Sri Lanka’s government should sell long-duration floating-rate bonds, even perpetual bonds in the style of UK Consols, to better manage its debt and utilize domestic capital.
When a country with monetary instability and a flawed central bank faces an external debt crisis, the International Monetary Fund typically advises issuing longer-term debt or restructuring existing debt to reduce the need for frequent refinancing. After Sri Lanka’s first default, the maturities of pension fund debt were extended, and the politicians managing the crisis faced significant political backlash.
During a crisis, most investors prefer short-term Treasury bills over long-term bonds, leading to an increased gross financing need (GFN). This, in turn, results in a quick rise in interest costs if short-term debt dominates. Reducing GFN and restructuring debt are short-term measures that address the effects of monetary instability and interventionist central banking.
Two Birds, One Stone
One way to achieve both objectives is by issuing floating-rate notes. In the US, inflation-protected bonds are available, while in the UK, perpetual government debts known as Consols have existed since the 1750s.
These were fixed-rate instruments at a time when macroeconomic policy and persistent inflation were not yet concerns. Sri Lanka should consider issuing floating-rate bonds—either perpetual or long-term (20-30 years). Given the country’s monetary instability, long-term interest rates, which reflect multiple risks including credit risk, could approach double digits.
While initial demand may be low, some banks may be willing to use such instruments. The sooner Sri Lanka incorporates them into its financial system, the better. If the central bank triggers another crisis, these bonds will make banks safer. If monetary stability is maintained, either voluntarily or through parliamentary oversight, government borrowing costs will decline.
Dollar Consols
Sri Lanka could also consider issuing long-term dollar bonds for banks, tied to US Treasuries. Currently, offshore banking units of Sri Lankan banks hold about $1.9 billion in reserves abroad.
Keeping some reserves offshore mitigates risks from the domestic economy. The central bank’s inflationary open market operations often cause monetary crises, and holding foreign reserves helps reduce the current account deficit—a key concern of Sri Lanka’s mercantilists.
However, while exporting capital and building foreign reserves have their benefits, there are limits. Sri Lanka’s exporters and government could also make use of these funds. Instead of expecting banks to buy such instruments through simple advertisement, the debt management office should engage with banks to assess their interest. Like a syndicated loan, the issuance should involve proper lead managers and co-managers, with appropriate fees.
The proceeds from these instruments could be used to settle outstanding sovereign bonds upon maturity or to repurchase and retire short-term debt.
Illiquid Bonds
Countries like Sri Lanka should avoid selling sovereign bonds that lack liquidity. While the rupee bond market has deepened, some bonds remain thinly traded. In the past, market participants suggested consolidating bond issues to improve liquidity.
If liquidity is a concern in the domestic market, it is an even bigger problem for sovereign bonds. Only two or three market makers typically provide bid quotes for these instruments, and some bonds receive no quotes at all.
The space created by selling long-term rupee bonds could be used to convert some of the central bank’s bond holdings into treasuries, which could then be sold to maintain a steady deflationary policy.
Sri Lanka aims to regain market access in a few years, making bond rollovers easier. However, if the central bank initiates another crisis by cutting rates and printing money to maintain its 5% inflation target, the resulting reserve losses and currency depreciation could cause bond yields to spike and undermine market access.
Without a deep and liquid bond market like those of the UK or US, relying on billion-dollar bullet repayment bonds is risky. Instead, Sri Lanka should prioritize amortizing syndicated loans.
It was Loans, Not Bonds
Once aggressive open market operations begin, central banks in countries like Sri Lanka find themselves in perpetual crises. Historical evidence shows that Latin American debt crises were triggered by excessive reliance on commercial debt, regardless of revenue, debt levels, or annual deficits.
A useful lesson comes from Ecuador, a dollarized country with low public debt and low financing needs. Despite these advantages, excessive borrowing—particularly from China—eventually led to economic distress.
If Sri Lanka successfully reins in its central bank’s inflationary tendencies, it could become an exporter of capital. The country already has a high savings rate and conservative banking practices, which could support such a transition.
Running Good Budgets
There are only two ways to permanently reduce debt: either cut overall spending or increase revenues sustainably. The parliamentary cap on primary expenditure at 13% of GDP is a step in the right direction.
However, effective budgeting requires controlling the central bank’s ability to depreciate the currency and drive inflation beyond 5%. When the central bank prints money to cut rates, inflation surges, wages and expenses rise, and fiscal planning becomes impossible.
This was evident during J.R. Jayewardene’s economic reforms, which included some of the most drastic subsidy cuts in Sri Lankan history. Despite efforts to transition to a more open economy and attract foreign investment, the absence of a stable monetary anchor after the IMF’s Second Amendment prevented Sri Lanka from achieving the same level of success as East Asian economies.
Most high-performing East Asian nations maintained monetary stability. Hong Kong consistently ensured it, except during the late 1970s, which led to the establishment of a currency board. Taiwan gained monetary stability in 1960, and Singapore had it post-World War II.
Monetary stability is critical for sound fiscal policy. Today, Sri Lanka faces constant demands for ad hoc salary hikes, but under British rule, wage increases were predictable and legislated.
The US fiscal situation offers a similar narrative. Historically, the country only ran deficits during major wars. However, the introduction of activist monetary policies in the 1960s made sustained budget surpluses difficult. After the collapse of the Bretton Woods system, surpluses became nearly impossible, as gold prices soared from $35 per ounce to $800 by 1980.
It was only when Paul Volcker controlled inflation that gold prices fell to $284 during the late 1990s, and the US briefly ran surpluses in 2000-01. However, subsequent monetary expansion led to asset bubbles, quantitative easing, and rising debt levels.
Sri Lanka also lost its ability to control budgets in the 1980s. It now risks falling into the same cycle as Argentina, where excessive reliance on commercial bonds leads to recurring debt crises. While some economists, including Brady Plan advocates, believed shifting from loans to bonds would resolve Latin American crises, the real issue was excessive monetary intervention and open market operations.
If Sri Lanka does not reform its monetary policies and central bank practices, it will remain trapped in recurring crises. High volumes of commercial debt will eventually trigger another default, regardless of government revenue or deficit levels. However, if Sri Lanka enforces fiscal discipline and curbs central bank intervention, it could transition towards monetary stability and capital export, avoiding the pitfalls faced by other crisis-prone nations.