markets are reacting?

Vajirapanie: From the end of March up to now the yields have declined; Treasury bills by 130 basis points and bond yields have come down about 280 basis points. Once we get more clarity on the domestic debt operation front, we will see bond yields also normalising.

If you look at Uruguay, in 2003 they did a bond restructuring. And Uruguay is considered a poster child of debt restructuring because they did a voluntary debt restructuring and they achieved a 99% participation rate. They offered a lot of sweetness. When Uruguay, announced their domestic bond operation yields were hovering around the exit yield. The exit yield is the yield at which the old bonds will be converted to new bonds.

The bond operation concluded in mid-May of 2003. So by April, it fell down to 18%, and by May it fell to 16%. And once the bond operation was finalized and concluded, the bond yields fell to as low as 12%. We will see some sanity once the market gets an indication that is a successful bond exchange. So that’s from the bond yield front.

We’ve seen some volatility in the last two treasury bill auctions because some of the market participants we’ve spoken to think in the April period the outflows are high.

Now, treasury bills are off the table, as per what the government has said, so why are the yields going up? And there’s another school of thought that, in March inflation was about 54% which was a little higher than the market expectation possibly due to the electricity price hike.

But inflation is declining and if the T-bill restructuring is off the table, they should normalise. Then comes the T bonds. which will come to their normal equilibrium level once the bond restructuring is finalised.

One final question on the exchange rate forecast that is likely to be used in the negotiations. What is the long-term implication of the exchange rate not being where IMF has forecast it to be?

Sanjeewa: We expect the rupee to be between 315 to 325 by year-end and maybe 4 to 5% depreciation during the next few years.

I think the IMF will adjust their numbers on the exchange rate expectation. In the board-level approval, they were referring to GDP as a contraction of 8.7%. By 15th March, the GDP numbers came in at $74.4 billion. So they were using a relatively low GDP to come up with the numbers that they had provided for the board-level report.

These adjustments that happened in the market and then the expected low inflation and low Rupee depreciation will require surgery that may not be as deep as the IMF indicated when they offered a 420 rupees exchange rate forecast.

So if it is less painful, does that mean it is likely the government will have more fiscal space than initially forecast?

Sanjeewa: Correct. The IMF’s forecast was very conservative on GDP and the currency. One reason could be; if you slip on fiscal numbers, still if your GDP is growing and the exchange rate depreciation is not too much, you still might do fine in terms of the deficit to GDP target.

The numbers will matter if the domestic and external debt restructure takes more time. For instance, if they are postponed to December, the number as of December will matter because your base is going to be set on that.

If we agree on a programme now and if we don’t meet those numbers two, or three years down the line, then we won’t be able to access international markets again and then we are back in the scenario where we were before.

For the moment what we have to worry about is where we stand right now and getting the programme completed as fast as possible. When it’s delayed, that means that you are funding your interest at 21%, and you won’t receive any bilateral or multilateral funding.

When will Sri Lanka be able to tap international markets again and will it matter then how we are doing versus the agreed IMF programme? Can we tap international markets during the IMF programme period?

Sanjeewa: IMF projection says sovereign financing will come in by the end of the programme in 2027, of 1.5 billion dollars. Your being able to tap the markets will depend on how well you do on these programmes. Foreign capital will not be available at a reasonable price locked in for a 10-year period if they don’t see progress in the country.

Should we outperform because the exchange rate isn’t under pressure as much as the IMF has forecast and that has some serendipitous effect on the budget and we have flexibility? Do you think we can access markets sooner?

Vajirapanie: It is usually possible to access markets within two years. But as per the IMF programme projections, it will take us four years.

Further, why it is important that we do well and why we are in the programme, is because it affects the risk spreads when we go to the international capital market. If we are not meeting programme targets that will affect the risk spreads usually within the first one or two years of the programme.

Sometimes bondholders demand the inclusion of clauses for their protection. One such clause is principal reinstatement. What it says is, if there is a trigger event and we are not staying in the IMF programme then whatever the haircuts and claims become null and void, and everything goes back to where it was.

Bondholders could ask for such protection.

The IMF is expecting an average of 3.1% GDP growth during the programme period. GDP growth from 2000 to 2009 was 5.2% annually on average and 5.4% from 2010 to 2019. So this is where we might also have an opportunity to entice the external bondholders, by giving them a value recovery instrument.

Recently the governor of the Central Bank said we are looking at giving new instruments like GDP-linked bonds. So what happens is we are telling bondholders, you take a haircut but we are giving you another instrument where you should be able to recoup some of your losses if the country prospers.

If we agree on a programme now and if we don’t meet those numbers two or three years down the line, then we won’t be able to access international markets again and then we are back in the scenario where we were before

Is this one of the sweeteners you were talking about earlier?

