Debt restructuring and a path to confidence and hope

Sri Lanka is in a perilous, and perhaps inevitable, position with regard to restructuring her outstanding debt

The ongoing foreign exchange crisis has raised calls to restructure external debt. Recent articles, including “Reckless decision to repay sovereign bondholders” by Shanta Devarajan in the Daily FT on 10 January, advocate pre-emptive restructuring. While restructuring seems to be necessary at this time due to the low level of reserves, there are two paths Sri Lanka can follow. 

One where it focuses on medium and long-term objectives, and implements a comprehensive process to regain the confidence of the international financial markets quickly and smoothly. A second path is where short-term objectives dominate, and where a partial and piecemeal restructuring agenda is followed. The latter can result in many years of difficult access to foreign capital markets, particularly by the domestic banking system, and, perhaps worse, repeated sovereign debt restructuring episodes every few years. This article sets out the kind of steps necessary to gain confidence through a robust process that can successfully restructure external debt.

First, restructuring of debt should be seen as only part of a solution to a fiscal problem (a high debt to GDP ratio and negative fiscal balance), rather than a solution to a liquidity problem (declining reserves or weakening exchange rate). While the latter can often be managed through short-term borrowing or swap lines, the fiscal problem itself requires a comprehensive set of policy actions in which restructuring is only one part. A negative current account and fiscal balance, coined the “twin deficits”, mean that however large a restructuring is made, the debt-to-GDP ratio will only continue to climb. Significant improvements in public sector finances, particularly in large loss-making public enterprises, is necessary for any path out of the crisis.

Second, restructuring of debt should be done in a coordinated way, affect all the outstanding foreign held liabilities (private, governmental, and multilateral), and be significant in the reduction of the outstanding debt. Hastily announcing restructuring or payment suspension may cause confusion among a disparate set of creditors, and create an environment where creditors who are owed debt further in the future attempt to secure repayment at the cost of creditors who are owed debt sooner. This inevitably leads to protracted and difficult negotiations with little ability to control the direction nor outcome of it.

Each sovereign debt restructuring episode is unique, however there are a few principles that could be of help to the current Sri Lankan situation in being able to 1) gain the confidence of current lenders in the restructuring process and hence shorten the time it will take and 2) to access international markets again in a timely manner. Relatively successfully completed restructuring programs can take up to nine months from the date of the first deferral of payment (temporary suspension of payments) while unsuccessful programs can take up to 36 months and lead to ‘sequential restructuring’ episodes over many years.

The following principles may be of particular relevance for the Sri Lankan case:

nInvolvement of the IMF is a prerequisite 

• The IMF is in a unique position as a lender of last resort to provide credibility and transparency for the restructuring process. This is particularly so for participants who belong to the Paris Club.
• Declarations and commitments by the IMF together with policy commitments by the government greatly enhances the confidence of participants of both the restructuring process and the information released. Fiscal reform plans gain credibility if developed together with the IMF – the “twin deficits” need to be addressed up-front. Furthermore, the IMF can provide additional back up and emergency loans when the process is done together with them. 
• All creditors should be at the table
• The restructuring should be seen as a one-time event and a comprehensive final solution to the fiscal solvency issue. 
• Together with the private bond holders, multilaterals such as the IMF, and bilateral sovereign lenders should participate with transparency across all lenders about the terms of the restructuring to all creditors. This prevents the likelihood of lawsuits and holdouts, as well as facilitates confidence by the international markets that future private bond issues will be treated on a level playing field with bi/multi-lateral loans in the event of restructuring in the future.
• A creditor committee for private lenders should be established 
• A committee that includes the key private bondholders can facilitate and expedite the development of consensus, thereby removing the burden of and complexity of this from the government. 
• A creditor committee can help verify data and assumptions used in restructuring proposals and help the government gauge the response of the response of the creditor group to various proposals. 
• Although large lenders may have disproportionate influence on the committee, the lack of a single agreed creditor committee may lead to holdouts by certain bond holders and lead to lawsuits by the lenders not participating in the committee (as was the case with Argentina).
• A deep haircut is needed
• The reduction in the total value of debt (in a present value sense) may be of central importance to lenders, but to the government it is the repayment schedule which will matter. Inevitably reducing the repayments by extending the maturity of the bonds will reduce their value.
• As Verite Research point out in their October 2021 report “Charting a Path for Debt Sustainability in Sri Lanka” the sustainability of debt depends on interest rates and the “twin deficits”.
• Nevertheless, the reduction in the total value of debt needs to be sufficiently large to such that 1) debt is sustainable under any credible policy actions to address the “twin deficits”, 2) there is sufficient room post-restructuring to accommodate any further unexpected macroeconomic conditions, and 3) allow fiscal space to issue additional debt in the future. As an example, under the 2012 Greek debt restructuring the overall haircut was over 50% and affected 97% of privately held debt. Although large, this still was insufficient to prevent significant and politically difficult tightening of fiscal policy and the cutting of pension, social and welfare programs there.
• Post restructuring liquidity is needed 
• Any restructuring plan should include provisions for accessing short-term liquidity. This is especially important for the banking system and can be achieved through active participation by multilaterals such as the IMF.

An overarching issue preceding restructuring is the legal covenants of the outstanding privately held debt. If a Collective Action Clause (CAC) is in place, it is relatively straightforward to identify private bond holders and commence renegotiation procedures. If it is not, then additional mechanisms may be necessary including commitment to renege on debt held by those that do not participate in the renegotiation process.

Sri Lanka is in a perilous, and perhaps inevitable, position with regard to restructuring her outstanding debt. However, Sri Lanka is not alone, being among several countries that are currently in a similar position. The way the Government manages the restructuring process given the presence of large bilateral lenders such as China will have significant implications for the many developing and emerging countries with a similar debt profile, and in turn affect potential negotiation outcomes for Sri Lanka. While a path out of the current situation will be painful for Sri Lanka and her citizens, regardless of the choices made, it is critical that this path does lead to future active, positive, participation in the international financial markets.

(The writer is an Associate Professor of Finance at the National Research University Higher School of Economics (HSE University), Moscow, and has a PhD in Financial Economics from Oxford University.)