Demystifying debt restructuring

As a country, we need to be prepared for continued pain in the short term as we begin negotiations. It will only get worse before it gets better. To navigate the reforms necessary, the government needs credibility in the eyes of the people and the international markets

We are dangerously low on foreign reserves and are on the verge of a default on our upcoming ISB. We are unable to raise sovereign bonds to refinance the upcoming maturities since we lost access to markets following the 2019 Presidential Elections when the 2016-2019 fiscal consolidation programme was abandoned.

This government’s focus on maintaining power instead of governing has led to a lack of medical supplies, power cuts, cooking gas shortages and rapidly rising food prices. We need to restructure our debt immediately. We cannot fool ourselves that going to the IMF immediately and starting the process will magically solve our economic challenges. Sovereign restructurings are complicated processes, and mishandling it could lead to long drawn-out pain, with no access to credit markets, lack of trade finance, capital flight, and financial sector instability. 
There is a lot of misunderstanding of what a debt restructuring entails. In this article, I will try to demystify some aspects of the process, so that we are better informed of what to expect. 

Sri Lanka’s debt composition

Around 90% of our foreign debt is made up of three main components: bilateral loans, multilateral loans and ISBs. Each of these debt types have a unique set of creditors with differentiating profiles. 

Bilateral loans are loans from one country to another. For Sri Lanka, this includes loans from countries such as Japan and China. Bilateral loans are not merely for profit but are also a policy tool, providing assistances for crisis response and official development. Some bilateral lenders, such as Japan and the United Kingdom, are Paris Club lenders. This means that they coordinate to offer the same terms on debt relief when negotiating with countries in debt distress. However, China is not a Paris Club lender, which could complicate restructuring negotiations. Bilateral lenders want to be treated equally. An exception for another lender could make a workout more difficult. 

Currently, Sri Lanka could also call upon the Common Framework for Debt Treatment, an agreement among G20 countries on how to provide debt relief that is consistent with a country’s ability to pay. As one of the first middle-income countries to call upon this, there are strategic decisions that Sri Lanka needs to take that would impact how other middle-income countries will negotiate with bilateral lenders in the future. 

Multilateral loans are from entities such as the Asian Development Bank and the World Bank. Multilateral loans are more straightforward because their institutions play a clear role in providing new financing and facilitating restructuring processes. 
ISBs and loans held by commercial private creditors will be the most complex. ISB bondholders are a diverse and fragmented group – ranging from institutional investors, such as investment funds, insurance companies, and retirement funds, to potentially distressed debt funds and retail investors. They want to make sure all creditors bear the losses of restructuring equally and could insist on equal treatment between those who hold domestic and foreign debt. 

In previous negotiations, there have been creditors who have been “holdouts” – where a creditor may not accept a restructured package and use litigation or other tactics to cajole a sovereign to pay the creditor back in full. The likelihood of having holdout creditors increases as Sri Lanka successfully receives debt relief from other creditors, because that means our liquidity has improved and therefore, we can pay some creditors back in full. The decisions made by a majority of creditors need to be binding to all.  Some of the bonds issued more recently may have clauses to limit holdouts, but older bonds may not. We do not want to end up in a situation where we face a hard default because negotiations do not consider how diverse the ISB holders are. 

There are many pertinent questions that arise out of this: who is included in the restructuring process? Is it just foreign debt holders or also domestic debt holders? How do we ensure all creditors are treated equally? Who provides us financing during the restructuring negotiations? How do we implement an economic adjustment programme given political instability? 

State-owned enterprises

A key question around the sovereign debt restructuring is how state-owned enterprises (SOEs) are treated. In Sri Lanka, SOEs such as Srilankan Airlines have credit that has been explicitly guaranteed by the government. It may become unavoidable for us to treat such sub-sovereign debt as part of the overall restructuring package. 

Banking sector

As of Q4 2021, the non-performing loans for the banking industry was reported to be 4.5%, which grossly understates the true quality of assets given loan moratoriums and negative economic growth in the past two years. SOEs have been largely provided liquidity through the state banks. The state banks will have to be recapitalized without much delay. 

Role of the IMF

The IMF plays an important role here for both near term financing and credibility. They can provide balance of payments financing with conditionality to support a country to implement an economic adjustment program. Being in an IMF programme will provide our government with the credibility necessary to go to creditors and begin the restructuring programme. Any programme will need to prioritize protecting the vulnerable. The IMF’s recent programme with Argentina shows that there has been a shift in their policies, with a prioritization of social protection for the poor. Looking to the recent IMF negotiations in Lebanon, the IMF also faces the dilemma of negotiating with a country that has lost the mandate of its people. 
Next steps

As a country, we need to be prepared for continued pain in the short term as we begin negotiations. It will only get worse before it gets better. To navigate the reforms necessary, the government needs credibility in the eyes of the people and the international markets. 

While welcoming the appointment of a new Central Bank Governor, Treasury Secretary and a competent advisory team, the politically unstable environment also needs to be addressed. While the management structure is being tackled, those politically responsible for the crisis have to be replaced for political and social stability in Sri Lanka. Mere technical appointments will not improve Sri Lanka’s credibility internationally. 
The writer of this column is the former Vice President of CitiBank, Director/CEO of National Development Bank