Sri Lanka is desperately trying to restructure US$41.5bn of external debt to ensure further assistance from the IMF but Chinese creditors are delaying the exercise. By Jason Mitchell.
In 2020, the Sri Lanka lost access to the international financial markets following credit rating downgrades. Official reserves had depleted to a critically low level of US$2.8bn by the end of July that year. The country announced an external debt service suspension in April 2022 and in May the same year it defaulted on its debt for the first time in its history.
The country – which has a population of 22.6 million people – had been due to pay US$7bn in debt service in 2022. Experts say the crisis was precipitated by excessive foreign currency debt and a pandemic-induced collapse in foreign exchange receipts from tourism, exports and remittances. It triggered an outflow of foreign exchange owing to a speculation-driven rise in the prices of fuel and food.
Gotabaya Rajapakse – who became president in November 2019 and represented the Sri Lanka Podujana Peramuna, a right-wing political party – was forced out of power amid mass protests prompted by 12-hour power cuts and persistent fuel and food shortages. Ranil Wickremesinghe – who represents the centre-right United National Party – took over in July 2022. Presidential elections are scheduled to be held before September 2024 and Wickremesinghe is eligible to run for a second term.
On 1 July 2023, Sri Lanka’s parliament approved – through a majority 122 to 62 vote – a plan to restructure the domestic public debt, which totalled Rs15.4trn (US$47.6bn) at the end of March 2023. The sovereign has a total debt of more than US$83.6bn (US$41.5bn foreign and US$42.1bn domestic). China is the island’s biggest bilateral creditor and Chinese lenders were owed US$7.4bn – almost one-fifth of Sri Lanka’s external public debt – at the end of 2022, according to the China Africa Research Initiative. The Export-Import Bank of China has offered Sri Lanka a two-year moratorium on its debt.
The government would like to reduce half of its local debt through a restructuring programme. It wants foreign debt holders to take a 30% haircut but that is still under discussion. In March 2023, Sri Lanka secured a US$2.9bn bailout – under an extended fund facility arrangement – from the IMF. The country received its initial disbursement of about US$330m under the EFF programme in March.
An IMF team is scheduled to visit the island's capital, Colombo, from 14 to 27 September to conduct the first review of the EFF arrangement. A second disbursement of financing depends on the fund’s assessment of the country’s progress on its commitments, including on debt treatment.
Furthermore, in June 2023, the World Bank approved US$700m in financing for Sri Lanka's projects on economic stability and support for the poor and vulnerable.
Currently, the government is pursuing the external debt restructuring negotiations with all its bilateral creditors with a view to completing a deal in time for the IMF visit. However, analysts expect a delay, with discussions likely to close in December 2023. China has refused to become a member of the common platform that 17 creditor countries set up in May to negotiate the sovereign’s foreign debt.
While India and Japan emphasise the need for comparable terms, parity and transparency, China continues to be an observer in the “official creditor committee”, co-chaired by India, Japan and France. Experts say China’s decision to stay out of the forum has made other creditors wary.
Taking steps
“In just one year after the crisis hit, Sri Lanka has made some progress in addressing serious challenges facing the economy,” said Faris Hadad-Zervos, the World Bank’s country director for Maldives, Nepal and Sri Lanka. “Some difficult reforms are being implemented and the economy is showing initial signs of stabilisation.”
The economy contracted by 7.8% in 2022 and by 11.5% in the first quarter of 2023, according to the World Bank. It estimates that the poverty rate doubled from 13.1% to 25% between 2021 and 2022, creating an additional 2.5 million poor people.
“The crisis has had a devastating impact on people’s standards of living, taking a heavy toll on the poor and vulnerable and jeopardising Sri Lanka’s past development gains,” said Hadad-Zervos. “This dramatic increase in poverty and vulnerability has wiped out decades-long human capital gains. The government has committed to an ambitious reform agenda and is undertaking some difficult and necessary reforms including tax reforms, cost-reflective utility pricing, a stronger social safety net and a debt restructuring to stabilise the economy.
“Given Sri Lanka’s debt and debt service composition, including large gross financing needs, it is important to conduct a domestic debt restructuring process to restore debt sustainability. This will complement external debt restructuring. However, there are important trade-offs in a domestic debt operation. On the one hand, it should be adequately deep to support restoring debt sustainability and to avoid the need to repeat a debt restructuring. On the other hand, the operation should be carefully crafted to protect the stability of the financial system. The ultimate objective is to achieve debt targets with minimal disruptions.”
