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Sri Lanka: President hints at inclusion of local debt in restructuring

  • President Wickremesinghe shocked the local debt market by saying domestic debt may have to be included in restructuring

  • Domestic debt has already received upfront "haircut" via >60% inflation and inclusion could cause financial instability

  • IMF DSA will define restructuring perimeter, but in meantime comments will worsen financing challenges and monetisation

Sri Lanka: President hints at inclusion of local debt in restructuring
Tellimer Research
8 August 2022
Published byTellimer Research

In a speech on Friday, President Ranil Wickremesinghe shocked the local debt market by saying that domestic government debt may also have to be included in Sri Lanka’s debt restructuring, saying that “the financial advisors are looking at both debts…we have to look at both the foreign debt and the local debt.” This contravenes the widely held assumption that domestic debt would be excluded in the restructuring, an assumption that we shared (see the excerpt below from our recent note outlining the complicated dynamics of Sri Lanka’s restructuring):

While we had previously said domestic debt would need to be included in a restructuring to achieve a sustainable debt trajectory, there is now a stronger argument for excluding it since it has essentially received a large inflation-induced haircut and will have significant financial stability implications (with around one-third of banking sector assets comprising government debt).

Indeed, inflation has continued to rise since, with the Colombo CPI reaching 61% yoy in July from 55% in June. Further increases are likely given LKR depreciation of nearly 45% ytd and rapid money printing by the Central Bank of Sri Lanka (CBSL), which reached LKR1tn in H1 (over 6% of last year’s GDP). As such, domestic government debt has already received a large up front “haircut” via inflation.

Pencilling in 50% nominal growth for purely illustrative purposes (60% inflation and a 10% real GDP contraction), the end-2021 domestic debt stock would fall from 63% to 42% of GDP, all else equal. This reduces the need to restructure Sri Lanka’s domestic debt stock, but, as alluded to by President Wickremesinghe, may not fully eliminate the need.

The government had previously signalled plans to exclude SLDBs (US$-denominated bonds issued under local law) from the restructuring, instead asking holders to either accept payments in LKR or extend maturities as they come due. This form of relief will likely amount to far less in present value (PV) terms than other external debt holders will be asked to accept, and the decision has already formed the basis for a lawsuit by a holder of the SRILAN 5 ⅞ 07/25/2022 eurobond.

The statement by President Wickremesinghe may indicate a desire for a similar “voluntary” treatment for LKR-denominated domestic debt, or may conversely signal that a more comprehensive treatment of SLDBs is in store (which we think is probably necessary to restore debt sustainability and facilitate negotiations with external creditors, who will likely push for the SLDBs to be treated pari passu with other FX-denominated debt).

Either way, there are likely to be far-reaching consequences. Firstly, domestic investors will likely be wary of participating in government bill and bond auctions until there is more clarity on the issue, which will push yields up even further (the weighted average auction yield for 364-day T-bills has risen from 8.2% at the end of 2021 to 29.2% at the latest auction on 3 August) and make it difficult for the government to fund its budget deficit.

Indeed, the secondary market for local government debt has dried up since the announcement, with local news source EconomyNext reporting no quotes for T-bills in the secondary market and only limited quotes for bonds. Unless there is a steep increase in primary auction yields, this week’s T-bill auction will likely be undersubscribed, which will force the CBSL to monetise an even greater portion of the budget deficit and exacerbate price and currency pressures.

Secondly, net credit to the government comprised 28% of the assets of domestic banks in May (and likely even more at the two large state-owned banks). This is down from 36% in May 2021 but still relatively high, meaning that the inclusion of domestic debt in the restructuring will have to be done in a way that minimises financial stability risks and the potential fiscal costs of bank recapitalisation and/or direct transfers to the state-owned banks.

The announcement may also cause depositors to get jittery and start to withdraw their money from the banking system due to concerns that banks may be forced to shut down temporarily if they run into trouble from the restructuring while they await capital re-injections. Bank bondholders would also likely begin to haircut their recovery assumptions while they wait for clarification on how Sri Lanka’s domestic debt will be treated.

Overall, we are surprised by the President’s announcement but await further clarity in the months ahead. Ultimately, the envelope of the restructuring will be defined by the IMF’s Debt Sustainability Analysis and negotiations with official sector creditors, and we don’t rule out the possibility that domestic debt restructuring will indeed be required to bring Sri Lanka’s debt burden below the relevant sustainability thresholds.

However, inclusion of local government debt is rare, occurring in just 12 of the 52 sovereign debt restructurings tracked by the IIF since 1999 (or 23% of the total). This is consistent with the longer-term data from Carmen Reinhart and Kenneth Rogoff’s seminal 2009 book “This Time is Different”, which found that the bulk of domestic debt defaults take place by the back door via excessively high inflation rather than explicitly via nominal haircuts, maturity extensions, and/or coupon cuts.

We await further clarity from the government, IMF, and other official sector creditors on the potential perimeter of Sri Lanka’s debt restructuring, but in the meantime, President Wickremesinghe’s remarks will cause anxiety for holders of Sri Lanka’s domestic debt (all of which are based locally barring US$11.5m, or 0.04% of the total) and potentially complicate Sri Lanka’s already difficult financing challenges.

Note: Click here for a more comprehensive analysis of the dynamics and potential difficulties of Sri Lanka’s debt restructuring.

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