Domestic Bonds

Pay off external debt or finance essential imports


By Dr Roshan Perera and Dr Sarath Rajapatirana

The country’s available foreign reserves can be used either to repay foreign creditors or to finance imports of essential goods and services required by its citizens. This is the dilemma Sri Lanka faces today. Repaying the full value of the bonds using the limited foreign exchange reserves available would provide an exceptional gain to those who currently hold these bonds (1). But it will come at a great cost to the citizens of the country who will face shortages of essentials like food, medicine and fuel.

Under these circumstances, it is in the best interests of all of its citizens that the government defer payment of the $ 500 million International Sovereign Bond (ISB) due January 18, 2022, until the economy can recover and rebuild completely.

Just as an individual with co-morbidities is more likely to develop serious illness if infected with Covid-19 and more likely to require hospitalization and even treatment in an intensive care unit, Sri Lanka was vulnerable to economic shocks. long before Covid-19 hits. The country was already facing several macroeconomic challenges; moderate economic growth and an unsustainable fiscal situation. Although a rigorous consolidation program has been put in place to put public finances back on a more sustainable path, sweeping tax changes implemented in late 2019 have reversed this process, with negative consequences for public revenue collection. Weakness of the external sector due to high repayments of external debt and insufficient foreign exchange reserves to service these debts. The Covid-19 has only exacerbated these macroeconomic challenges. And as a patient who gets over the worst of Covid-19 has a long road to recovery; Sri Lanka’s economy faces many challenges getting back on track.

The appearance of Covid-19 in early 2020 only worsened an already gloomy macroeconomic situation. The country has lost the confidence of international markets and the sovereign’s ability to renew its external debt has become difficult, if not impossible. Under these circumstances, there was a strong case for sovereign debt restructuring. But the response from the government and the Central Bank of Sri Lanka (CBSL) was a firm “no”. The argument was that Sri Lanka had never defaulted on its debt and was not going to do so now. The official position was also that the government had a “plan” to repay its debt and therefore there was no reason to engage in a debt restructuring exercise. However, Sri Lanka faced high debt sustainability risks: the debt-to-gross domestic product (GDP) ratio at 110% was one of the highest in history and interest payments on revenue over 70% were among the highest in the world.

Fast forward to 2022. The country’s foreign exchange reserves have declined to $ 3.1 billion (2). Usable reserves are much lower. CBSL has sold more than $ 200 million of the country’s gold reserves to meet its debt obligations. In the first week of 2022, CBSL announced new swap facilities and its commitment to repay the $ 500 million International Sovereign Bond (ISB) due in January. According to Central Bank statistics, in addition to the BSI payment, there are predetermined outflows of foreign exchange reserves amounting to $ 1.3 billion in the first two months of 2022.

In addition, based on trade data for the past five years, the country has on average a trade deficit of around $ 2 billion to finance in the first quarter of the year (Table 1). With expected tourism flows threatened by the appearance of the Omicron variant and the continuing decline in workers’ remittances, funding this external current account deficit will add further pressure on available foreign exchange reserves. India, which accounted for around 20% of recent tourist arrivals, is now forcing returnees to the country to self-quarantine. This will probably further curb tourist arrivals.

In this context, the country faces a trade-off between using its limited foreign reserves to repay its debt or using them to finance essential imports. $ 500 million is enough to finance fuel imports for five months; or pharmaceuticals for one year; or dairy products for a year and a half; or fertilizer for two years.

Table 1: Summary of the performance of the external sector Q1 – 2017 to 2021 (millions $)

Q1 2017 Q1 2018 Q1 2019 Q1 2020 Q1 2021
Exports 2,774 2 989 3 156 2,650 2 982
Imports 5,279 5,971 4 817 4,503 5,041
of which sugar and confectionery 63.8 88.1 48.9 73.1 137.4
Medical pharmaceuticals 125.2 130.0 121.8 125.4 143.8
Fuel 882.6 1075.2 1,019 948.2 977.2
Trade balance -2,505 -2 982 -1.661 -1 853 -2,059
Tourism income 1,122 1,329 1,396 682 13
Workers’ discounts 1 911 1 979 1,617 1,600 1,867
Global balance -176 -311 912 143 -1 101
Note:
International reserves (billion $) 5.1 7.3 7.6 7.5 4.1
(Months of imports) 3.1 4.1 4.3 4.6 2.9

Therefore, it is in the best interests of the country and its citizens that the government postpone paying its debt and use its limited foreign reserves to ensure an uninterrupted supply of essential imports. But it requires a plan. To minimize the cost to the economy, the government must immediately engage its creditors in a debt restructuring exercise. This will require a Debt Sustainability Analysis (DSA) by a credible agency to identify the resources needed for debt relief and the economic adjustment needed to put the country back on a sustainable path (3). This will be essential to bring creditors to the negotiating table and assure them that the country is able and willing to repay its debt obligations in the future.

The cost of not restructuring is much higher. A non-negotiated default (if and when the country runs out of options to service its debt) would result in a greater loss of production, loss of access to finance, or a high cost of future borrowing for the sovereign . It could even spill over into the national banking sector, triggering a banking or financial crisis.

The consequences are clear. What will we choose?

The references:

Sri Lankan sovereign bondholders have been anticipating debt restructuring for over a year and a half and the losses have been reflected on the market basis.Foreign exchange reserves at the end of December 2021 reached 3.1 billion US dollars with the inclusion of the swap with the People’s Bank of China which had been excluded in previous months. Given that the IMF has just completed its Article IV review, this assessment has likely already been undertaken.

(Dr Roshan Perera is Principal Investigator at the Advocata Institute and former Director of CBSL. Dr Sarath Rajapatirana is the Chair of the Academic Program at the Advocata Institute and former Economic Advisor to the World Bank. He has served as the Director and the principal author of the World Development Report 1987 on trade and industrialization. The Advocata Institute is an independent think tank on public policy)

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The views and opinions expressed in this column are those of the authors and do not necessarily reflect those of this publication.