Sunday Times 2
Sri Lanka’s long road to economic stability through foreign debt restructuring
View(s):By Dr. Srilal Perera
Sri Lanka’s outstanding foreign debt of over US$50 billion has pushed the nation into an economic abyss. Every variable and statistic points to a perilous road ahead, to attain even a semblance of stability for economic recovery. There is very little to celebrate, although every little step taken in the right direction will be a lifeline. Sri Lanka’s economic recovery is now fundamentally based on the International Monetary Fund’s (IMF) Extended Fund Facility (EFF) agreement concluded under Article 4 of the Articles of the International Monitory Fund (IMF). It is the singular most important reprieve from an otherwise overwhelming economic collapse. Under this agreement, Sri Lanka will be extended close to US$3 billion of relief funds to address the immediate stress on almost every sector that the country finds itself, after declaring sovereign default on its foreign debt. Additionally, approximately US$6 billion of funding or credit lines from multilateral financial institutions such as the World Bank will be made available when the Government of Sri Lanka meets specific milestones based on the required conditions under the EFF.
The economic wounds in Sri Lanka were clearly self-inflicted over the years, pointing to serious mismanagement, lack of monetary and fiscal discipline, a bloated and inefficient public sector, refusal to implement remedial policies, indebtedness through non-performing loans, and rampant uncontrolled corruption. Recourse to the IMF was inevitable.
The IMF’s EFF for Sri Lanka is based on tranches being released with strict conditions being satisfied to ensure a return to fiscal and monetary stability; the first of which was released in March 2023, and the next to be released in September, 2023. There are five broad conditions that the Government of Sri Lanka has agreed to in order to trigger the release of the tranches. These five conditions or required reforms were succinctly expressed by Mr. Krishna Srinivasan, IMF’s Director of Asia and Pacific Department during his Press Briefing in May, 2023. They are: first, restoration of public debt sustainability; second, revenue-based fiscal consolidation, with strong safety nets to safeguard the most vulnerable; third, price stability under a flexible exchange rate system based on building reserves and containing inflation; fourth, adoption of policies to ensure financial sector stability; and fifth structural reforms to address public sector corruption. The Government seems to be addressing these five areas as it is required to do. While all of these conditions are critically important, the foundation for recovery will clearly be based on the foreign debt restructuring exercise. This is what this essay addresses.
Foreign Debt Restructuring
Once the government officially declared sovereign default, it signaled to the entire global financial community that it did not have any foreign currency to service debt denominated in foreign currency. This situation has two significant adverse effects. One is the domino effect of all outstanding debt being defaulted one after the other, when due. In such circumstances, for creditors there is only one recourse left: officially demand payments under the respective loan agreements, declare a default and activate legal remedies, under individual loan agreements, against the Government as was the case with the Hamilton Reserve Bank of the United States that held approximately US$250 million in International Sovereign Bonds (ISBs). Second, is the severe economic impact the government will have to confront. Further lending from any source will cease, except for multilateral lending with long tenures and under strict conditions, bilateral aid and assistance. It will be near impossible to raise foreign capital in the global capital markets, given the consequent downward ratings by the three key rating agencies, Fitch, Standard & Poor, and Moody’s. Investors contemplating foreign investments in Sri Lanka, dependent on debt financing for projects will be immediately thwarted, until the ratings for Sri Lanka improve to “investment grade”. Only an upward rating will signal that there are sufficient foreign currency reserves to service debt. Whether Sri Lanka can get to that point will depend heavily on the debt restructuring exercise and is probably still years away. Sri Lanka has the significant benefit of having one of the world’s best financial advisors – Lazards, and as legal advisors – Clifford Chance, to negotiate the restructuring exercise with lenders. The foreign debt of Sri Lanka can be categorized into, private borrowings (both individual and official, including government guarantees); sovereign bond issues, through issuance of treasury bills and treasury bonds to individuals or institutional buyers; bilateral official borrowings, that is State to State lending; and multilateral lending to the Government, for example, from the World Bank or Asian Development Bank.
In similar situations as Sri Lanka finds itself, what the negotiators on behalf of the debtor State will do, is focus on three elements with regard to settling outstanding foreign debt. The first element is postponement of debt servicing, or a temporary moratorium. This means, suspending loan payments for an agreed period of time and extending through an amendment to the lending documents the tenure of the loan. The objective here would be to enable Sri Lanka, during the hiatus, to shore up reserves that the country would otherwise have had to use for servicing of debt. Second, in a similar manner seek a reduction in interest payments from that of the original interest rate and elimination of any penalties for late payments or existing defaults. This will immediately reduce the outstanding debt burden saving the country more foreign exchange reserves over the remaining term of the loans. The third is to negotiate a complete forgiving of interest payments, with an obligation to pay only the outstanding principal over time. This latter position may be achievable only if the specific category of loans has been serviced over time until their default and there is significant evidence that the interest payments already made have more than compensated for the cost of the loan. In Sri Lanka’s case, it is the first two methods which are highly likely to succeed. One advantage that the debtor State has over its creditors is that the State knows that the Creditors have only two options; either agree to negotiate a settlement and receive something or engage in long-drawn litigation that may well end up with the Creditors writing off loans without recovery. The serious risk for Sri Lanka, in the latter circumstances, is that it will remain on record as a debtor state for perpetuity.
