Ecuador’s been there, so has Argentina, Pakistan from 1999 to 2001, and Russia in 1997. All these nations have had to restructure their commercial sovereign debt. It’s now evident, that Sri Lanka too will have to negotiate with its creditors to restructure its commercial loans.

The restructuring will help Sri Lanka overcome the liquidity crisis it faces, which has made it difficult for it to repay the foreign currency debt. However, Sri Lanka will also have to make changes to its economic model to emerge from the present crisis. The economic crisis has impacted businesses and ordinary people. Changes to the economic model will impact everybody.

During an interview with Chayu Damsinghe, the Product Head at research firm Frontier we discussed the impact that commercial debt restructure will have on businesses and asset markets. Excerpts of that interview follow.

Is Sri Lanka’s sovereign debt sustainable?

It’s not sustainable. The debt has been a long term problem for Sri Lanka and now it’s come to the fore. We’ll have to take steps to restructure the debt soon.

Should Sri Lanka decide to preemptively restructure or begin negotiations with creditors, what happens to its credit rating?

Ideally, we should commence restructuring negotiations ahead of a default. Before we run out of money we should tell our creditors that we are about to run out of money and won’t be able to repay our debt sustainably and that we should figure out how to restructure the debt.

If we do that for the commercial debt our credit rating will be classified as ‘selective’ or ‘restricted default’. Some credit rating agencies call it a selective default while others refer to it as a restricted default; meaning you choose to default on some of the obligations or a specific type of debt, but not necessarily all the outstanding debt.

Sri Lanka has now run out of foreign exchange. Without bridging financing it’s also possible we will fall to a default or D rating. But what usually happens is that countries get bridging finance.

Once the debt is restructured a country’s credit rating may get upgraded. Some countries have seen their ratings rise to B-levels; not just one notch up but to a relatively high level.

Who’s going to give us bridging finance?

What happens is that international agencies like the IMF, the World Bank, and in Sri Lanka’s case, the ADB are likely to either finance or reschedule loans owed to them which releases resources. That can serve as bridging finance.

Often bilateral partners too come to the aid of the country recognizing that it’s taking steps to correct the situation. This aid, or bridging finance, can help avert the worst humanitarian impacts of a debt crisis.

In the event Sri Lanka does go into what is termed selective default, does that mean we continue to pay interest on our sovereign bonds or do we enforce a moratorium on those payments?

We would first have to announce that we are suspending bond repayments, both principal and interest. The other thing that can happen is that we miss a payment, and the credit rating will fall to default. It’s better to work with the creditors ahead of time rather than default.

This applies to sovereign bonds. However, we can continue to service other debt, like development bonds (foreign currency bonds issued under Sri Lankan law), and bilateral debt payments.

If Sri Lanka resists engaging with creditors, as it has so far, what are the likely consequences?

That would result in a far worse outcome. The eventual adjustments the country has to make will be harder. There is a risk this will happen. We hope the more likely scenario is we do something ahead of time and not wait until we run out of money.

Let’s talk about that first scenario, that of Sri Lanka approaching creditors soon to discuss potential terms of restructuring. What’s this likely to mean for the economy? What’s been the experience of countries that have gone through something similar?

Restructuring itself will end up being positive for the economy because the money that was going to pay creditors can now be used for other purposes. The problem is that restructuring is required because the country is in debt distress.

In most countries, at the time of debt restructuring, you have to also be making other structural adjustments, which end up being quite painful.

For example, Mongolia in 2016 restructured its debt early with minimal economic impact. Then there is Argentina and Pakistan, which restructured their debt around the same time but had left the process fairly late. In these places, there were increased interest rates, steep currency depreciation, and high inflation.

The experience that most countries have had is a year-long or maybe a year and a half long, weak economy. Several economic variables will deteriorate and that deterioration is often sharp in the short term, that is in the one to three-month period and will stabilize after that

It looks like Sri Lanka is similar to that second group of countries that have delayed restructuring. What does that mean, what will that translate into in the economy here?

The experience that most countries have had is a year-long or maybe a year and a half long, weak economy. Several economic variables will deteriorate and that deterioration is often sharp in the short term, that is in the one to three-month period and will stabilize after that.