The contraction in national GDP is stark – from US$94.5bn in 2018 to US$75.3bn in 2022, according to the IMF. Income per head plummeted from US$4,360 in 2018 to US$3,360 in 2022. Inflation was estimated at 46.3% in 2022 and the IMF forecasts it will be 28.5% this year, before declining to 8.7% in 2024. Official reserves dropped from US$7.6bn in 2019 to less than US$400m in June 2022 (excluding a currency swap equivalent to US$1.5bn with China). The foreign exchange reserves grew in March 2023 to US$2.69bn from US$2.22bn in February after the country secured the IMF bailout.
Sri Lanka continues to be among the most highly indebted developing nations. As a share of GDP, the public and publicly guaranteed debt jumped from 80.7% in 2016 to 118.7% in 2022, according to the World Bank.
The country would like to build up foreign reserves of around US$10bn while more or less halving its foreign exchange debt service from 9.4% of GDP today to a maximum target of 4.5% in the 2027–2032 period, according to Nandalal Weerasinghe, the central bank’s governor. A loan extension agreement with foreign creditors would help Sri Lanka to recommence payments of the suspended foreign loans at a practicable level while accumulating foreign reserves. A haircut of that magnitude would bring down foreign loan repayments from the current US$6bn a year to US$3bn, which the governor says “won’t be unfeasible” to repay.
The government would like to reduce its gross financing needs to below 13% of GDP between 2027 and 2032, down from a high of more than 34% in 2022.
“We are encouraged that parliament approved a domestic debt optimisation strategy, presented by the government with the debt advisor’s support,” said Hadad-Zervos. “This strategy is now being implemented. We understand that discussions with private creditors are continuing. We hope the negotiations will soon be completed, which is important to bring Sri Lanka back to a sustainable path, build confidence among investors and development partners, and regain international financial market access that Sri Lanka lost in 2020.”
Restoring sustainability
Restoring public debt sustainability is one of the key objectives of the IMF programme, which requires policy actions and comprehensive debt treatment. The structural reforms the IMF and the World Bank have prioritised include: ensuring sustainable fiscal consolidation by phasing out subsidies and implementing an automatic pricing mechanism; institutionalising fiscal discipline though medium-term debt strategies; a new Central Bank Act to build monetary independence; asset quality review and capitalisation of the banking system; and the introduction of an anti-corruption framework.
In late June, the government released its proposed domestic debt restructuring deal, which in turn also signalled the terms it would seek from its external creditors. Domestic debt accounts for about half of the country’s total debt stock and external creditors insist this must be included in any debt restructuring.
Sri Lankan banks hold most of the government’s domestic debt, and bank financial health is already under enormous strain from the ongoing economic crisis. Experts say that imposing further large losses on the banks would only exacerbate the situation – hampering credit extension, undermining recovery and potentially triggering a banking crisis. Furthermore, such losses could require the government to recapitalise the banks, undermining the value of reducing the government’s financing needs in the first place.
In this way, the government has decided to concentrate the burden of restructuring its rupee-denominated debt on the country’s superannuation funds.
“The economy is slowly recovering post the IMF first board approval in March,” said Saurav Anand, an economist for South Asia at Standard Chartered. “Consequently, the pace of contraction likely slowed in the second quarter 2023 after a sharp contraction in 2022 and the first quarter of 2023. Supply-side issues are gradually easing and the economy is likely to report positive growth in the second half of 2023 (aided by statistical base effects as well). Remittances and tourism have improved.
“Foreign exchange reserves are now around US$3.7bn after declining to US$1.7bn in 2022 (includes U$1.5bn of People's Bank of China swap line, which has conditionalities attached related to usage). The government is keenly pursuing the external debt restructuring negotiations with an intention to complete the negotiations by September. We do expect a delay in the debt restructuring negotiations, with discussions likely to close in December 2023. This should lead to a gradual improvement in 2024 growth prospects. We expect 2023 real GDP growth of 3%.
“The DDR plan is voluntary and encompasses T-bills, T-bonds, Sri Lanka development bonds and other locally issued debt. However, it appears narrow and targets only specific debt holders: first, the central bank for its T-bill holdings and, second, superannuation funds for their T-bond holdings, totalling around 44% of local debt. Domestic banks, which own around 31% of local currency debt, and other holders (adding up to an estimated 25%) are excluded from the restructuring.”
CB governor optimistic
Weerasinghe remains optimistic that Sri Lanka will complete the debt restructuring before the IMF’s first review of the EFF arrangement. He said there is a “little delay” in passing legislation required to carry out the domestic restructuring, owing to cases filed at the supreme court against the proposed deal. He says the negotiations with the country’s external creditors are progressing well.
