How to avoid an SVB type catastrophe? Sri Lanka’s debt restructuring challenge.

Sri Lanka has finally sealed an IMF deal. The long-awaited $3 billion bailout is now on its way, but in installments over a 4-year period. The path ahead towards economic stability of the country is not less bumpy than it was during the past year. 

An unprecedented economic crisis unfolded in Sri Lanka a year ago, when the pandemic and other external factors hit harder on the long mismanaged economy. Inflation, peaked 74% in September, long queues due to shortages and routine power blackouts fueled mass protests forcing the President to resign.

Lawmakers elected a new President in July. Negotiations with the IMF were expediated since then to reach a staff level agreement in September. However, the country had another hurdle to clear before the final board approval- the consent of its bilateral creditors to restructure their debt and ensure country’s debt sustainability.

The previous regime had gone too far sidelining the IMF and already defaulted on its foreign debt in April. IMF board does not disburse any funds immediately when a country is already in default.

Bilateral creditors are on rescue

Almost 50% of country’s public debt stock -128% of GDP- is in foreign currency and issued under a foreign law. Another 5%, issued under local law, also is foreign currency debt. 7% of this is already in arrears as the country’s foreign reserves are drained. Though the bilateral and commercial debt repayments have been suspended, the country still serves its multilateral debt.

The IMF required a guarantee from all its bilateral creditors on their willingness to restructure debt in a manner that the country can ensure debt sustainability. 43% of this debt is from China. 15 Paris club countries, which includes Western countries and Japan has a 39% share. India’s share is 15%.

India’s assurance came in January and the Paris club followed suit. It was reported that the Paris club was offering a 10-year debt moratorium. The final obstacle to clear was China.

China’s initial offer of a 2-year debt moratorium was not acceptable to the IMF. At a time, the “Lending into official arrears” policy also was considered. That practically means IMF will lend on the assumption that Sri Lanka will not pay its dues to China and that will make the county’s debt sustainable. However, the Chinese assurance finally came preventing a diplomatic issue.

The next hurdle is commercial credit

Sri Lanka’s problems are not over yet. Bilateral debt is only 27% of country’s foreign currency debt. The lion’s share, 48%, is commercial debt. Before the next review of the IMF in 6 months, Sri Lanka should negotiate with its private creditors to restructure this debt.

This step is not easy. Zambia, after signing an agreement with IMF in last August, has still not been able to finish restructuring its debt.

As it appears, the IMF expects Sri Lanka’s gross financing needs -the new financing needed to pay its debt installments and interest- to reach around 15% of GDP by 2027. The value which includes both foreign currency debt and local currency debt now stands around 38%.

The mission of the government would be less challenging with a 10-year moratorium on foreign currency debt. But that is not likely based on the responses of China so far. If the country will have to restart paying its foreign currency debt sooner, it may have to also restructure its local currency debt.

That’s where the risk of a SVB type catastrophe is.

Banking system is at risk

Banks have 37% of their assets loaned to the government, mostly through their investments in local currency denominated Treasury Bonds. Interest rates of these bonds have now surpassed 30% cutting the market value of some of these bonds by 50%. Consequently, the unrealized losses stay hidden in the balance sheets as happened with SVB.

This is known as the interest rate risk faced by banks. If a bank can hold these bonds until maturity, there’s no issue. SVB incurred a loss when they sold some of their bonds before maturity.

In debt restructuring talks, often the market value of a security is the starting point of negotiation. If Sri Lanka’s local debt would be restructured, it could resemble a forced sale of these securities as some loss is inevitable.  

Banks in Sri Lanka have also invested in USD denominated sovereign bonds, issued under US law. Even if local currency bonds would not be restructured, these sovereign bonds will be. Domestic holders of these bonds also will have to share the same burden as their international counterparts.

Possible scenarios for restructuring debt

Debt restructuring can take several forms: face value reduction, coupon reduction, maturity extension or a combination of these.

The effect of first two actions are similar to a loan default – credit risk faced by a bank. Banks will have to write off a part of their asset portfolio which will immediately reduce the net worth and thereby the value of the stocks.

A maturity extension affects in a different way. The immediate effect is a reduction in liquid assets leading to liquidity risk- inability to pay a banks dues when demanded even when the overall financial health of a bank is sound.

A combination of these action, the most likely scenario, will reduce the market value of assets in books, weakening the second line of defense against withdrawals. The more cash-constrained a bank is the more will be the risk that these unrealized losses in books becoming actual losses.

Sri Lanka’s challenges are not over

During the past year, Sri Lanka has successfully managed to bring inflation down through austerity measures. Taxes have been increased substantially while strictly controlling public expenses. Even the local elections have been postposed without appropriations for the purpose. Electricity tariff has been raised by close to 300% within a year to reflect the costs of the government monopoly based on the IMF recommendations. All these unpopular measures, while helped the country to stabilize the economy, have sparked anger among people and several state sector trade unions are on strike protesting increased power tariff and high taxes.

The government’s challenges are not over even after the IMF deal. One of the biggest challenge the policymakers must face, in addition the political risks, is to ensure debt sustainability as expected by the IMF while maintaining the stability of the banking system.