Sri Lanka state finances would improve with domestic domestic restructure: think tank
ECONOMYNEXT – Sri Lanka’s debt could be reduced to 101 percent of gross domestic product by extending the maturity of domestic debt by 10 years, Verete Research, a think has said.
The real value of domestic debt has already halved due to High Inflation and Financial Repression (IFR), as the rupee soft-peg to the US dollar (now called a ‘flexible’ exchange rate) collapsed from 200 to 360 to the US dollar on debt which paid about 7-9 percent.
Annual inflation is now running at 70 percent in September and nominal GDP is expected inflate to at least 2.2 trillion in 2022 alone.
New debt is sold at around 30 percent, about 8 to 10 percent higher than what market participants were initially demanding, due to a flaw in the current debt sustainability process where buyers are not informed early whether domestic debt would be re-structured or not.
“It is likely that the best debt restructuring package that the country can obtain from its external creditors will still leave Sri Lanka with severe problems of financial (in)solvency and debt sustainability,” Verete Research said in research note.
“Assuming that Sri Lanka manages to negotiate a haircut on (International Sovereign Bonds (ISB)/Sri Lanka Development Bonds (SLDB) of 50% and a 25% haircut on multilateral/bilateral loans, the ratio of debt to GDP is still projected to rise to 136% by 2032.
“However, if the maturity of domestic treasury bonds were simultaneously extended by 10 years, the ratio of debt to GDP would rise to just 101% in the next 10 years.”
Debt sustainability as advocated by the International Monetary Fund currently involves bringing the debt to GDP ratio down over the longer term, but also the annual rollover (Gross Financing Need) in the short term as well which depends on the maturity structure of the debt.
Sri Lanka defaulted on its foreign debt after three currency crisis in rapid succession as money was printed to keep rates down artificially under flexible inflation targeting, which critics say is virtually unanchored monetary policy, which led currency crises in rapid succession and output shocks.
Each crisis was associated with foreign borrowing spree from sovereign bonds and Chinese budget support loans. The state-run Ceylon Petroleum Corporation also borrowed separately as liquidity injections created forex shortages, particularly in 2018 when taxes were hiked to bring down the deficit.
Latin American countries with market access with similar monetary regimes (flexible exchange rates or soft-pegs which are neither clean floats nor hard pegs) default repeatedly with debt to GDP ratios or 60 percent or less (Argentina), and sometimes with budget surpluses (Mexico) as US tightens policy.
From 2015, Sri Lanka also abandoned standard fiscal consolidation by jettisoning cost cutting (abandoning spending based fiscal consolidation) in favour of one sided revenue based fiscal consolidation which saw spending as share of GDP rise from 17 to close to 20 percent of GD.
Instead of fixing the bloated public sector, including a large military, new and innovative direct taxes were devised to transform investible capital to government current spending, critics have said.
A highly progressive personal tax rate also led to a push back from ‘professionals’ who backed the last regime.
Macro-economists who wanted more stimulus despite two recent currency crises in 2015/16 and 2018 cut taxes including value added tax saying there was a ‘persistent output gap’, while the central bank cut rates and scuttled bond auctions to stop rates from going up and the public and banks from financing the widening budget deficit.
In Sri Lanka, as in some Latin American and African countries where there is persistent monetary instability with un-anchored policy, there is a strong belief that inflation is fully or partly non-monetary and that it is the deficit itself and not the monetary accommodation of the gap that causes inflation and BOP troubles.
After getting market access, countries running un-anchored monetary policy with reserve collecting pegs in Latin America keep defaulting, including on re-structured debt despite severe fiscal corrections by political authorities. Argentina defaults with deficits around 5 percent of GDP and revenue to GDP around 20 to 22 percent.
The full Verete Research statement is reproduced below:
The Desirability of Domestic Debt Restructuring: Verité Research Sri Lanka Economic Policy Group
The third research note published by the Verité Research Sri Lanka Economic Policy Group presents an analysis by Professor Udara Peiris, Oberlin College, USA, explaining four ways in which Sri Lanka would benefit if the government were to restructure its domestic debt. The analysis finds that, if the government were to act soon and restructuring is carried out early, economic policy goals could be achieved without needing to impose ‘haircuts’ on coupons or capital of domestic creditors. It would be adequate to simply reprofile its domestic debt, i.e. move repayments further into the future.
On 12th April 2022, the Sri Lankan government announced a standstill on debt servicing to external creditors. Domestic debt was not subject to this standstill. Although, the real value of those domestic debts already has been considerably eroded by inflation, the cost to government of rolling over maturing domestic debt remains very high. It is currently paying around 30% annually for new loans.
There is understandable concern about the implications of any domestic debt restructuring for the domestic banking system, the national economy, and pension funds. A follow-up analysis will be released to explain how the consequences can be constructively addressed. The current analysis focuses on the benefits of domestic debt restructuring.
(i) Provides a quicker path to debt sustainability and economic recovery
It is likely that the best debt restructuring package that the country can obtain from its external creditors will still leave Sri Lanka with severe problems of financial (in)solvency and debt sustainability. Assuming that Sri Lanka manages to negotiate a haircut on (International Sovereign Bonds (ISB)/Sri Lanka Development Bonds (SLDB) of 50% and a 25% haircut on multilateral/bilateral loans, the ratio of debt to GDP is still projected to rise to 136% by 2032. However, if the maturity of domestic treasury bonds were simultaneously extended by 10 years, the ratio of debt to GDP would rise to just 101% in the next 10 years.
(ii) Provides a foundation for recovering macro-stability
Government’s debts are so large relative to the size of the national economy that the Central Bank is unable to tame very high inflation purely through monetary policy. The continuing high cost of rolling over government’s domestic debt will perpetuate the problem. The interconnectedness of fiscal solvency and inflation makes monetary policy less effective, even with high interest rates that have a negative impact on investment and growth. Domestic debt restructuring will provide a foundation for resetting these negative dynamics and achieving conditions conducive to economic growth, with reduced interest rates and reduced inflation.
(iii) Achieves a more targeted and progressive sharing of the adjustment burden
The present path of quietly restructuring domestic debt through high inflation disproportionately hurts Sri Lanka’s wage-dependent working population and increases poverty. Reducing domestic debt through explicit restructuring allows the costs to be targeted progressively to those sectors of the economy that are most equipped to bear the burden of debt reduction.
(iv) Reduces the risk of repeating the present debt crisis in the medium term
It is not unusual for countries that enter into insolvency and debt restructuring to fall back repeatedly into the same set of problems. The main reasons are poor governance, over-optimistic fiscal targets, and shallowness of the debt restructure. Currently Sri Lanka faces high risks in all three areas. If interest rates remain at current levels and the government’s highly ambitious targets for increasing revenue are not fully met, the country faces the prospect of a relapse into another debt sustainability crisis in the medium-term. An early domestic debt restructure can mitigate that risk – even though it cannot compensate for the continuing risks of poor governance.
The Verité Research Sri Lanka Economic Policy Group was formed to contribute workable, analytically evaluated, durable solutions for economic recovery. The core group consists of four international and local economists. They are supported by an expanded team of local and international economists and researchers. The core group members are: Prof. Dileni Gunewardena, Prof. Mick Moore, Dr. Nishan de Mel, and Prof. Shantayanan Devarajan.
The full research note laying out this policy is accessible online via www.veriteresearch.org/verite-research-sri-lanka-economic-policy-group/