What happens if a future government undermines the IMF programme, overturns the painful measures and reforms, or scuttles the debt restructuring agreements (currently in their final stages)?

“It is unlikely, but if that happens, we give Sri Lanka three months to hit rock bottom again,” says Ranjan Ranatunga, Assistant Vice President of Research at First Capital Holdings. “Absolutely! If a new government experiments with alternative economic models without pursuing the necessary reforms, the food and medicine shortages, gas and petrol queues, and power outages will start all over again just like it did in 2022,” adds Dimantha Mathew, Chief Research and Strategy Officer at the same investment house.

Why three months? “Because our current external reserves can support only three months of imports,” Ranjan explains with a matter-of-fact shrug.

Despite being mildly satisfied with the progress on debt restructuring and the IMF programme, Mathew and Ranatunga acknowledge that many critical reforms remain unfulfilled. Worse, delays in implementing reforms or deviation from the current path could plunge Sri Lanka into chaos. The uncertainty about the election outcomes is palpable. Mathew warns, “We can’t afford experimentation, but we can ensure to establish fiscal discipline and restructure state-owned enterprises to gradually bring down debt to sustainable levels, improve governance and transparency, adopt anti-corruption frameworks and strengthen social safety nets as Sri Lanka outlined in its commitments to the IMF”.

In June 2024, Sri Lanka announced that it reached an agreement with an ad-hoc committee of private investors holding 50% of the outstanding ISBs (International Sovereign Bonds) issued by Sri Lanka. That was close on the heels of bilateral creditors agreeing to restructure nearly $10 billion of debt by extending the maturities. The proposed ISB restructuring of bonds worth $12.6 billion is unlike the bilateral treatment because it is more than a maturity extension.

ISB investors have agreed to a 28% haircut or reduction of the principal owed in the form of $9,036 billion in eight macro-linked bonds and two plain vanilla bonds with instalments spread from 2029 to 2038, with coupon rates spread from 3.5% to 9.75% (see Graph 1). The agreement also includes an 11% reduction on past interest payments worth $1.9 billion. The interest payments, now down to $1.67 billion, are converted into five bonds maturing between 2024 and 2028 with a coupon rate of 4%.

Briefly, the macro-linked bonds would enable Sri Lanka to adjust its repayments according to economic performance. According to First Capital analysis, if GDP remains at the IMF baseline annual average of $87 billion between 2025-2027, Sri Lanka’s annual ISB maturity payments would total $15.9 billion by 2038. If GDP averages $100 billion, ISB repayments would increase to $19.6 billion, and if GDP falls to $84.7 billion, the repayments would decline to $13.7 billion (Please see Graph 2).

According to Mathew and Ranatunga, the bondholder groups and Sri Lanka have reached a middle ground. This agreement also involves rescheduling the loans to a much longer term with a lower interest rate. Notably, for the first time globally, this includes a macro-linked bond.

If the economy improves beyond the IMF benchmark, the country’s ability to pay improves, potentially reducing the haircut to a lower level. Conversely, if the economy contracts due to inflation or currency depreciation, the haircut could increase to as much as 40%. “This approach aims to address debt sustainability across various scenarios, setting a possible precedent for future debt restructuring as a win-win solution,” Mathew argues.

“However, there are significant risks to consider,” Ranatunga warns. The IMF programme runs from 2023 to 2027, meaning that debt is being pushed beyond this period, raising concerns about the financial situation after 2027 should fiscal indiscipline and money printing resume, which exacerbate debt sustainability, the macro-linked bonds notwithstanding.

The gross financing need of Sri Lanka is around 34% of GDP and could decrease under the IMF programme through debt rescheduling and interest rate reductions. Gross Financing Need (GFN) refers to the total amount of funding a government or organization needs to cover its expenses and debt obligations within a specific period, usually a fiscal year. It includes all expenditures, debt servicing and repayments, and budget deficit financing. Essentially, GFN represents the money required to meet all financial commitments, ensuring that the entity can operate and service its debt without interruption.

GFN is often expressed as a percentage of GDP, providing a sense of the scale of financing needs relative to the size of the economy. This metric helps assess the debt sustainability of a country and its ability to finance its obligations without causing economic instability, like when Sri Lanka defaulted in 2022 and shut the country to international financing for essentials like food, medicine and fuel.

“The IMF calculates gross financing needs as a percentage of GDP, so achieving economic growth could ease the financial pressure. If Sri Lanka can achieve around 4% GDP growth, the gross financing needs ratio could decrease due to an improved economic base,” Ranatunga says.

However, Sri Lanka needs to do a lot more. Significant reforms are needed, particularly in implementing the proposed restructuring of state-owned enterprises. Improving governance and efficiency and possibly incorporating public-private partnership arrangements could help prevent future financial crises, but that is only the iceberg above the waterline.

