Reckless decision to repay sovereign bondholders

This $ 500 million could enable people, especially poor people, to buy and cook food for themselves and their children. Instead, the Government is choosing to reimburse bondholders, who are hardly poor

Everyone expects the country to default. The question is how it can be managed. By suspending the $ 500 million reimbursement of sovereign bonds and entering into a pre-emptive debt restructuring, Sri Lanka avoids two worse consequences

The announcement by the Governor of the Central Bank that Sri Lanka has earmarked $ 500 million to repay a maturing sovereign bond on 18 January is reckless for two reasons.  

First, Sri Lanka is facing an acute shortage of foreign exchange – people queue in long lines to buy cooking gas; there is no powdered milk; food prices are rising rapidly; power cuts are becoming frequent. This $ 500 million could enable people, especially poor people, to buy and cook food for themselves and their children. Instead, the Government is choosing to reimburse bondholders, who are hardly poor.

Secondly, Sri Lanka’s debt is unsustainable. Repaying maturing bonds in full today does not change that. It increases the chances that the country experiences an uncoordinated default in the near future. In this scenario, the country stops paying its bills because it cannot. The consequences of such a badly managed default can be devastating.  

In Lebanon, a country that shares many similar characteristics with Sri Lanka (history of civil war, sectarian divisions, dependence on tourism and remittances, dysfunctional public enterprises, cronyism), imports contracted by 40%, GDP fell 20% in a year, inflation rose to 150%, and the currency depreciated 130%. Sectarian violence returned to the streets of Beirut.

There is an alternative. Sri Lanka embarks on a pre-emptive debt restructuring that leads to a debt that is sustainable, new resources from multilateral institutions, and re-engagement in international capital markets. Such a managed default has been used by countries such as Jamaica and Ukraine when their debt levels were unsustainable. They all start with a temporary suspension of debt service payments, such as the $ 500 million sovereign bonds coming due on 18 January.  

Typically, the Government requests the IMF to undertake a debt sustainability analysis, which serves to “anchor” expectations about how much debt the country can repay. The country then negotiates with its creditors the amount of debt reduction that is feasible to arrive at this sustainable debt. While not necessary, having an IMF program helps build confidence in capital markets about the future prospects of the country, which leads to new resources from the IMF, World Bank, Asian Development Bank, and others.  

In most countries, the negotiations conclude in about six months and the country’s credit rating improves to pre-crisis levels. Jamaica, for instance, issued a sovereign bond nine months after it began a pre-emptive debt restructuring and it was oversubscribed.

A pre-emptive debt restructuring is not painless. The country’s credit rating may decline further before rebounding. Since Sri Lanka has never defaulted, some worry its reputation will suffer. But today, with a credit rating of CC, without access to international capital markets for a year-and-a-half, and a rising parallel market premium, the country has all the characteristics of a default.  

Everyone expects the country to default. The question is how it can be managed. By suspending the $ 500 million reimbursement of sovereign bonds and entering into a pre-emptive debt restructuring, Sri Lanka avoids two worse consequences. One is an uncoordinated default. The other is a continued shortage of foreign exchange that deprives people of basic needs such as food and fuel, possibly leading to a humanitarian disaster.

(The writer is Professor of Georgetown University and a former World Bank Chief Economist of South Asia, Africa, and the Middle East and North Africa.)