The extent of this economic impact depends on several individual factors, ranging from the political will to take that action, to how the populace responds.

What do you think the worst can be for Sri Lanka? Can you quantify this?

In countries like Lebanon, the exchange rate is controlled, similar to Sri Lanka. But the unofficial exchange rate is something like 24,000% depreciated compared to the official rate. The scale is very different to Sri Lanka. We are not talking anywhere near that.

For Sri Lanka, we think the worst possible case will be akin to the Asian financial crisis, which was a private debt default rather than a sovereign default. They had an immediate depreciation, in some places as much as 500%. So that’s the absolute worst case. There is a low probability of that situation here, we think.

What would normally happen is that following restructuring the creditors will want a credible exchange rate, one that is market-determined.

What does all this mean for asset markets, like stocks, private equity, fixed income, and real estate? What has been the experience of countries that have gone through a restructuring?

One of the factors to impact asset prices is how good a hedge it is against the local economy’s weakness, and how insulated that asset is compared to the economy.

The general sense is, that as the economy weakens, asset markets across the board generally weaken. However, the impacts are very individual. Fixed income markets can do better as interest rates rise. There can be pockets of opportunities, but very individualized, and very dependent on the situation in each country.

The biggest challenge will be the poor sentiment about how it was handled. If you’re restructuring ahead of time, that’s an acknowledgment of our past mistakes, and that you are taking steps to deal with those mistakes

How do you quantify what a bad performance is in an asset market?

In Ecuador, equity markets fell 10% to 15%. In Indonesia, they fell closer to 90%. So it’s a very wide range.

Real estate is an asset class that has done well in many countries. I think in Lebanon, real estate returns are ahead of inflation. It depends more on the particular real estate asset, what interest rates are, and how all this is forecast to be impacted by economic conditions. But the general sense is that impacts are specific to each asset.

Let’s look at the second scenario of Sri Lanka stumbling into a messy default. What can be expected in this case?

The biggest challenge will be the poor sentiment about how it was handled. If you’re restructuring ahead of time, that’s an acknowledgement of our past mistakes, and that you are taking steps to deal with those mistakes.

Compared to when you run out of money, you’ve lost control of the whole situation and the narrative. In most countries, we’ve seen the reason for the delay in restructuring is due to these involving politically difficult decisions.

Whatever decision you make you’re going to take a political hit. So that’s often what leads to this inaction until the very end.

 So if Sri Lanka defaults without warning, is that likely to be reflected differently in asset markets like equity, fixed income and real estate?

So those are the upper ends of the impacts I talked about. In Indonesia, stocks fell by 90%. That level of volatility would be higher in a messy default compared to a pre-emptive one.

The more you delay, the greater the negative impact. In Indonesia’s case, for example, it took two years for their leaders to act. That action also came after the overthrow of a government. Lebanon hasn’t been able to take any action for over two years now. As a result, the impacts of the crisis include a hyperinflationary spiral downwards.

Ecuador has been one of the best-case scenarios. It commenced negotiations ahead of time and has taken action needed so that it can re-enter international markets sooner.

Ecuador’s economy is a dollarized one. Did that help establish credibility with creditors?

Yes, there is no depreciation risk in the Ecuadorian economy. But their debt restructuring process was considered to have been managed well. They spoke to the right people got the right people involved, and got rid of people who were confusing the picture.

In Ecuador’s case, they have imposed a haircut on outstanding capital on the International Sovereign Bonds and they’ve delayed the payments or reprofiled some of the debt. So capital and interest payments are pushed back by several years. Given Sri Lanka’s current circumstances, do you think something similar can be done here?

You might have heard this argument that Sri Lanka has a solvency crisis and not just a liquidity crisis. We’ve had this issue of spending more than we can afford for several decades, and that’s led to insolvency. But we also do have a liquidity crisis in the short term. So you have both these problems.

The debt restructuring will address the liquidity part of the problem. For example, in 2022 Sri Lanka has to repay $2 billion in ISB’s and that can be pushed back after negotiations. That alone is not enough though. Because the structural issues also need to be addressed at the same time.

