Alicia Garcia Herrero & Junyu Tan (Natixis) | After the pre-emptive announcement to suspend all foreign debt repayments until discussions for an IMF bailout are completed, on May 18 Sri Lanka stepped into the dangerous path of a sovereign default as it missed the 30-day grace period on its USD 78 million worth coupon payments originally due April 18. Against this backdrop, investors’ key question is how deep the debt restructuring and the economic adjustment will need to be for Sri Lanka to go back to debt sustainability. In this note, we draw lessons from the experiences of Argentina and Ecuador in 2020 to shed some light on the circumstances of Sri Lanka.
Based on recent debt restructuring deals with the involvement of IMF, private investors, accounting for 47% of Sri Lanka’s sovereign foreign debt holding, should prepare for a full-fledged debt restructuring with not just a coupon haircut, but also a principal haircut and maturity extension.
Firstly, a significant reduction on coupon payments is very likely given the necessity to save forex reserves for food and fuel imports. In fact, recent large sovereign restructurings have applied a large coupon haircut of over 40% (45% for Argentina and 42% for Ecuador).
Secondly, a principal haircut cannot be ruled out either since Sri Lanka need to repay at least USD 1 billion per year until 2030 on sovereign bonds in foreign currencies. As if this were not enough, it has only USD 1.8 billion of forex reserves left, including a USD 1.5 billion swap with China. Meanwhile, the scale of a notional haircut could be small since the agreement on a large haircut would take time to resolve. As a result, Argentina only applied a small notional haircut at 1.9% in 2020 and Ecuador slightly higher at 9%.
Thirdly, a maturity extension is also likely as it allows more time to return to debt sustainability. Although Argentina did not seek maturity extension and only ask for a three-month moratorium on payments in 2020, Ecuador has managed to extend its principal payment by 6.6 years.
Fourthly, some unique bond structures may apply to give the economy more time to recover. For example, the debt restructurings for both Argentina and Ecuador have offered investors a step-up coupon structure with lower coupons in the first few years. The inclusion of value recovery instruments linking debt payments to GDP growth is also likely to align the interests of sovereigns and the creditors as in Argentina’s debt restructuring proposal.
As for bilateral and multilateral lenders, they typically offer debt service extensions with relatively small losses accrued. In fact, China, the largest bilateral lender accounting for 10% of Sri Lanka’s outstanding foreign debt, has reportedly proposed bridge financing, including USD 1 billion to repay existing Chinese loans due in July and another USD 1.5 billion credit line to purchase goods, and unwillingness to accept any haircut. As a result, the discussions of funding have been halted after the Sri Lanka government embarked on debt restructuring.
Regarding the bailout package from the IMF, the case of Ecuador shows securing an IMF program could lead to faster resolution of debt restructuring and less NPV losses. But latest IMF Article IV report suggests that revenue-based fiscal consolidation and near-term monetary tightening are the necessary conditions for an agreement on the bailout package Sri Lanka is seeking for. For the former, the government has announced on May 31st a VAT hike to 12% from 8% with immediate effect, but that only partially reverses the populist cuts in late 2019 from 15% to 8% since the room for fiscal consolidation is constrained by the plummeting economic growth and difficult social and political situation. For the latter, although the Central Bank of Sri Lanka (CBSL) left policy rates unchanged in the last monetary policy review, it should not be read as if the situation is stable. In fact, the reason is really to allow time for April 700bp hike to filter through but the currency remains stubbornly week, so more hikes may be needed, all the more so as the FED tightens further.
In short, private investors are likely to take the bulk of losses from Sri Lanka’s debt restructuring, including a significant coupon reduction of over 40%, whereas public creditors may have to offer debt payments extensions. Securing a bailout from IMF will help with the negotiations, but the agreement for such a program could involve more fiscal and monetary tightening in the near term even with increased growth headwinds. Finally, a big difference between Sri Lanka’s restructuring and that of at least Argentina is that China accounts for a much larger share of the debt, making a haircut in the notional value much harder to agree upon. This is due to China’s role as the largest creditor to the emerging and developing countries (accounting for almost one fourth of their external debt based on World Bank estimates) and, thus, the unwillingness to set a precedence for other distressed debtors.