Sri Lanka and Zambia are both in the middle of complicated debt restructurings that will have major implications for future restructurings. We wrote about this in detail in our Global Themes for 2023, but reiterate some of the key points here, along with the investment implications.
There are several similarities between the two cases, including a similar debt stock, service and composition and the presence of China as the main bilateral creditor. There are also several key differences, with Zambia restructuring under the Common Framework and Sri Lanka, as a middle-income country, restructuring outside it.
This has important implications for how debt sustainability is assessed, with Zambia subject to the DSA for low-income countries (LICs) and Sri Lanka subject to the DSA for market access countries (MACs). All else equal, this should mean that less relief is required in Sri Lanka to set debt on a sustainable path, and calls into question the logic of Zambia trading at a >50% premium (with ‘27s trading at US$47 in Zambia and just US$30 in Sri Lanka).
However, Sri Lanka is the first MAC to restructure under the recently revamped MAC DSA framework, so the more concrete implications of his distinction are still unclear. And, as we recently observed, ongoing restructurings are facing common issues whether or not they are taking place under the Common Framework. The key issues include delays in getting the official sector creditor committee to the table (mainly due to China) and disagreements with private sector creditors (mainly due to a lack of early engagement from the official sector and difficulties with sequencing).
Indeed, a footnote of a G20 statement last month highlighted that one member (understood to be China) "has divergent views on debt issues...and emphasized the importance of debt treatment by multilateral creditors like MDBs [multilateral development banks]". The seniority of MDB debt is a fundamental cornerstone of all Paris Club/IMF-backed restructurings, and China's refusal to accept this principle could derail any restructurings where it is a major creditor.
World Bank President David Malpass also spoke out on the issue last week after discussions with Chinese lenders and Premier Li Keqiang, saying that the IMF and World Bank “discussed the urgency of more rapid progress in the ongoing debt restructuring discussions, including for Zambia" and that “Changes in China’s positions are critical in this effort". Meanwhile, a brief IMF statement at the conclusion of its mission on 8 December provided no new insights, saying that and first ECF review is expected in spring 2023 but that "Achieving timely restructuring agreements with external creditors is essential to secure the expected benefits of the Fund-supported program".
How these issues are ultimately dealt with will set important precedents for future restructurings. The reason we have listed Sri Lanka and Zambia as trades to watch, however, is because of the massive uncertainty that still exists about recovery value for each country’s eurobonds, which have been subject to huge swings in recent years both leading up to the events of default and after the restructuring were well underway.
In Zambia’s case, private creditors have taken issue with the sustainability thresholds in the DSA, which are calibrated for a low-income country with a “weak” debt-carrying capacity. These thresholds are more stringent than they are for a country with a “medium” carrying capacity, which creditors argue Zambia will classified as by the end of the IMF programme and should thus be subject to [Note: Carrying capacity is based on a “Composite Indicator”, which in Zambia’s case is currently 2.59 versus the “medium” threshold of 2.69. See page 14 of the latest DSA for how the score is calculated].
An investor presentation by Zambia has clarified that the government is asking for net-present value (NPV) relief of 49% versus the 35-45% range we initially cited, calculated at a 5% discount rate with the face value of debt in the denominator. This would imply a recovery value cUS$39 at a more reasonable 12% discount rate (or NPV relief closer to c69.5%) versus the current price of cUS$47. However, we still think this should be seen as the starting point, with bondholders fighting hard for the reclassification of Zambia as a “medium carrying capacity” country and likely to seek some sort of other recompense if the IMF does not acquiesce (like inclusion of domestic debt in the restructuring, for example).
With the benefit of hindsight, the Buy recommendation we initiated at a price of US$57 no longer looks appropriate given the clarifications that we have since received on the DSA. However, at the current price of US$47 our recommendation stands, with a downside scenario of US$39 (-17% relative to the current price) and upside scenario of US$57.5 (+22%) if a PV of external debt to exports ratio of a 108% is adopted instead of 84% as currently specified (consistent with a “medium carrying capacity” and “sufficient space” to absorb shocks). This would lower the amount of required NPV relief to 24% at 5% discount rate, which is equal to 54.5% at a 12% discount rate and a cash price of US$57.5.
In Sri Lanka’s case, the restructuring is likely to be even messier given the additional complications at play. However, as an MAC, Sri Lanka should presumably have a higher debt-carrying capacity than Zambia (again, all else equal), so logic should follow that its recovery value should be higher. While this may not hold in practice (indeed, our estimated recovery range of US$25-40 in Sri Lanka is lower than our new worst-case US$39 recovery in Zambia), it would mean there is more upside for Sri Lanka’s eurobonds (or, conversely, downside for Zambia’s) given the existing premium of c55% on Zambia’s bonds.
As such, investors will be keenly watching how the restructurings unfold in Sri Lanka and Zambia. After several volatile years for their eurobonds, it is possible that more volatility is in store, with major implications for current and perspective bondholders.
This report is extracted from our publication Top picks for 2023, dated 12 December.