Now that Sri Lanka has reached preliminary agreements with bilateral creditors and ISB investors, the IMF has to ascertain if they place Sri Lanka on a debt sustainability trajectory. Only then can the agreements be finalized. The concluded domestic debt restructuring and the two restructuring plans for bilateral and international private credit could bring down Sri Lanka’s debt closer to 100% of GDP from a peak of 128%.

However, bringing debt down to 95% of GDP over the next eight years and 85% beyond that requires following through with the economic reforms detailed in the IMF programme, from improvements to fiscal management, increasing income tax compliance, improving governance and irradicating corruption, restructuring loss-making state institutions, Customs and Inland Revenue Department, and targeted welfare for vulnerable groups. The IMF programme (of our own devising) has it all.

A pandit on Al Jazeera recently likened Sri Lanka’s frequent IMF bailouts to persistently visiting a quack doctor. “If the patient is not getting well, then there is something wrong with the doctor,” he said glibly, and he has a rich trove of history and IMF-bashing to back him up. In reality, though, this is what happens. Sri Lanka slips into another currency crisis of its own making and then approaches the IMF for relief. The IMF and Sri Lankan officials assess the situation, and Sri Lanka submits an action plan to fix the problem, which the IMF then reviews to gauge its efficacy towards improving the fiscal and balance of payments situation. The so-called IMF conditions are in reality self-imposed conditions of the country’s rulers.

Officials then scapegoat the IMF for the painful reforms thrust upon the poor citizens (see story below). IMF officials bear this in their stride; it comes with the territory, and there is small comfort when reforms work. In Sri Lanka’s case, we visited the IMF 17 times, self-prescribed our medicines to impress the IMF for money to rebuild reserves and meet external payments, and then the first chance we got, we abandoned reforms. That is how we ended up where we are today, nurturing unsustainable debt, a money-printing Central Bank, low tax compliance, a bloated and unproductive public service, loss-making state enterprises, and subsidies for all.

The utility of the IMF, apart from the immediate balance of payments relief, is in its presence, sending positive signals to investors and creditors, including suppliers of imported essentials and capital goods and production inputs to run the domestic economy.

Positive Trend

Mathew and Ranatunga are clear about the ever-present threat: If we deviate from the IMF programme and revert to previous policies, we risk falling back into economic turmoil. “However, there are positive developments in Sri Lanka, such as the passage of the Central Bank Act, which grants more independence to the Central Bank and limits money printing. This Act and the IMF proposal provide automatic checks and balances. For example, if government spending gets out of control, it will impact interest rates and the currency, helping maintain stability,” Mathew points out.

“However, if we resort to excessive money printing, we would breach the conditions of the IMF programme, losing external support and creating numerous problems,” Ranatunga adds. “The new Central Bank Act also mandates that inflation be kept at a target of 5%. If inflation exceeds this target, the Central Bank must explain the situation to Parliament. This accountability helps prevent unchecked spending and inflation, ensuring better economic management”.

The duo are satisfied with how long it took to engage with international bondholders and reach a deal. “We did it within just two years, which is relatively swift compared to other countries, often taking two to two-and-a-half years. A key difference in Sri Lanka’s approach is the IMF’s involvement in the negotiation process. While not directly negotiating, the IMF reviews and checks proposals to ensure they align with the overall conditions, speeding up the process and ensuring the deals are sustainable,” Mathew notes.

The domestic debt restructuring concluded earlier primarily affected superannuation funds like the EPF, leaving banks, private investors, and corporates largely untouched. This approach was crucial, as private investors and corporates were already burdened with high inflation and increased taxation. “Impacting them further could have delayed economic recovery significantly,” Mathew notes.

The banks, holding a large portion of government securities, were a key reason for not extending the restructuring beyond superannuation funds. Banks have been gradually recovering after facing loan moratoriums during the Covid-19 pandemic and rising non-performing loans over the past four years.

“Despite a 28% haircut on International Sovereign Bonds (ISBs), banks had made strong provisions, cushioning potential losses. Some banks, such as Commercial Bank and DFCC, have been reinforcing their capital buffers through rights issues and asset sales, ensuring stability and compliance with capital adequacy thresholds,” Mathew says.

Ranatunga says the financial system remains stable and liquid, which is vital for supporting credit growth and business activity. With banks now in a better position, there is an uptick in loan activity, which is crucial for economic growth, traditionally driven by consumer loans. Recent data shows a positive trend in credit growth, with private sector credit expected to grow by 7.5% this year and potentially reach 10% next year as the economy picks up.

