Alicia Garcia Herrero & Junyu Tan (Natixis) | After the preemptive announcement to suspend all foreign debt repayments until talks for an IMF bailout were completed on May 18, Sri Lanka embarked on the dangerous path of sovereign default as it missed the 30-day grace period on its $78 million worth. coupon payments originally due April 18. Against this backdrop, the main question for investors is how deep debt restructuring and economic adjustment will need to be for Sri Lanka to return to debt sustainability. In this note, we draw lessons from the experiences of Argentina and Ecuador in 2020 to shed light on the situation in Sri Lanka.
Based on the recent debt restructuring agreements with the participation of the IMF, private investors, who account for 47% of Sri Lanka’s sovereign external debt, should prepare for a full debt restructuring with not only a haircut of the coupon, but also a principal discount and a maturity extension.
First, a significant reduction in coupon payments is very likely given the need to save foreign exchange reserves for food and fuel imports. In fact, recent major sovereign restructurings have applied a large coupon discount of over 40% (45% for Argentina and 42% for Ecuador).
Second, a principal discount cannot be ruled out either since Sri Lanka has to repay at least $1 billion a year until 2030 on foreign currency sovereign bonds. As if that weren’t enough, it is left with only $1.8 billion in foreign exchange reserves, including a $1.5 billion swap with China. Meanwhile, the scale of a notional haircut could be small because the deal on a large haircut would take time to resolve. As a result, Argentina applied only a small notional haircut at 1.9% in 2020 and Ecuador slightly higher at 9%.
Third, a maturity extension is also likely as it allows more time to return to debt sustainability. Although Argentina did not request a maturity extension and only requested a three-month moratorium on payments in 2020, Ecuador managed to extend its principal payment by 6.6 years. .
Fourth, some unique bond structures may apply to give the economy more time to recover. For example, the debt restructurings of Argentina and Ecuador offered investors a graduated coupon structure with lower coupons in the early years. The inclusion of value-recovery instruments linking debt repayment to GDP growth is also likely to align the interests of sovereigns and creditors, as in Argentina’s debt restructuring proposal.
As for bilateral and multilateral lenders, they generally offer debt service extensions with relatively low losses. In fact, China, the largest bilateral lender accounting for 10% of Sri Lanka’s outstanding external debt, has reportedly offered bridge financing, including $1 billion to repay existing Chinese loans due in July and another line of credit of 1.5 billion USD to buy goods, and refusal to accept a haircut. As a result, financing talks stalled after the Sri Lankan government embarked on debt restructuring.
Regarding the IMF bailout, the case of Ecuador shows that securing an IMF program could lead to faster resolution of debt restructuring and fewer NPV losses. But the IMF’s latest Article IV report suggests that revenue-based fiscal consolidation and short-term monetary tightening are the necessary conditions for a deal on the bailout Sri Lanka is seeking. For the former, the government announced on May 31 a rise in VAT to 12% from 8% with immediate effect, but this only partially reverses the populist cuts at the end of 2019 from 15% to 8% since the consolidation margin budget is constrained by the fall in economic growth and the difficult social and political situation. For the latter, although the Central Bank of Sri Lanka (CBSL) left its key rates unchanged during the last review of monetary policy, the situation should not be interpreted as if it were stable. In fact, the reason is really to allow time for the April 700 bps rise to filter through, but the currency remains stubbornly weak, so further hikes may be needed, especially as the Fed tightens. any further.
In short, private investors are likely to bear the bulk of the losses from Sri Lanka’s debt restructuring, including a significant coupon reduction of over 40%, while public creditors may be forced to offer debt repayment extensions. Securing a bailout from the IMF will ease negotiations, but agreeing such a package could involve more fiscal and monetary tightening in the near term, even with headwinds to growth. Finally, a big difference between the restructuring of Sri Lanka and that of Argentina at least is that China accounts for a much larger share of the debt, which makes a notional value discount much more difficult to agree. This is due to China’s role as the main creditor of emerging and developing countries (accounting for almost a quarter of their external debt according to World Bank estimates) and, therefore, the reluctance to set a precedent for other debtors in difficulty.