The dirty R-word

After the bill auction on 24 August, dealers witnessed a much-anticipated rate increase. Sri Lankan Treasury bills and T-bonds which were held stable while the Central Bank’s interbank guidance peg remained, succumbed to market forces owing to higher perceived risk. 

Partly due to President Ranil Wickremesinghe’s constant mention of local debt restructuring and the CBSL inability to turn away market participants, and virtually print its way out of the current conundrum; the three-month T-bill yield increased from 29-30% on Tuesday to 31-32%. An inversion from the slightly longer six-month and 12-month tenures was witnessed, hopeful of the short-lived nature of the situation. 

Moreover, only 56.7 billion rupees worth of Treasury bills were sold during this auction, with the majority of the funds coming from three-month bills, causing dealers to speculate that investors may be exercising caution until more information on the local debt restructuring is made available. Therein, comes the dreaded R-word.

Due to the current crisis, Sri Lanka has officially defaulted, and under IMF supervision, must restructure its foreign debt. International sovereign bonds (ISBs), among other debt commitments in foreign currencies, are still unpaid by the Sri Lankan Government. Although Sri Lanka’s sovereign rating is still at Selective Default (SD), the country’s sovereign bonds have been downgraded to “D” as a result of late interest payments, according to rating agency Standard and Poor’s. 

As soon as the Government’s bond restructuring is complete, Sri Lanka would boost its long-term foreign currency sovereign credit rating. The rating would represent Sri Lanka’s creditworthiness following the reform. Depending on the new debt structure and ability to service that debt, post-restructuring ratings for sovereigns typically fall into the “CCC” or low “B” category. 

If there is a greater chance that the Government’s local currency debt will be excluded from any debt restructuring, the outlook would also become more stable, boosting the local currency ratings. This might be the case, for instance, if the Government gets a sizable donation or credit line, giving it the opportunity to carry out immediate and radical reforms.

However, the rupee debt has practically been cut in half in terms of dollars, with the economy inflating. After embarking on a borrowing binge in 2015 as part of flexible inflation targeting, a reserve-collecting peg, and output gap targeting – printing money to spur growth – which frequently resulted in forex shortages and currency collapses, Sri Lanka defaulted on its loans.

On Wednesday, the Central Bank of Sri Lanka confirmed that the interbank guideline peg would remain at 361 rupees to the dollar, down from 361.95, in contrast to unofficial data showing that commercial banks offered dollars for telegraphic transfers between 368 and 370 for small transactions.  

Soft-peg credibility is typically destroyed, and currency shortages are brought on by persistent money printing for post-sterilisation of reserves used for imports – money printed to prevent reserve money from adjusting downwards – to maintain artificially low-interest rates, or in some cases, to finance deficits. 

Now due to the high-interest rates seen the erosion of private credit can be seen. Yet, capital outflows too would slow down and help re-establish the soft-peg legitimacy; the peg’s resulting budget deficit typically remains high in the immediate aftermath of a currency crisis.

Afterward, nations with soft pegs, that is flexible exchange rates, would approach the IMF with requests for monetary tightening and deficit reduction, frequently in the midst of social unrest and poverty brought on by currency collapses. In the backdrop of fiscal and monetary tightening, this would cause some short-term stress but help the economy settle faster, with the recovery in forex inflows leading to economic recovery. 

Therefore, while right now the R-word is only feared, it is evidently making a splash in financial circles for the right reasons. Only time will tell how external and perhaps local restructuring would play out.