The dreaded DDR

It is largely agreed that Sri Lanka is out of the financial pot of hot water it found itself in last year. With the IMF Extended Fund Facility (EFF) agreement reached, pending the actual payment for the bailout and restructuring of foreign debt, half the battle is won. However, the need to still work towards the mammoth task of meeting the IMF Debt Sustainability Assessment (DSA) remains, and with it the dicey reality of restricting rupee-denominated local debt. 

This is known as Domestic Debt Restructuring (DDR) and is likely to be felt closer to home, within the connected web that is the financial system. The advantages of meeting these DSA parameters for Sri Lanka have been made plain and accepted, and the EFF is the catalyst for resuming Sri Lanka’s development and poverty reduction trajectory, as well as its macroeconomic and banking/financial system stability. 

The debt in question, of which ISBs (International Sovereign Bonds) make up a higher portion than other types of debt, dominates the discussion about restructuring. These ISBs are held by regional organisations and banks with foreign exchange licenses. However, now without an ISB debt restructuring as well as the DDR, the global and bilateral debt restructuring will be so burdensome as to be ineffective. 

What is more worrisome is that an ineffective and failed debt restructure will destroy the EFF’s standing, as well as leave Sri Lankans with severe and lasting wounds and a hefty load of private sector insolvency. The implications on the state pension fund system, the EPF and ETF, and other safety nets should be adjusted to preserve capital and prevent returns from falling to prevent a greater fallout.

Domestic sovereign debt owed by banks, financial institutions, insurance funds, and private citizens would also need to be restructured in order to prevent returns from falling below the levels seen in 2021. This can be done by combining coupon reduction with re-profiling and capital haircuts. 

The FDs represent a lesser share of the bank’s obligations in terms of liquidity ratios, but they are proportionally more likely to cause societal unrest, bank runs, and even the failure of smaller banks. 

Interbank borrowings, both domestic and international, make up a larger share of liabilities in the liquidity ratios and are politically and otherwise a better candidate for restructuring. The downside is that these borrowings have a greater potential to destabilise the interbank market and elicit retribution from overseas correspondent banks.

The Treasury is the primary sovereign debtor, responsible for Government spending, and the ultimate issuer of the now-in-default Sri Lankan debt, and the Secretary to the Treasury should be in charge of dealing with and negotiating with the banks on the DDR rather than the CBSL. While it is not completely outside the regulatory scope of the bank regulator and may have some sympathy for the banks they oversee as well as the banking system for which they are accountable for systemic stability. 

A DDR will undoubtedly have a detrimental effect on the capital of the banks as the story of global sovereign debt problems goes. Although they will emerge hopefully with greater buffers moving forward and a better-managed banking system without excessive exposure to any default entity. Financial Institutions with sufficient capital beyond the regulatory buffers will absorb this blow. Much of the planning of the DDR is yet to be decided, however, the importance and the impact it will have on the financial system and populace, remains.