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ECONOMYNEXT – Sri Lanka’s primary dealers would see capital slashed from a possible domestic debt re-structuring with a coupon clip probably delivering the biggest shock, a top official of an independent primary dealer said.

Primary dealers were set up by the late A J Jayewardene, a classical economist who reformed the central bank to reduce money printing, reduced financial repression and high inflation leading to the end of widespread strikes that dogged the country from 1980 to around 1995.

There are bank and non-bank primary dealers. Collectively dealers have to subscribe to all the bonds offered at each auction.

A depletion of capital that wipes out primary dealers could hit the government’s ability to raise money.

“With foreign funding sources being closed currently the government relies mainly on the domestic market for funding its deficit,” says Ajith Fernando – Chief Executive Capital Alliance Plc, a non-bank independent primary dealer.

“Each week primary dealers buy and distribute over Rs 100 billion in debt. Each dealer may bid about 20 to 30 billion rupees.”

“Therefore a domestic re-structure that wipes out the primary dealers or seriously affects the ability of the dealers to carry out their duties will seriously affect the ability of the government to raise funds.”

Sri Lanka senior officials dealing with re-structuring are trying to avoid debt sustainability analysis driven default of domestic debt, whose holders are still willing to roll them over unlike foreign investors.

Sri Lanka’s Treasuries yields which were falling to around 20 to 23 percent as external sector started to stabilize shot up to 30 percent over concerns that domestic debt will be re-structured.

Due to a flaw in the latest debt resolution framework used by the International Monetary Fund externally defaulting countries (most are soft-pegs which mis-target rates for stimulus and runs out of forex reserves in a currency crisis), there is no early clarity on the treatment of domestic debt.

Unlike foreign investors, domestic buyers continue to fund the government in the style of a senior creditor.

Primary dealers have restricted business, where they are required to deal mostly in government securities.

“The late A S Jayawardena called them the extended family of the Central bank simply because they were established as an extension of the bank itself,” Fernando says.

“They cannot engage in any other significant business and can invest mainly (95 percent) in government securities by regulations imposed by the central bank itself.

“We are also not allowed to take deposits and can raise funds mainly only against government securities.

An independent primary dealer is are required to hold a capital of around 2.5 billion rupees. Some have capitals of around 4 to 5 billion.

“So you can see that they are not in a position to absorb big losses,” says Fernando.

“A loss will significantly restrict the ability of a primary dealer to operate. Though primary dealers distribute large volumes of bonds every week our total holdings at any given time are not significant compared to the total outstanding debt.

“It may be about 100 to 150 bn. Therefore the benefit of re-structuring PD’s holdings will be outweighed by the negative effects.”

A debt restructuring is carried out in several ways. One is a coupon clip – a reduction of the interest rate, another is a hair-cut – a reduction in the face value. A third is a maturity extenstion.

“In terms of types of DDR, a coupon clip probably be the most damaging while a maturity extension to reduce the gross financing need may be somewhat more manageable,” says Fernando.

“However, this depends on the type of securities each dealer is carrying. In some cases, even a small face value reduction on a long-term bond may not be as damaging as a coupon reduction.”

In Sri Lanka large volumes of rupee debt is held by captive sources like the Employees Provident Fund and Employees Trust Fund which are legally required to hold them, while banks also have liquidity requirements. (Colombo/Jan08/2022)

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