Vajirapanie: This is one of the sweeteners. How it works is now the growth target is 3.1%. But if we achieve 4% or 5% growth, then we give a step-up coupon and if it comes below we give a step-down coupon.

So there is both an upside and a downside that they will have to agree to.

Vajirapanie: Absolutely. It is a very popular instrument. In Mexico, they used it in 2020, and Ecuador used it. Belize also did something similar. These instruments are new to the market so there is a novelty premium.

What are the other options for sweeteners that Sri Lanka can throw at the commercial bondholders to get them to sign up for a deal sooner?

Sanjeewa: Let me talk about what they can offer the local guys. The problem is going to be mostly on the sweetness of the rupee-denominated debt. Government can obviously finance the recapitalization of state-owned banks by borrowing from multilateral and bilateral agencies and infusing it as equity to state banks. They can only bring the state banks into the parameter for voluntary haircuts or maturity extensions.

That loss is financed by the government by infusing capital into the state banks. You cannot do that with the private banks because of the ownership.

Bank of Ceylon and People’s Bank hold 60% of the T-bonds held by Sri Lankan commercial banks. So if you touch those holdings you are touching a large part of the overall T-bond holdings. Bank of Ceylon and People’s Bank as a percentage of sector assets is about 45%.

Many banks got stuck investing in low-yield bonds, buying at 7% to 8% which they have now categorised as held to maturity on their balance sheets. One thing to do is offer, say a $100 face value bond with an 11-12% coupon or yield. This will be a voluntary offer. As a bank you will have bonds which you bought at 7, 10, 15, 20%, and likewise. You will exchange the bonds which are below that particular interest rate range. So you will exchange the bonds at 7% for ones now offering 11%. But the ones that are at high yields you will continue to hold.

For the government what this does is help the GFN. The 7-year bond which matures in 3 years, will now only be due in 11 years. So it helps with the GFN target.

The government does lose on interest costs but it helps on the GFN front. That’s a likely scenario that they can offer to all banks.

There is also a bank asset quality review report that is expected soon, right?

Sanjeewa: Excluding government banks, there will be around five private banks where their capital buffer, which is the reported capital adequacy ratio minus the required capital adequacy ratio for tier 1, is lower than 200 basis points.

So if it is lower than 200 basis points, previously the procedure was the banking supervision department of the central bank will demand a plan to restore the capital buffer. Now these numbers have gone below even 50 to 100 basis points for some banks. So whether it is voluntary or not, you may need to come up with a plan for your own bank.

So let us talk about the contours of such a plan, what are the options because the health of the banking sector will impact Sri Lanka’s ability to recover from this economic crisis. How do we start addressing this broadly?

Udeeshan: The margins that commercial banks have in terms of their capital cushion are very narrow at the moment. A lot of the mark-to-market losses are currently being converted to held to maturity on the balance sheet. Without this change in the treatment of treasury bills and treasury bonds, you might see banks that are already short of capital.

The tier one capital that Sanjeeva was talking about?

Udeeshan: Correct, which is the main thing that we have to look at, it is a capital problem. Because the banks won’t have too much of a liquidity impact by postponing the payments because banks always have 20% of the deposits in liquid instruments. So that amount you can afford to extend the maturity on.

Banks have provided 35% on the carrying value of sovereign bonds, but the price of the sovereign bond is now trading at about 40 cents to the dollar. So it’s indicating a 60% loss. This means any banks that bought bonds at 100 might have to provide more on those.

On the other hand on the NPL front, there is still more bad news to come because more loans will have to be rescheduled. So that impact or hit is still not fully factored in.

IMF has indicated recapitalization aid of the banking sector to be about 6% of GDP. Which is even larger than the current capital of what the listed commercial banks have at the moment.

Of course, this is a weird number, $4.5 billion. Rs1.3 trillion is the commercial banks’ total capital. We haven’t seen a scenario where multilateral lenders give so much money for the recapitalization of banks in other countries. We have seen in other countries a billion-dollar, or one-and-a-half billion dollar problem but not on a scale of four and a half billion dollars.

Another thing is banks treat SOE (state-owned enterprise) exposure as zero risk. It is no more a zero-risk product. There will have to be writedowns on SOE exposures as well.

Banks are under a lot of stress. And I think the IMF is also aware of this. If you do a domestic debt restructure, you are really putting the domestic financial system under stress.

It is usually possible to access markets within two years. But as per the imf programme projections, it will take us four years. Further, why it is important that we do well and why we are in the programme, is because it affects the risk spreads when we go to the international capital market. If we are not meeting programme targets that will affect the risk spreads usually within the first one or two years of the programme.

So this impact of potentially four and a half billion dollars of capital shortfall in the banks is without domestic debt restructuring. What are the likely scenarios that Sri Lanka can take to address this challenge?

