Debt settlement and a path to trust and hope

Sri Lanka is in a precarious, and perhaps inevitable, position regarding the restructuring of its outstanding debt.

The ongoing foreign exchange crisis has raised calls to restructure external debt. Previous articles, including Shanta Devarajan’s “reckless decision to repay sovereign bondholders” in the Daily FT on January 10, advocating pre-emptive restructuring. Although restructuring seems necessary at this time due to the low level of reserves, there are two paths that Sri Lanka can follow.

One in which it focuses on medium and long -term goals, and implements a comprehensive process to quickly and smoothly regain the confidence of global financial markets. The second path is where short-term goals dominate, and where a partial and gradual rehabilitation agenda is followed. The latter could result in many years of difficult access to foreign capital markets, particularly of the domestic banking system, and, perhaps worse, repeated phases of sovereign debt restructuring every few. years. This article sets out the types of steps needed to gain confidence through a robust process that can successfully restructure external debt.

First, debt restructuring should be seen as only part of a solution to a financial problem (a high debt -to -GDP ratio and negative financial balance), rather than a solution to a liquidity problem (decreasing reserves or exchange rate weakening). Although the latter can often be managed through short -term lines of borrowing or swapping, the financial problem itself requires a comprehensive set of policy actions of which restructuring is only a part. A negative current account and financial balance, the creator of the “twin deficit”, means that no matter how much the restructuring, the debt-to-GDP ratio will only continue to rise. Significant improvements in public sector finances, especially with large public enterprises that are losing money, are necessary for any way out of the crisis.

Second, debt restructuring must be done in a coordinated manner, affect all remaining foreign liabilities (private, government, and multilateral), and be significant in reducing outstanding debt. The haste in announcing a restructuring or payment suspension can cause confusion among a diverse range of lenders, and create an environment where future indebted lenders attempt to obtain repayment in the amount of lenders who owe earlier. This inevitably leads to lengthy and difficult negotiations with little ability to control its direction or outcome.

Each episode of sovereign debt restructuring is unique, however there are some principles that can help the current Sri Lankan situation to 1) gain the trust of current lenders in the restructuring process and therefore shorten the time it takes and 2) to re-access international markets in a timely manner. Relatively successfully completed restructuring programs can take up to nine months from the date of the first deferral of payment (temporary suspension of payments) while unsuccessful programs can take up to 36 months and lead to ‘sequential restructuring’ stages over many years.

The following principles may be particularly relevant for the Sri Lankan case:

nThe involvement of the IMF is a must

  • The IMF is in a unique position as a lender of last resort to provide credibility and transparency for the restructuring process. This is specifically for participants belonging to the Paris Club.
  • The IMF’s declarations and commitments along with government policy commitments greatly increase participants ’confidence in both the restructuring process and in the information released. Financial reform plans gain credibility if developed together with the IMF – the “twin deficit” needs to be addressed early. Furthermore, the IMF can provide additional back up and emergency loans when the process is done with them.
  • All lenders should be at the table
  • The restructuring should be seen as a one -time event and a comprehensive final solution to the issue of financial solvency.
  • Along with private bond holders, multilaterals such as the IMF, and bilateral sovereign lenders must participate transparently with all lenders regarding the terms of the restructuring of all lenders. This prevents the possibility of lawsuits and holdouts, as well as facilitating the confidence of international markets that future private bond issues will be treated at a level of play with bi/multi-lateral loans in the event of resumption. future adjustments.
  • A lender committee should be established for private lenders
  • A committee comprising major private bond holders could facilitate and expedite the formation of the consensus, thus removing its burden and complexity from the government.
  • A creditor committee can help verify the data and assumptions used in the restructuring of the proposals and help the government measure the creditor group’s response rate to the various proposals.
  • Although large lenders may have disproportionate influence on the committee, the lack of an agreed lender committee can lead to holdouts by some bond holders and lead to lawsuits by lenders who do not participate in the committee. (as happened in Argentina).
  • Needs a deep haircut
  • Reducing the total amount of the loan (in the sense of the current amount) may be very important to lenders, but in government it is the repayment schedule that matters. The inevitable reduction of payments by extending the maturity of the bonds will reduce their value.
  • As Verite Research points out in their October 2021 report “Charting the Path for Debt Sustainability in Sri Lanka” debt sustainability depends on interest rates and on “twin deficits”.
  • However, the reduction in the total amount of the debt must be large enough so that 1) the debt is maintained under any credible policy action to meet the “twin deficit”, 2) there is sufficient room after the restructuring to meet any unexpected additional macroeconomic conditions, and 3) allow fiscal space to issue additional debt in the future. As an example, under the debt restructuring in Greece in 2012, the total cut was more than 50% and affected 97% of private holding debt. Although large, it is still not enough to avoid significant and politically difficult monetary policy restrictions and the cutting of pension, social and welfare programs there.
  • Liquidity is required after restructuring
  • Any restructuring plan must include provisions for short-term liquidity access. This is especially important for the banking system and can be achieved through the active participation of multilaterals such as the IMF.

A general issue before the restructuring was the legal covenants of outstanding private held debt. If a Collective Action Clause (CAC) is in place, it is relatively straightforward to identify private bond holders and initiate renegotiation procedures. Otherwise, additional mechanisms may be needed including a promise to renounce debt held by those not participating in the renegotiation process.

Sri Lanka is in a precarious, and perhaps inevitable, position regarding the restructuring of its outstanding debt. Sri Lanka, however, is not alone, being among the few countries currently in a similar position. The way the Government manages the restructuring process due to the presence of large bilateral lenders such as China will have significant implications for many developing and emerging countries with similar debt profiles, and in turn will affect the potential result of negotiations for Sri Lanka. While it would be painful for Sri Lanka and its people to find a way out of the current situation, regardless of the choices made, it is critical that this path leads to a future of active, positive, participation in global financial markets. .

(The writer is an Associate Professor of Finance at the National Research University Higher School of Economics (HSE University), Moscow, and holds a PhD in Financial Economics from Oxford University.)