Foreign Debt Restructuring: Too Late & Too Short To Get Out Of The Debt Trap

By W A Wijewardena –

Prudent practice of having sinking funds

Sri Lanka’s Government debt issue has become a perennial problem giving opportunities for politicians of the two major political camps which had been in power in the post-independence history to blame each other. They blame the other political party for adopting an irresponsible borrowing spree and gradually driving the nation to an inescapable debt trap. However, this was not the case when the country was under the British. Those colonial masters had adopted the practice of establishing a sinking fund, when a new loan is raised, to ensure its safe repayment.

For instance, when the Railway authorities resorted to borrowing, mostly foreign borrowing, one of the conditions was to build a sinking fund out of the profits of the services to repay those loans. Accordingly, when the railway lines were complete in 1905, the total in the sinking funds was Rs. 41 million, while the outstanding loans amounted to Rs. 39 billion. This prudent practice was continued by the British colonial masters throughout.

When they left the country in 1948, the external debt amounted to Rs. 125 million partly covered by a sinking fund in foreign exchange of Rs. 43 million. The domestic debt representing rupee loans at that time amounted to Rs. 367 million. The associated rupee sinking fund had Rs. 47 million to its credit. The sinking funds did not cover the full amounts of loans outstanding. But they established the good principle of borrowing that one should set aside a part of his income to ensure safe return of those borrowings.

Sowing the seeds of debt instability

Even after independence, Ceylon and later Sri Lanka followed this prudent practice. But in 1974, the then finance minister, Dr. N.M. Perera, hit by both chronic and acute foreign exchange shortages, decided to discontinue the sterling sinking fund. Since then, till 1983, the rupee sinking fund was continued. But the then finance minister, Ronnie de Mel, was advised by his Treasury officials that he could discontinue the rupee sinking fund too. The benefit was that he could use the current revenue for the current budgetary purpose. The risk factor associated with repayment that could be mitigated by borrowing from the markets when a loan matures. This practice, known as refinancing or rolling-over of debt, was to his liking very much. Hence, in 1983, the rupee sinking fund system too was abolished.

Since then, Sri Lanka continued with the practice of ‘borrowing and repaying’ as its debt management strategy. Since the new borrowings were much more than the growth in the economy, the debt stock rose as a percent of GDP to critical levels, above 100% in early 2000s, making refinancing more difficult and costly as well in each passing year. Hence, the seeds of the current debt crisis were sown partly in 1974 and partly in 1983. This is because the current external debt crisis has arisen mainly because of the Government’s inability to raise new borrowings to repay maturing loans.

Total country debt

This is pertaining to the central government debt. But today, a country should be worried about its total country external debt and not necessarily the debt contracted by the central government. The country debt consists of those borrowings by the central government, government corporations, government owned banks, the central bank, and the private sector entities. When it comes to debt repayment, Government banks or private sector entities may have rupee funds to buy foreign exchange to service debt. But if the country does not have foreign exchange to release, the debt will be defaulted, and it will run into a debt problem.

In the case of the present external debt problem faced by the Government, it is a pathetic situation in which it does not have either rupee funds or foreign exchange to repay the maturing debt. That is why on 12 April 2022, the Sri Lanka Government decided to suspend the debt servicing to two external creditors, namely, bilateral creditors and commercial creditors. But an undertaking was given to them that the instalments in arrears will be added to the principal at the same interest rates.

In the meantime, the Government said it would seek a restructuring facility from these two creditors. To facilitate the restructuring program, the Government was supported by IMF in March 2023 through an extended fund facility of $ 3 billion. One of the conditions was to get the two creditors, commercial and bilateral, to agree to a debt restructuring program. It is this program which is still being negotiated by the Government without a viable conclusion.

A too narrow restructuring program

It is crucial for Sri Lanka to reach a permanent solution to its overhanging external debt. What is being restructured is only two of the debt sources contracted by the central government. The total country debt as at end-2022 that includes those of the central government, government corporations, the Central Bank, and the private sector had amounted to $ 58 billion. This is the total liability of the nation to foreigners and all these loans should be repaid in foreign exchange. Of this, only the borrowings by the central government from the individual creditors, called bilateral creditors, and from commercial markets and under commercial conditions have been listed for restructuring. That had amounted to $ 27 billion or 47% of the total country debt.

In the case of the central government, what has been borrowed from international financial institutions like ADB, World Bank, or IFAD and what the Central Bank had borrowed from IMF, amounting to about $ 11.5 billion had been excluded from restructuring since, in terms of the agreement with those agencies, Sri Lanka cannot default payments without being blacklisted for further borrowing. These loans should be repaid irrespective of whether Sri Lanka has or has not reached a restructuring agreement with bilateral and commercial creditors. These loan repayment commitments will amount to about $ 1 billion per annum according to IMF’s estimates. But the actual payments made in 2023 had been about $ 1.9 billion. This is a continuing drain on the scanty foreign exchange resources of the country.

Unfunded debt relief

A country should gain capacity to repay its foreign debt by increasing net foreign exchange earnings through the export of goods and services which are permanent sources of foreign exchange earnings. In this context, remittances and foreign direct investments are temporary gains which may get reversed at any moment if there is an unfavourable global condition like a pandemic or a regional war. This gap is very large for Sri Lanka and IMF has estimated it to be about $ 25 billion during 2022-7.

