Fitch Rating’s October 2024 response to the debt restructuring agreements announcements between Sri Lanka and its creditors was positive. However, it was also a sober reminder that debt will remain elevated even after the debt restructuring.

The rating agency referenced IMF forecasts, projecting that the gross general government debt-to-GDP ratio will decrease to around 103% by 2028, down from about 116% in 2022, following local and foreign-currency debt restructuring. Incidentally, Sri Lanka remains locked out of international capital markets until 2028.

The government revenue-to-GDP ratio remains low, but the impact of several revenue-raising measures introduced since May 2022 is starting to show, Fitch noted. Revenue collection in the first seven months of 2024 increased by approximately 43% year-over-year, significantly exceeding the nominal GDP growth rate of 9.5% in the first half of 2024. “Our baseline projections assume an increase in the revenue-to-GDP ratio from 11.4% in 2023 to 15.5% by 2026, reflecting the current measures. However, these projections may change if the new administration implements fiscal reforms. The IMF programme allows some flexibility for adjustments in fiscal policy,” Fitch noted in an October 2024 statement.

The statement said of the new president: his ability to implement policy changes could depend on the results of the parliamentary election on 14 November. The JVP and its allies held a limited number of seats in the outgoing parliament, but recent presidential election trends suggest significant shifts in the composition of the new chamber.

The broader economy continues on a recovery path. Real GDP grew by 5% year-over-year in the first half of 2024, following a 7.3% contraction during the same period in 2023. Fitch estimates the economy will grow by 3.9% in 2024, with an average growth of 3.6% over 2025-2026. External liquidity pressures have eased, with foreign exchange reserves reaching $6 billion in August 2024, up nearly 66% year-over-year. However, the pace will slow once Sri Lanka resumes external debt repayments.

“The Sri Lankan authorities’ confirmation of their commitment to the IMF programme and their intention to proceed with debt restructuring under the terms agreed with international sovereign bondholders in September mitigates risks to the debt process that could have arisen from the outcome of the presidential election on 21 September,” Fitch stated.

The rating agency was initially apprehensive about the new president in September. It believed it could heighten policy uncertainty and raised concerns that the new administration might challenge elements of the IMF programme, potentially delaying foreign-currency debt restructuring. However, the apprehensions no longer hold after the new administration moved quickly on the creditor agreements.

Fitch noted that the Ministry of Finance announced on 4 October that consultations with the IMF and Official Credit Committee (OCC) comprising bilateral lenders like Japan, India and others excluding China, had concluded successfully, meaning that any policy adjustments are unlikely to disrupt the IMF programme or the debt agreement reached under the previous administration.

The Ministry also confirmed that the consultation maintained adherence to the principle of equal treatment between official creditors and bondholders. “We consider this a positive development for the restructuring process,” Fitch commented. With the debt burden remaining high post-restructuring, the challenges for the new administration and the economy are far from over.

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According to an analysis by CT CLSA, on September 19, 2024, the Sri Lankan government announced that it had reached a preliminary agreement on restructuring its debt. This follows discussions from September 12 to 18, 2024, with members of the Steering Committee from the Ad Hoc Group of Bondholders, representing about 40% of international bonds, along with their advisors, White & Case LLP and Rothschild & Co. The government advisors were Clifford Chance LLP and Lazard.

CT CLSA analysis highlights that the Sri Lankan government has also engaged in year-long discussions with the Local Consortium of Sri Lanka (LCSL), which holds around 12% of the bonds. These talks involved the LCSL’s advisors, Baker McKenzie and Newstate Partners LLP. The main focus was to revise the debt treatment plan to meet the expectations of the IMF and Sri Lanka’s Official Creditor Committee (OCC), particularly ensuring fairness and alignment with the IMF’s programme for Sri Lanka.

The revised proposal based on a Joint Working Framework (JWF) established in June 2024, was shared with the Bondholders Group and the LCSL, resulting in preliminary agreements. The agreement with the Steering Committee includes specific clauses related to bond governance, loss recovery, and treating all creditors equally. Meanwhile, the deal with the LCSL introduces a “Local Option,” allowing bondholders the option to receive repayment in Sri Lankan Rupees up to 25% of the total bonds, prioritizing local holders.

CT CLSA notes that Sri Lanka has received informal confirmation from IMF staff that these agreements align with its IMF-supported programme, with formal approval expected soon. The government is also working with the OCC to ensure compliance with the Comparability of Treatment principle, allowing the restructuring process to proceed quickly.

Under the agreement with foreign ISB investors, bondholders will exchange their existing bonds for new macro-linked bonds, with a 27% reduction in the nominal value of the current bonds. The restructured bond package includes four macro-linked bonds and one plain vanilla bond, linked to Sri Lanka’s GDP performance. An -11% haircut will also be applied to past-due interest with a new bond as of March 2024. Additionally, the government must provide an upfront consent fee equivalent to 1.8% of the original principal amount, excluding past-due interest, totalling $225 million).

CT CLSA estimates that, under these agreements, Sri Lanka could immediately reduce its debt by about $3.2 billion. Under the macro-bonds mechanism, the debt reduction could be as much as $4.6 billion if Sri Lanka misses GDP growth targets. Conversely, if the economic recovery is better than expected, the reduction could be as low as $2 billion.

Under the baseline scenario, debt payments to International Sovereign Bond (ISB) holders during the IMF programme period could be reduced by as much as $9.5 billion, with extended bond maturities and lower interest rates, adjusted from 6.4% to 4.4%.

Additionally, CT CLSA highlights that bondholders have agreed to a 40.3% reduction in the present value of their bonds in the baseline scenario, using an 11% discount rate. In a more favourable scenario, this reduction would be around 33%. Coupon rates have also been adjusted downwards, with the highest scenario leading to a reduction of around 160 basis points compared to previous terms and 60 basis points for the second-best scenario.

Sri Lanka has also finalized a principle agreement with the China Development Bank (CDB) to restructure approximately $3.3 billion in debt.

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Sri Lanka is close to completing its debt restructuring under the IMF programme, aiming for debt sustainability. The overall efforts have obtained over $17.5 billion (40.4% of total external debt) of debt service relief during the IMF programme period: $2.4 billion from EXIM Bank of China, $2.9 billion from the OCC (Official Credit Committee, and $2.5 billion from the China Development Bank, and $9.5 billion from the ISB holders.

Debt restructuring is a critical step towards fixing the economy, which is much more challenging. One misstep too many from hereon, and Sri Lanka could be facing another default. After all, debt-to-GDP will remain over 100% even after the restructuring.

We remain with the problem that caused the excessive borrowing in the first place. Government revenue (Rs3.8 trillion estimate for 2024) is inadequate to service public sector wages and pensions (Rs1.1 trillion), subsidies and transfers (Rs1.2 trillion), and loan servicing (Rs2.6 trillion) while state-owned enterprises add the fiscal problems with Rs744.6 billion in losses in 2022 alone.