The haircut Ecuador requested is one of the lowest we’ve seen, roughly at the 10% level. Sri Lanka may have to request creditors to take a haircut in the range of 30-40%.

A debt restructuring can take anywhere from three to 12 months to negotiate.

From the point of view of an investor in Sri Lakan bonds, reprofiling the debt is quite positive for them. They’d rather Sri Lanka have a credible plan for payback and will give them the necessary time for that plan to work. But it will be a tough negotiation nonetheless. Sri Lanka’s one advantage is that it has never defaulted on its debt before. We also don’t have a history of high inflation and high depreciation like, for example, in Argentina.

Plenty of companies will go under. Others that survive may sustain heavy losses and heavy impairments. Those that emerge, generally come out of the situation much stronger. So it’s very much about hunkering down and figuring out how you can survive

Let’s talk about how a debt restructuring will impact companies. If we start with the Sri Lankan banks; many of them have international sovereign bonds. They also hold, what is called Sri Lanka Development Bonds (SLDBs), which are issued under Sri Lankan law, but in foreign currency. In the event there is a 40% haircut on external commercial debt, what’s the impact on their balance sheets likely to be?

able, we think most banks have purchased their sovereign bonds at a steep discount. So the haircut might not be a haircut for them. It all depends on the price they purchased these bonds at? But it’s not likely to be a 30% hit on the banks.

The development bonds (SLDBs) we think are unlikely to feature in the restructuring because they are held entirely by local parties. Restructuring those kinds of debt adds a lot of pressure on the local banking system and causes unnecessary problems while a country is trying to recover from a situation.

Instead, these will most likely be rolled over, essentially bridging these while the restructuring happens on the international commercial debt, as well as on bilateral debt, which gets rescheduled.

Is a messy default, likely to cause a banking crisis?

It’s more likely during a messy default than otherwise. But a banking crisis for Sri Lanka is unlikely unless we have hyperinflation and that’s because Sri Lankan banks have good capital buffers. With hyperinflation, the value of those capital buffers, which are in rupees, will be quickly eroded.

Banks can sell these bonds in the secondary market, at least those on the short end of the curve, which for most countries tend to have smaller haircuts.

How should a leader of a company approach the potential of commercial debt restructuring? Strategically, what actions should they preemptively be taking now?

The first step is to talk to as many people as possible who know about the situation and try to understand whether your business will survive. Under a base case scenario, the impact might not be too bad for companies. Some will see profits fall.

But every company must protect itself from the worst case. What’s a realistic worst case? Companies must talk to people and figure that out. There are many countries, where private commercial foreign currency debt has been issued during a crisis.

Plenty of companies will go under. Others that survive may sustain heavy losses and heavy impairments. Those that emerge, generally come out of the situation much stronger. So it’s very much about hunkering down and figuring out how you can survive.

It’s very much to do with cost-cutting, reducing leverage and all those other common sense things to do during a crisis.

But after that, we expect the long term trajectory for Sri Lanka will be positive. Due to structural reforms, coming out of this crisis, Sri Lanka may be on a stronger footing than when we entered this

What will be the impact on small to medium-sized businesses during debt restructuring and its aftermath?

Depends a lot on the leverage of individual companies. If they have floating rate loans and interest rates shoot up, that’s going to affect them. And there’s wage increase pressure that could affect them.

When the IMF looks at the situation, taxation and policies will target larger companies that are better able to bear this and they will try as much as possible to recommend that smaller firms be shielded. So there’s no real reason for us to imagine it would be any different for Sri Lanka.

Regardless 2022 will be a difficult year for the country. But the experience of other countries suggests that countries that restructure their debt come out of it far stronger than when they went in.

If you take Indonesia, their GDP per capita halved in one year.

It was a terrible year for them. But today, Indonesia is widely considered a better economy than it was in the 1990s. So we do think that even for Sri Lanka it might be a tough year, we’re not expecting a halving of our GDP or even necessarily a contraction. But a tough year, nonetheless.

But after that, we expect the long term trajectory for Sri Lanka will be positive. Due to structural reforms, coming out of this crisis, Sri Lanka may be on a stronger footing than when we entered this.