Of this, IMF expects at least $ 14 billion by way of debt relief during this period. This amounts to about 51% of the debt to be restructured and this is the haircut which Sri Lanka should get from both the bilateral and commercial creditors if the country is to reach external debt sustainability level. Any other arrangement will simply postpone the debt liability to a date beyond 2027 passing the burden on the future generations.

A too short bargain

What is being bargained is much less than the relief of $ 14 billion expected through debt restructuring. While noting that it is not a relief for Sri Lanka, the Government’s initiative to reach some agreement with them should be commended. Hence, any delay in reaching an agreement will be a killer for Sri Lanka which will have to sacrifice all the hard-earned gains so far relating to pushing the country back to normalcy.

A massive haircut of 51% 

As mentioned above, the ideal outcome should entail a massive haircut of about 51% of the bilateral and commercial borrowings of Sri Lanka. According to the data collected by IMF, as at end-2022, Sri Lanka had owed $ 11.4 billion to bilateral creditors and $ 19 billion to commercial creditors if a SWAP facility of about $ 2 billion contracted by the Central Bank is not reckoned.

Decomposition of debt being restructured

It is useful to know of the decomposition of these two categories. Of the bilateral debt of $ 11.4 billion, the country had owed $ 4.8 billion to Paris Club members with Japan owning 2.8 billion, $ 4.5 billion to China, and $ 1.8 billion to India. Accordingly, any agreement with Paris Club members including India will cover only $ 6.6 billion. If China agrees with Paris Club agreement, even with a 100% haircut, Sri Lanka cannot meet the gap of $ 14 billion envisaged to be filled during 2022-7. Of the commercial credit, International Sovereign Bond or ISB holders own $ 13.4 billion including the arrears which had been added to them during April-December 2022. In addition, Sri Lanka owe $ 2.9 billion to China Development Bank and further $ 200 million to other creditors. What is being negotiated in London, known as London Club, because it is in London these commercial borrowings are handled, with ad hoc group amounts only to 50% or $ 6.5 billion.

Need for a wider debt relief

The haircut that Sri Lanka should get from both the bilateral and commercial creditors should be at least $ 14 billion if it is to be the ideal outcome. We all know that this is not possible and hence, Sri Lanka should have haircuts from other creditors excluding multilateral creditors to meet its forex gap during 2022-7.

Ad hoc group serious on its business

Some of the ISB holders, owning a value of about 50%, have formed themselves into an ad hoc negotiation group with the Government authorities. The have hired their own legal and financial advisors, namely, White and Case and Rothschild, respectively, to take their case forward at a cost. Hiring these advisors to place them on an equal putting with the Government which is also advised by legal and financial advisors means that the ad hoc group is serious on its business. Accordingly, they have also come up with alternative solutions to counter the move of the Government to minimise the cost to them. Apart from this ad hoc group, there is one investor, namely, Hamilton Reserve Bank of St Kitts and Nevis, that has taken the Government of Sri Lanka to courts urging the full repayment of the outstanding amount of $ 250 million plus interest accumulated. The case is still pending. Those who are not in the group have not expressed their opinion on the debt restructuring and it is assumed that they will fall in line with the ad hoc group if an agreement is reached with them.

Two alternative proposals

Sri Lanka authorities led by the Treasury Secretary Mahinda Siriwardena and the Central Bank Governor Nandalal Weerasinghe, supported by concerned IMF staff, had had a restricted negotiation with the ad hoc group in London in early April 2024. The outcome of the restricted discussion has been released by the London Stock Exchange in terms of the current applicable laws in the UK.

There are two proposals in issue presented by the ad hoc group, one presented in March relating to a macro-linked bond or MLB and the other in April 2024 relating to a governance linked bond or GLB. The response of the Sri Lankan authorities to either one has been lukewarm emboldened by the certificate issued by IMF that the first suggestion of the ad hoc group is not in conformity with the analysis made by it, while the treatment being pursued by Sri Lankan authorities adheres to their requirements. This may be a frustrating experience for the ad hoc group since IMF seems to be forcing all the creditors to go by its planned program for EFF. Any debt restructuring plan forced on creditors will not work in the long run just like the forced domestic debt optimisation on pension and superannuation funds is likely to create problems for its working in the long run. It is strange that IMF is not aware of these ground realities.

Larger than expected debt servicing commitments

According to the Central Bank data, as of 19 April 2024, within the next 12 months, Sri Lanka should repay $ 1,348 million to multilateral creditors. If a debt restructuring is made, this will be augmented by the loan repayment commitments to both bilateral and commercial creditors. In addition, there are SWAP facilities obtained by the Central Bank amounting to $ 3,280 million that will have to be rolled over if the creditors are willing to do so. If it is not possible, Sri Lanka’s meagre foreign exchange reserves amounting to some $ 3,400 million net of the SWAP facility from China are not adequate to meet the liabilities. This is a high-risk situation for the country since inability to refinance the maturing loans will force Sri Lanka back to the situation in April 2022.

Hence, time is running out for Sri Lanka, and it should fast track the restructuring program though it is not adequate to get the country out of the present debt trap.

*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com

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