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Navigating Economic Challenges: Sri Lanka’s Bold Step Towards Debt Restructuring

Sri Lanka, a nation grappling with a severe economic crisis and unsustainable levels of debt, is taking decisive action to address its financial woes. In a significant move, the country will temporarily shut down its banks and financial sector for five days, commencing Thursday, 29th of June 2023 as it prepares for an unprecedented debate in Parliament on the government’s proposed domestic debt restructuring plan.

This development comes on the heels of Sri Lanka’s decision, one year ago, to suspend servicing its foreign debt in a bid to combat the devastating economic meltdown that has gripped the nation—the worst crisis it has faced since gaining independence. In response to this dire situation, the government sought assistance from the International Monetary Fund (IMF) and successfully secured a substantial financial package of nearly $3 billion. As part of the agreement, Sri Lanka committed to restructuring both its foreign and domestic debt, estimated at around $41 billion and $42 billion, respectively, as of March 2023.

Signs of potential improvement have emerged, as highlighted by the IMF in May, which cautiously noted the “tentative signs of improvement” in Sri Lanka’s economic landscape. However, the urgency to forge timely restructuring agreements with the country’s creditors was emphasized, particularly in anticipation of the IMF’s first review scheduled for September.

As Sri Lanka prepares to embark on this critical journey of debt restructuring, it is essential to examine the multifaceted challenges and opportunities that lie ahead. A balanced and comprehensive approach is necessary to navigate the complexities of this process and ensure the long-term stability and prosperity of the nation.

In this article, we delve into the compelling reasons behind Sri Lanka’s decision to pursue domestic debt restructuring, exploring its potential impact on the government’s solvency, macroeconomic stability, and the equitable sharing of costs. We also address the interconnectedness of fiscal solvency, inflation, and access to international markets. Additionally, we shed light on the complexities of restructuring rupee debt, the role of financial institutions, and the need for careful recapitalization to maintain the stability of Sri Lanka’s financial system.

Domestic Debt Restructuring

Debt restructuring is a pressing issue for Sri Lanka as it grapples with an ongoing economic crisis fueled by unsustainable levels of public debt. In order to address this challenge, it is imperative for the country to consider early domestic debt restructuring (DDR) by reprofiling the capital repayments. This approach holds several key benefits, including expediting the government’s path to solvency, laying the foundation for macroeconomic stability, reducing the likelihood of future sovereign debt restructuring, and promoting a fairer distribution of costs to overcome the economic crisis.

Public debt in Sri Lanka can be broadly categorized into three types: external debt, domestic debt, and debt owed by government-owned institutions and enterprises. Currently, Sri Lanka’s public debt to GDP ratio stands at approximately 121%, significantly exceeding the recommended ceiling of 80% set by the International Monetary Fund (IMF). Restructuring external debt alone provides limited relief as it constitutes only a portion of the total debt burden. Bondholders’ external debt accounts for 20% of GDP, while loans from multilateral and bilateral lenders represent 32%. 

These lenders are more likely to extend their loans’ maturity or provide other forms of financial assistance rather than reducing the outstanding loan amounts. However, even with a 50% principal cut on bond debt and a 25% cut on multilateral/bilateral loans, projections indicate that Sri Lanka’s debt-to-GDP ratio would still rise to 136% within the next decade. Conversely, restructuring domestic debt, in addition to external debt restructuring, and extending the maturity period by ten years would result in a debt-to-GDP ratio of only 101% over the same period. Therefore, restructuring domestic debt immediately presents a significant improvement in Sri Lanka’s debt sustainability.

Monetary policy alone cannot effectively reduce inflation in Sri Lanka as the continuous rollover of rupee-denominated debt requires more money for transactions. In other words, inflation is likely to rise if the stock of debt cannot be repaid through tax revenue. The relationship between fiscal solvency and inflation leaves the Central Bank with limited room to control inflation independently of the path of rupee debt. The Central Bank gains an additional complementary tool to manage inflation by restructuring rupee debt.

The sustainability of Sri Lanka’s debt also influences its access to international markets. Without a reasonable expectation that existing debt can be repaid through tax revenue, foreign investors are less likely to invest in government bonds, leading to higher borrowing costs. By restructuring the rupee debt, foreign investment and capital can be encouraged, subsequently reducing the government’s borrowing costs and strengthening the currency. This, in turn, helps alleviate the burden of external debt, further reducing the overall debt-to-GDP ratio.

Cost of DDR

However, implementing DDR in Sri Lanka poses challenges due to the significant holdings of rupee debt by financial institutions such as banks. The income generated by these institutions, approximately 36%, relies on coupon payments from government securities, which are then used to pay the interest on public deposits and savings. Therefore, it is not advisable to implement a reduction in coupons. To mitigate this, financial institutions may require additional capital following DDR. Temporary regulatory forbearance can delay the need and size of recapitalization until yields return to lower levels. A follow-up plan should outline a sustainable method for recapitalization, ensuring financial system stability while reducing government debt liabilities.

Sri Lanka currently faces a twin deficit consisting of a fiscal deficit and a current account deficit, primarily financed through domestic means. To restore macroeconomic stability and debt sustainability, the country needs comprehensive short- and medium-term strategies that shape investor expectations and guide the path of the yield curve. Implementing comprehensive and convincing policy plans will quickly lower yields and accelerate the achievement of debt sustainability.

However, this strategy poses a trade-off with inflation. On one hand, a significant stock of domestic debt necessitates monetary expansion to accommodate the growing transaction values. Also, curbing inflation requires restraining monetary growth and increasing policy rates, potentially driving up yields and rupee indebtedness when debt is rolled over at higher yields. To address this dilemma, restructuring of both the rupee and foreign debt is necessary. The projected path of yields and debt over the next three to five years will be crucial in achieving macroeconomic stability over a 10-year horizon.

It is important to note that while we assumed the budget deficit would be entirely financed through domestic debt issuance, in practice, it is likely to be a combination of domestic and foreign currency debt. For foreign investors and overall yields, what matters is the government’s overall indebtedness. Therefore, the results presented on the path of overall debt to GDP become more relevant when considering the issuance of external debt to finance future budget deficits.

In summary, Sri Lanka must address its excessive burden of both foreign and rupee-denominated debt while safeguarding its financial system. The proposed economically feasible approach of restructuring both domestic and external debt offers a pathway to restore macroeconomic and financial stability in Sri Lanka. By undertaking early DDR, Sri Lanka can expedite its journey toward solvency, establish a foundation for economic stability, reduce the need for future debt restructuring, and ensure a fairer sharing of costs to overcome the economic crisis.

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