Out of the frying pan, dodging the fire?

The International Monetary Fund’s bailout plan for Sri Lanka marks a turning point in the country’s worst economic crisis but much of the hard work yet remains. Due to the country’s unstable political situation and the need to obtain debt relief from rivalling powers China, India, and Japan, any good news must be taken with a dollop of salt.

The agreement thus far is subject to management and the IMF Executive Board’s approval. It is also dependent on the Sri Lankan Government carrying out previously agreed-upon procedures.

The IMF’s 2.9 billion dollar rescue will depend on the Wickremesinghe Government squaring the circle. Along with getting finance guarantees from Sri Lanka’s official creditors, the IMF also stipulates that the nation make attempts to come to an arrangement with private creditors.

Foreign reserves were 1.8 billion as of July, according to the CBSL which ambitiously aims to reach a primary surplus of 2.3% of GDP by 2024. Sri Lanka’s economy would need to grow by roughly 6% in order to reach the IMF’s goal of raising its primary budget surplus to 2.4% by 2025, something it has not done in about five years. It is also anticipated a GDP decline of at least 8% this year.

Japan has promised to facilitate negotiations with Sri Lanka’s other major creditors, including its competitors in the region, India and China, in order to restructure its debt, which must be reduced by roughly 30 billion dollars. The majority of the 19 billion dollars in Government bonds, now categorised as in default, are held by foreign banks and asset managers, with whom Sri Lanka will also need to come to an agreement.

Sri Lanka is likely to get more financial assistance from other multilateral creditors when the IMF package is approved. The market should anticipate severe austerity measures and job cutbacks at State-owned businesses that are operating at a loss, despite the fact that welfare expenditures for Sri Lanka’s poorest residents would be maintained and even increased in the interim Budget.

Beijing, New Delhi, Tokyo along with multilaterals, and international asset managers must all bear losses in order to bring it to a sustainable level. The World Bank estimates that Beijing has loaned 7 billion, or 12% of foreign debt to finance expensive white elephant projects. Japan has contributed an additional 3.5 billion, while India has contributed around 1 billion.

According to the IMF Mission Chief Peter Breuer, the Fund’s money cannot flow without the assurances from these nations to restructure. The IMF also wants Colombo to obtain “financing assurances” — fund talk for debt relief and fresh loans — from regional powerhouses China, Japan, and India, which have long competed for influence. This is no less difficult.

Economists are quick to point out that the restructuring may have been much easier if we had participated in the G20 “Common Framework” plan, which was established during the height of COVID-19 to aid debt-ridden nations. Unfortunately, Sri Lanka was not eligible because it was considered a middle-income nation then. Under such a deal, China automatically receives debt relief together with “Paris Club” nations and private sector creditors.

Beijing has remained unresponsive, despite expectations that its leading position in Zambia’s reform may persuade it to do so, by means of setting precedent. India too has remained virtually silent till more information is available. However, pessimists are concerned that if China does not accept a restructure, other parties would do the same, including international asset managers who hold roughly 20 billion of Sri Lanka’s foreign bonds. As the biggest creditor nation, any plan won’t work without Chinese involvement.

Considering pragmatics, banks are prepared for a 40% haircut on foreign debts and ISBs, which are dollar denominated debt. CT CLSA Securities Head of Research Sanjeewa Fernando has pointed out that particularly with elections in 2024 just around the corner, the nation’s 50.5 billion locally held debt is likely to be a contentious problem. This is mostly held as capital by commercial banks and the local pension funds; and, is primarily denominated in rupees.  If the domestic debt is mostly held by domestic banks and you have haircuts, then that eats into their capital. This may need more bailouts in the future, which would increase the Government’s spending again.