Dilemma of restructuring foreign and local debt in one go

On Monday, the rating agency S&P Global officially accredited Sri Lankan bonds to ‘D’ status, following the missed interest and principal payments that were announced prior. Representing an economy that defaulted on sovereign creditor promise, the Government follows with a debt sustainability analysis (DSA) being presented to the IMF and Sri Lanka’s foreign creditors.

Protocol and procedure aside, looking at all viable options is not uncommon in the face of adversity. However, does talk about a rupee haircut arise prematurely, or is it warranted in the absence of a Government that can clean up the mess? 

According to sources at the Finance Ministry, the Government has been considering domestic, or rupee-denominated debt restructuring. This was previously not an issue as it comes within the purview of the Central Bank (CBSL) and the Finance Ministry. The general reason that local currency debt is considered low credit default risk, is because the issuer i.e., the sovereign, is by legal right able to create money, albeit with some constraints. 

This printing machine is used mainly as a lender of last resort, to avoid real economic fallout when there is too much liquidity in the system without a matching increase in efficiency or output. This was seen in Zimbabwe during President Robert Mugabe’s tenure, where hyperinflation and vast shortages were rampant. Therefore, as Sri Lanka has to seriously curb printing efforts, debt restructuring is the only possible path, if the worst-case scenario was to be encountered.  What the worst-case scenario looks like began as rhetorical but now fails to get a coherent answer. According to the Government, this is only a part of a broader policy package to address the massive debt vulnerability running up to trillions of rupees. At the end of March 2022, the total accumulated domestic debt stood at Rs. 12 trillion, while domestic borrowings of the Government overshot Rs. 1.6 trillion in the first four months of 2022 alone. 

The main Opposition Samagi Jana Balawegaya too has moved to provide the Government with its own blueprint of the economic crisis. While there is a clearer plan taking place, overall, the decision is expected to be taken outside party politics. 

CBSL Governor Dr. Nandalal Weerasinghe has his own qualms. According to the CBSL, the domestic debt restructuring would exert an adverse force on local bank Balance Sheets, further exacerbating the problem. In order to avoid this impact, measures should be taken to recapitalise some banks or replenish superannuation funds such as Employees Provident Fund and Employees Trust Fund according to some economists. 

While this too may be a costly pursuit for banks to issue equity over their debt claims, it may be a viable option out of a greater mess. Bankers too seem to account for it this earning season with significant additions to their write-offs, in order to clean their books and lessen the impact of even a potential haircut.

The CBSL has attempted to avoid the tumultuous refinancing by increasing rates and soaking up everything from the market. But, with investor pressure on rates mounting, this operation too, meets a dead end at which a liquidity crunch in the domestic financial system appears. In the case of dollar-denominated debt, repayments have to be made by eating into our reserves or borrowing from friendly countries.  The sustainability of this too appears defunct and if rupee debt is repaid by borrowing from the CBSL, neither is sustainable. If dollars and rupees both dry up, it’s outside the control of any local monetary authority. Terms are then truly dictated by outside creditors and multilateral lenders like the IMF. In the case of the IMF, debt sustainability is both a problem and a prerequisite to obtaining funds. A bad haircut would be much better than a poor touch-up job.