The dynamics of debt restructuring in Sri Lanka

Sri Lanka suspended normal debt servicing of several categories of its external debts in April 2022, followed by rating downgrade to default on expiry of 30-days grace period in May 2022 since it could not pay the coupons due on two of its International Sovereign Bonds (ISB).

The scope of suspension included bonds issued in international capital markets, foreign currency denominated loan agreements and credit facilities with commercial banks and institutional lenders.

This suspension in debt payment, however, did not include servicing of domestic debt. But the long-term local currency issuer default rating continued its slide to ‘CC’ in Dec 2022 to reflect a probability of default on local currency debt, as well.

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At that time the interest / revenue ratio of the government had worsened to 56%, the borrowing from central bank was increasing, and pressure was building up on domestic lenders due to lack of availability of foreign financing.

Sri Lanka had not negotiated any IMF programme since its last program ended in 2020.

However, as part of consultations, in March 2022 (before default), the IMF declared public debt of the country as unsustainable and stressed the urgency to implement a strategy to restore stability and debt sustainability.

Amidst limited choices, the government engaged in negotiations for a extended fund facility for meeting the foreign financing shortfall in Apr 2022.

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Due to the severity of the situation, it took them eleven months to approval for a 48-month arrangement under the extended fund facility of $3 billion.

During this period Sri Lanka had to obtain specific and credible financing assurances from official bilateral creditors.

As per its procedures, the IMF had to ensure that financing needs of the country are met during the program period. The shortfall between the financing requirement and the capacity to pay based on financing assurances was marked as the funding gap, which must be met by debt relief.

Initially a local debt restructuring was not being considered as it would have elevated the funding and liquidity stress, given the predominance of local currency funding, at 74% of the total, and large holdings of local currency denominated government securities. However, the financing assurances obtained were not sufficient to bring the gross financing needs down to 13% of GDP.

The government determined in coordination with the IMF, that without participation from domestic creditors the debt could not be brought back into sustainable limits which would run a risk of debt becoming unsustainable once again during the program period. To avoid any such risk rescheduling was expanded to domestic lenders.

The restructuring named ‘Domestic Debt Optimization’ (DDO) was presented to domestic creditors on July 7, 2023. The scheme targeted the longer-term Treasury bonds (T-Bonds) in the inventory of superannuation funds (Funds) only. These funds held 43% of the treasury bonds in May 2023.

The restructuring scheme was offered as a choice to either replace their holdings in T-Bonds with new T-Bonds or pay a higher 30% tax on income from them, instead of 14%. Most funds accepted the offer.

Domestic banks and companies were exempted on the basis that they are already paying higher taxes than Funds.

Individuals were also exempted from the scheme considering the administrative cost since their investment in Treasury bonds constituted only 1%of the total.

Sri Lankan Development Bonds (SLDB) issued in foreign currency with an outstanding amount of $885 million were also to be restructured under the DDO. Unlike for local currency T-Bonds, 85% of SLDBs subject to restructuring were in the holding of commercial banks.

The government offered three choices to the holders. Investors interested in maintaining their claim in US dollars could choose from either repayment in 6-years with a 30% loss of principal or a 15-year maturity with no loss of principal amount.

Alternatively, the investors could convert into LKR T-bonds with 10-year maturity. Like local currency bonds, individuals were exempted from restructuring of SLDBs.

Treasury bills were generally not restructured as part of DDO, however these in the holding of The Central Bank of Sri-Lanka (CBSL) had to take the largest share of restructuring by exchanging its holding against longer term T-bonds.

This action had a significant impact on the balance sheet of CBSL, converting its equity into negative. The government had to present a plan for injecting additional capital into CBSL under the IMF program.

This is followed by restructuring of foreign debts. Recently, Sri Lanka managed to reach agreements-in-principle with the Official Creditors Committee and Export-Import Bank of China on debt treatments while effort was being made in reaching a resolution with external private creditors on comparable terms.

Besides domestic and foreign debt restructuring, the government had to take measures to protect commercial Banks and state-owned enterprises.

An Asset Quality Review of five largest banks comprising two state-owned and three largest private sector banks (covering 70% of bank assets) was completed, while review of additional four banks is to be carried out by February 2024 to identify recapitalization needs through diagnostic exercise, forward-looking stress testing based on macro-financial scenarios amidst restructurings.

The government is also bound to develop a plan for private sector banks which are unable to close capital shortfall from private sources.

Restructuring scope also included four largest state-owned entities including Ceylon Petroleum Corporation (CPC), Ceylon Electricity Board (CEB), Sri Lanka Airline (SLA) and Road Development Authority.

The government kept LKR 230 billion in budget to pay to the CEB and SLA in equity investment, which will be used by these entities to clear their debts towards CPC which will in turn repay the debt to the treasury for supplies made through Indian line of credit of almost identical amount.

While this will settle part of overdue debt, CPC and CEB must determine pricing which ensures cost recovery in future.

The strained path to stabilization will gradually bring down debt from the present 128% to less than 100%, debt servicing to 13% and servicing of foreign currency debt to 4.5% of GDP by 2030.

After the restructuring is complete and subject to meeting targets the earliest Sri Lanka expects to resume its borrowing from the international market is the year 2027.

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