The Central Bank’s new mandate to control inflation and avoid excessive money printing supports financial stability. “As inflation and interest rates stabilize, we can expect gradual GDP growth, potentially reaching 4%. Combined with favourable conditions for equities, this outlook presents a good opportunity for investment, especially as interest rates are lower and alternative investment options are limited,” Ranatunga says.

The debt restructuring is like making it to the ER on time. The recovery has just started. For one thing, Sri Lanka’s credit rating will likely remain in the triple-C range, making it difficult to access international markets. Besides, the high interest rates and global economic conditions make borrowing expensive, Mathew argues. “The target is to reduce debt to 95% of GDP by 2032, but this still leaves Sri Lanka in a challenging position compared to countries in the B range, where debt is around 80% of GDP”.

The IMF agreement includes a clause preventing Sri Lanka from accessing international markets until 2027, protecting the country from taking on more debt. Post-2027, the situation remains uncertain.

“Without the IMF programme, Sri Lanka would struggle to access international markets due to concerns about debt sustainability. The country needs to focus on governance reforms and economic diversification, attracting foreign direct investment (FDI), and expanding into high-growth areas like electronics to reduce reliance on imports and balance payments,” Ranatunga says. This is the transformation or system change Sri Lanka needs. 

 

IMF on Sri Lanka’s Debt Restructuring, The Poor and Corruption

The IMF continues to push for relief to vulnerable groups and measures to eradicate corruption

In August 2024, IMF Senior Mission Chief Peter Breuer said its assessment of the ISB restructuring agreements had been shared with Sri Lanka, indicating that all that was necessary now was a quick resolution. He also noted that Colombo had made commendable progress with putting debt on a path towards sustainability.

“The execution of the domestic debt restructuring and finalizing the agreements with the Official Creditor Committee and China EXIM Bank are major milestones,” he said in an August 2nd statement. IMF staff assessed the Joint Working Framework announced after the second round of restricted discussions with the bondholder committee and have provided this assessment to the authorities and on their request, to the financial advisors of the bondholders.

“We encourage a swift resolution of the remaining steps to achieve debt sustainability and regain investor confidence. We will continue to support Sri Lanka’s ongoing debt restructuring efforts,” Breuer said.

He noted that the economic reform programme implemented by Sri Lanka is yielding commendable outcomes with the real GDP posting three consecutive quarters of expansion, and growth accelerating to 5.3% year-on-year in the first quarter of 2024. Inflation remains contained below the Central Bank of Sri Lanka’s 5% target and domestic borrowing rates have declined. Gross international reserves increased by $1.2 billion during the first half of 2024 and reached $5.6 billion. Fiscal revenue collections increased during the same period.

“Going forward, these improvements need to translate into better living conditions for all of Sri Lanka’s people,” Breuer said. “Protecting the poor and vulnerable through improved targeting and better cash transfer coverage remains critical,” he said.

“With Sri Lanka’s knife-edged recovery at a critical juncture, sustaining the reform momentum and ensuring timely implementation of all programme commitments are critical to cement the hard-won economic progress to date and put the economy on a firm footing. Maintaining macroeconomic stability and restoring debt sustainability requires further efforts to raise fiscal revenues.

The IMF mission said the 2025 Budget must incorporate appropriate revenue measures and continued spending restraint to achieve the medium-term primary balance objective of 2.3% of GDP, which is essential for restoring Sri Lanka’s debt sustainability.

Relaxing import restrictions on motor vehicles will boost revenue in 2025, and tax administration reforms, including a functioning VAT refund system for exporters by April 2025, can enhance compliance. Any measures that weaken the fiscal position must be balanced by high-quality compensating measures.

Avoiding new tax exemptions will reduce corruption and revenue leaks, ensuring a more predictable and transparent tax system. Maintaining energy prices at cost-recovery levels is crucial to prevent potential fiscal costs.

Parliament’s recent approval of the Public Financial Management Act and the Public Debt Management Act is a milestone for improving fiscal discipline and prudent debt management, enhancing transparency and accountability. Developing a holistic debt management strategy and establishing a well-structured Public Debt Management Office will help lower the government’s financing risks.

Inflation is well-contained, and monetary policy should remain prudent to anchor inflation expectations. Maintaining price stability also depends on safeguarding CBSL’s independence. Continued reserve accumulation and exchange rate flexibility are key priorities.

The National Anti-corruption Agenda, building on earlier governance action plans, is a welcome step. Breuer said. Steadfast implementation of governance reforms outlined in the Governance Diagnostic Report and prioritizing near-term commitments under the EFF programme are critical to addressing corruption risks and correcting past policy missteps. An enabling environment for governance reforms is key to bolstering public confidence and facilitating these efforts.