Vajirapanie: When I saw in the IMF reporting that banks require the equivalent of 6% of the GDP for recapitalizing, I was also alarmed. But when we inquired from some of the sovereign debt analysts, they said, given that the banking sector’s exposure to external debt is high, it is the norm to do a stress test and asset quality review and see what the impact is under a worst-case scenario.

The first thing is the liquidity support fund coming from the IFIs (international financial institutions) and may include the IMF as well.

The second angle is for the Central Bank to offer some regulatory forbearance, which has already happened. The fair value losses for capital adequacy calculation can now be taken on a pro-rata basis, this regulation came in June 2022.

There could be more lenient accounting standards too. For example, now a majority of the bonds are held to maturity, at amortized cost. Only, when selling or derecognizing the asset will it be recorded at a fair value. Now when a debt exchange is happening, you are recording the bonds at fair value, then you have to incur a loss, a day one loss.

In Lebanon in 2020, for the banking sector, they did not take the day one loss into the books, there was an accounting treatment. And even if you look at 1997, during the Asian financial crisis, they also introduced non-standard accounting practices and did not take day-one losses to the books.

Now let’s say you have to take it to the books, again the Central Bank could intervene and say, you can take it on a phased-out basis.

But is this enough to deal with the capital shortfall that Sri Lanka is likely to see in banks?

Sanjeewa: Just to clarify, once and for all, I think we are expecting a majority of this, whatever the number, will go to government banks. Based on the capital requirements that banks have indicated to us, they may not require more than Rs120 billion and that’s just 8% of what the IMF forecast. So Rs120 billion versus $4.5 billion.

For private banks that may be digestible. Then you have to see why government banks need so much capital. Their exposure to SOEs is a large part of the challenge.

In terms of recapitalizing banks, what are the success cases out there?

Udeeshan: There are several where international financial institutions come in to help the banks meet minimum capital requirements.

Does that mean they buy bank shares, or do they provide liquidity support or what?

Udeeshan: It can work either way. It can be capitalised, and sometimes the money can come to the government and the government will infuse it as capital.

So that’s a dilution of existing shareholders immediately?

Udeeshan: Sometimes the international funding agencies can also come and take direct stakes and they can have a programme where they can exit in a couple of years or five years’ time. They usually have an exit plan.

In the case of Ghana, which happened recently, there was regulatory forbearance. For example, if the interest rates are running at 20%, the discount rate they use can be 12%. As a result, banks don’t see the hit in terms of market value being reflected. Second, they also had a liquidity support fund coming in from some of the international financing agencies.

Vajirapanie: Do you think now, since the majority of the problem is with the two state banks, they might even look at the listing route?

Sanjeewa: In the budget, they indicated that either the staff or the depositors can come in with capital or else they’ll find an investor. That’s one path and the other path is they also allowed the usage of the capital conservation buffer during the second quarter of 2022.

Should the government be concerned about listing state banks because banks are trading at a fraction of their net asset values now? So it’s unlikely state banks will trade at book value either?

Udeeshan: One-time book value on a clean book is possible.

Final thoughts everyone?

Sanjeewa: We remain positive about the restructure, about the adjustments that Sri Lanka has already adjusted their fiscal position, inflation is falling and monetary adjustments have been done already.

We remain positive that there will be significantly low inflation by the end of the year. Although a soft monetary policy may not be adopted, the Central Bank may have a discussion with IMF about loosening.

Before that, we have to conclude the domestic debt restructuring, you will see those premiums getting adjusted in the market.

Many banks got stuck investing in low-yield bonds, buying at 7% to 8% which they have now categorised as held to maturity on their balance sheets. One thing to do is offer say a $100 face value bond with an 11-12% coupon or yield. This will be a voluntary offer. As a bank you will have bonds which you bought at 7, 10, 15, 20%, and likewise. You will exchange the bonds which are below that particular interest rate range.

Udeeshan: Overall we are happy with the outcome from the IMF because it was somewhat lenient compared to what we were expecting and what we have seen in other countries. The domestic populace has already taken multiple hits in terms of taxes and the currency. So they also understand that you cannot push too much from that angle.

All these numbers don’t factor in the SOE sales and privatization proceeds. If they are able to do 3 billion dollars of sales, that is equal to doing a 10% haircut on T-bills on a total basis.

The initial set of SOE sales that the government has proposed could be more than 2 to 2.5 billion dollars and they are targeting 6 billion dollars in total. What the IMF wants is for us to hit that number, how we do it is up to us. So you can cover some part of it through SOE sales as well.

Vajirapanie: Overall the government together with the governor, have done a commendable job. Nobody thought that we would ink an IMF deal by March.

The next step is a successful debt exchange.

If you look at countries that have been extremely successful in debt exchanges, there’s Jamaica and even Uruguay in 2003, with 99% participation in a voluntary debt exchange.

On the external debt front, the key is to convert soft assurances from official creditors to actual debt relief as soon as possible.