Debt restructuring: What’s next?

Originally appeared on The Morning

By Dhananath Fernando

Sri Lanka is passing through a crucial week in its history. The details of the final domestic debt restructuring are yet to be known, but we will soon come to know the final details. However, domestic debt restructuring won’t be the be-all and end-all that will confer the expected level of economic growth – we need reforms across the board for a growth trajectory. Progress can only be achieved through a comprehensive reform plan.

Domestic debt restructuring

No debt restructuring plan is easy. Debt restructuring itself is a very painful process. The ideal solution is to have a sound economy in order to avoid any type of debt restructuring, but we are far from such a scenario. The consequences of any type of debt restructuring would be broadly negative. It would only be positive compared to consequences of not undergoing debt restructuring.

When someone borrows money and later says that they cannot pay it back as promised, it is never a pleasant experience. Sri Lanka’s debt restructuring is no exception. The debt restructuring will have consequences at this stage; it is just a matter of who will bear the burden and whether the relief will be enough for Sri Lanka to at least settle the remainder of its debts.

In the proposed plan by the Central Bank of Sri Lanka (CBSL), it has been suggested the Central Bank, superannuation funds, and the holders of Sri Lanka sovereign bonds and other USD bond holders (issued under Sri Lankan Law) bear the burden of local debt. International sovereign bond holders and bilateral creditors are expected to primarily bear the burden of foreign debt.

Although technically it seems as if bond holders and other creditor segments bear the burden, the truth is that most of the burden has already been shared by people of Sri Lanka through inflation.

In the initial plan, the banking sector was excluded from the debt restructuring process. The CBSL has provided four broad reasons to justify this exclusion.

The banking sector pays about 48% taxes (after tax revisions) (30% corporate tax and 18% VAT on financial services) as opposed to previous taxes of 39% (24% corporate tax and 15% VAT on financial services)

The Non-Performing Loan (NPL) ratio of banks is on the rise (8.4% NPLs in 2022 Q2 to 13.3% in May 2023)

Banks are expected to be impacted by International Sovereign Bond (ISB) restructuring as well as Sri Lanka Development Bond (SLDB) restructuring (banks hold 17% in ISBs and SLDBs)

Many concessions and moratoriums were already provided during Covid, Easter attacks, and the economic crisis, where about Rs. 1.6 trillion worth of loans were under concessions, amounting to about 15% of total loans

The main question is whether the provided debt restructuring is adequate for Sri Lanka to reach its target of 13% Gross Financing Needs (GFNs), 2.5% primary surplus, and 95% of debt to GDP ratio by 2032.

If the restructuring is not adequate enough for us to settle our debts, we will likely have to undergo another restructuring. Most countries which have gone through sovereign debt restructuring have to go through two subsequent debt restructurings on average. We are yet to see the analysis by the CBSL on how to ensure that this restructuring plan is adequate for us to achieve targets.

Ideally, we should avoid any further debt restructuring, because further restructuring would be more difficult, economically and socially.

Impact on superannuation funds

With the proposed restructuring, the social conversation is on the impact on superannuation funds. The Government has assured a minimum of 12% until 2025 and a 9% interest until maturity for the EPF. This is projected to amount to an average of 9.1% in rate of returns.

However, we have to keep in mind that any interest rate needs to be compared to inflation. There is no value in getting a 9% interest rate if inflation is 12%. If so, the Central Bank has to ensure that inflation remains around 5% for the real interest to be 4%.

However, the key impact of the proposed debt optimisation plan on superannuation funds would be that as per the Government’s projections, the rate of return would be 9.1%, which is slightly lower (0.3%) than the current returns. This means that if the status quo continues (for instance with no DDO) at 9.4%, the rate of return will be 0.4% higher than if superannuation funds took part in DDO.

The EPF is a nearly Rs. 3 trillion fund where withdrawals per year are less than Rs. 150 billion. Its collection was approximately Rs. 170 billion in 2022 and generally there is a Rs. 30 billion surplus between collections and refunds every year. People can still withdraw the money and their balance will not be affected, instead, it will result in the forgoing of the additional returns the fund could have made.

Domestic debt restructuring to be considered with other reforms

This debt restructuring will only bring partial relief, even if we undertake the necessary reforms. Even if this debt restructuring is successful, our debt to GDP ratio will be 95% in 2032 as per predictions. That is still a very high number. Ideally, an emerging market like Sri Lanka should remain in the range of 60%.

Sri Lanka will only be able to emerge from this crisis if we move forward with State-Owned Enterprises (SOEs) reforms, monetary sector and monetary reforms, and trade reforms. For us to grow our economy, we have to engage in trade. Secondly, we have to avoid growing our debt further through unproductive SOEs. If we fail to fix the rest, we will most likely return to square one, with a much difficult context.

What we, the common people, can do is push our policymakers to allow the market system to operate and limit the size of the Government while pushing for key reforms.