“Sri Lanka’s economy is in a much better state when compared to last year, when its reserves were near zero and inflation was 70% with fuel shortages,” said Talal Rafi, an economist at Deloitte Economics Institute. “The economy has stabilised with inflation under single digits and policy rate cuts by the central bank, the economy is set to recover and show economic growth for the second half of 2023. Import restrictions are being lifted. But the challenge going forward would be bringing in structural reforms.
“Sri Lanka has a history of bad fiscal discipline, as it has achieved a primary budget surplus only four times in 75 years. Sri Lanka’s state employs 1.5 million people, which resulted in 86% of government revenue in 2021 going to paying salaries and the pensions of state sector employees. Structural reforms also include improving ease of doing business and changing the country’s land and labour laws. Without the deep economic reforms, Sri Lanka has a high risk of moving towards another economic crisis in the long term.”
Under the government’s plans, local currency bonds held by superannuation funds, including pension funds, will be exchanged for longer-maturity bonds (2027– 2038), which will have 9% interest until maturity. Furthermore, the central bank’s holdings of Treasury bills will be converted to bonds maturing between 2029 and 2038, with a step-down coupon structure. This will be implemented during the DDR’s second phase.
“The domestic debt restructuring was much lighter than anticipated because it only targeted the stock of Treasury bills held by the central bank itself and the Treasury bills and Treasury bonds held by the superannuation funds, which is mainly the employees’ provident fund,” said Shehan Cooray, director and head of research at Colombo-based Acuity Stockbrokers.
“This is a fund that all private sector employers contribute to and is managed by the central bank. There are also some smaller private superannuation funds that were targeted. The authorities want to extend the maturities on the bonds that are held by those funds. These bonds will be cancelled and reissued with new bonds with longer maturities but with the same face value. Basically, it’s only a maturity extension.
“The coupons would gradually be reduced to around 9%, so given inflation expectations of around 5%, they would still give a positive return. It has been approved by parliament but they are just waiting for certain tax changes to be done to enable it, so it should go through in the next few weeks.”
The external bilateral creditors are yet to finalise the structure of their debt treatment plan and are exploring a number of options including a moratorium, a longer repayment term, a partial write-off or a combination of these measures. Sri Lanka has expressed confidence in China’s bilateral cooperation over a debt restructuring plan while assuring other creditors that the treatment will be comparable.
In August, Chinese Foreign Minister Wang Yi “vowed that China will help Sri Lanka effectively address the challenges of financial debt”.
“The foreign debt restructuring is handled by the central bank and the foreign creditors and they have been maintaining a radio silence as required under the negotiations,” said Cooray. “But the expectation is that – because Sri Lanka has made a considerable effort on doing its part of the restructuring in terms of having higher taxes to bring the fiscal deficit to a manageable level – the foreign creditors will make a similar effort. Our understanding is that there has been some push-back from China.”
Opposition growing
At the peak of the recent economic crisis, virtually no opposition to the IMF or the reforms existed, but that has now started to grow. First, experts say that there is a lack of economic understanding in the population. This plays into the hands of politicians wanting to whip up opposition to the government’s proposals. Second, political instability could disrupt the reforms. A stable government is needed to set the reform agenda. The closer Wickremesinghe gets to next year’s election, the more pressure he will be under from his party to embrace populist policies rather than pursue unpopular reforms.
Third, implementing reforms can be tough in Sri Lanka because of its weak institutions. Implementing policy changes through a maze of bureaucracy can be difficult and time-consuming, which allows time for opposition to gain momentum.
“Structural reforms are needed,” said Deloitte's Rafi. “In 2021, the losses made by Sri Lankan Airlines, the national airline, were greater than the entire social safety net spending of the government. Privatisation of state-owned enterprises with commercial interests is a must. Land and labour law reforms are needed to improve Sri Lanka’s ease of doing business and to draw foreign investments. It is one of the most protected economies in the world, making trade more complex. Sri Lanka needs to tap into global value chains and sign more free trade agreements to open the economy to trade and investment opportunities. It also has one of the lowest government revenue-to-GDP ratios in the world. A widening of the tax base is important.
“Sri Lanka’s economic opportunities are in tourism and trade. It is located very strategically. It has the oil-rich Gulf nations to its west, the vibrant Association of Southeast Asian Nations countries to its east and the fastest-growing large economy in the world, India, to its north. Sri Lanka can become a trade hub if it can open its economy further and sign more free trade agreements. The World Bank states that Sri Lanka has offshore wind energy potential which exceeds its demands. If it can utilise it, the country can become a net energy exporter, especially to India.”
Sri Lanka’s economic opportunities are enormous and it has the potential for rapid economic growth. However, it must first achieve a successful restructuring of all its domestic and external debt. It must also thoroughly implement a whole raft of comprehensive structural reforms so that the island state is set on a more sustainable growth path.
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