One of the problems that the government will encounter is with regard to the outstanding Chinese debt, which is reported to be as high as 10 percent of the total outstanding foreign debt. The Chinese authorities have announced that restructuring of Chinese sovereign debt will only be undertaken bilaterally.
There is possibly a fourth way. This is generally termed a “debt-equity” swap. This, of course, requires the Government to release ownership of viable public asset(s) to a lender in exchange for the outstanding debt. To do so would require a valuation of the public asset. Here, the creditor has to be convinced that the asset is a going concern and in the long term can more than compensate for the debt through a steady dividend yield. It is not necessarily, in such circumstances, a total loss of the asset for the Government either. First, the Government ceases payment of the outstanding debt thereby preserving foreign exchange. Second, the Government could still earn revenue through taxation on income generated from the asset. It is doubtful, however, whether the use of this method is within the mandate of Sri Lanka’s negotiators.
Building Foreign Currency Reserves
It is still not known where the restructuring of the foreign debt exercise is and what the ultimate results will be. Whatever the outcome, it is, however, just the beginning of a critical path to recovery and must be supplemented and complemented by several other fiscal and monetary policies and regulations to ensure debt repayment through a self-sustaining build-up of foreign currency reserves. Against a current foreign debt of over US$50 billion, serious discipline in debt management is key to recovery. Present foreign currency income is wholly insufficient to repay the debt even if debt restructuring is successfully accomplished. Over time, there are some fundamental areas that must improve and others that must be avoided, at all costs, to reach sustainable stability.
The trade gap from which foreign exchange can be earned is of acute concern. Trading Economics reports that at the end of the first quarter of 2023, Sri Lanka’s trade deficit is minus US$466 million, leaving Sri Lanka requiring foreign currency borrowings to pay even for basic necessities such as food, fuel and medicine. From every negative circumstance, though, some positive opportunities can arise. This is an environment in which existing local enterprises in the manufacturing sector with export-oriented products can thrive. One example is that the government can introduce incentives via fiscal measures for such enterprises to produce and export more, find new markets and that such enterprises be further favored if the foreign currency earnings are repatriated back to Sri Lanka. At present exports are taxed at 30 percent with no incentives.
Present foreign currency earnings from tourism have improved to US$132 million at the end of 2023 first quarter, but still not at a level where it will have a positive impact on the balance of payments. Tourism, however, is seasonal and may also react adversely to any political or social unrest. One positive impact is foreign currency remittances from Sri Lankan expatriates which at the end of the first quarter is reported to be US$480 million (Trading Economics). Remittances should continue to improve and with the current increasing trend of reported emigration of Sri Lankans, over the short term, inward remittances are bound to increase. The downside is that Sri Lanka is very likely to lose its technically skilled labor force in vast numbers.
Foreign direct investments (FDI) have been seriously anemic. At the end of the first quarter, it remained a mere US$171 million (Trading Economics). FDI will continue to be very modest since it cannot be anticipated that any large-scale investment will be undertaken without debt financing. To the extent that ratings for Sri Lanka are below investment grade, there is hardly any chance for debt-financed investments to take place. One of the ways for FDI to increase would be for foreign investors to partner with well-established local enterprises. Such partnerships can not only meet the capital requirements for investment but also enable the spread of attendant risks. Such foreign investor-local investor partnerships (FILIPs) will strengthen the investment environment significantly.
Application of laws and regulations, whether existing or new, and their strict and disciplined implementation will strengthen the foundation for the positive monetary health of the nation. In this regard, some areas that may be addressed would be to set strict limits for the issuance of foreign currency-denominated treasury bills or bonds and tie their issuance to available levels of reserves. If not already in place, laws and regulations may need to be adopted which will prohibit the Government from foreign currency borrowings on commercial terms for projects that will not yield a return or from issuing guarantees for foreign loans which do not have any potential for repayment. Equally important is to set limits to the printing of local currency. Admittedly, many of these measures may already be underway.
All the other issues strangling the nation economically, can only be remedied if these fundamental factors are addressed. The EFF is only a beginning and the Government must address the conditions agreed to with discipline and focus as well as formulate prudent policies for sustainability beyond the IMF’s EFF. Any non-compliance or variance from them will further harm the nation irreparably.
(Dr. Srilal Perera is currently Adjunct Professor of Law at the University of Miami School of Law. Previously he worked as Chief Counsel (Retired) of the Multilateral Investment Guarantee Agency of the Word Bank Group).