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Saturday July 20th, 2024

Sri Lanka bondholder deal gives NPV benefit of 40-pct, 27-pct in upside: FinMin

ECONOMYNEXT – Sri Lanka’s deal with bondholders gives a benefit of 27 percent in net present value terms even if gross domestic produce grows faster than projected in an International Monetary Fund program, the Finance Ministry said.

Under the baseline scenario Sri Lanka would get an NPV benefit of 40 percent.

If GDP grows faster than expected, and part of the hair cut is reversed, Sri Lanka would still get a benefit of 27 percent, the statement said.

The discount rate used is 11 percent.

The full statement is reproduced below.

The negotiated Joint Working Framework enables a fair sharing of upside or downside between
creditors and Sri Lanka in case of an economic over-performance or under-performance by Sri Lanka.

• Any upside payouts would only occur in a manner that does not compromise Sri Lanka’s longer
term debt sustainability.

• The risk of higher payouts being triggered whilst capacity to pay is weak is mitigated by the
inclusion of a control variable. Therefore, any increased payments would be to a great extent be
balanced by enhanced capacity to pay.

• The baseline scenario results in a NPV effort of 40% at a discount rate of 11% whilst the scenario
with the highest payments by Sri Lanka (resulting from the most significant economic overperformance) would result in a NPV effort of 27% at a discount rate of 11%.

1. Background

Following successive credit rating downgrades and the loss of access to global capital markets in early 2020, Sri Lanka’s foreign currency reserves steadily declined until by April 2022, usable reserves had declined to near zero levels. On April 12th 2022 the government implemented a temporary moratorium on the service of Sri Lanka’s official bilateral debt and external commercial debt.

The government commenced discussions with the International Monetary Fund (IMF) in April 2022 with a view to implementing an IMF-supported macroeconomic reform programme to address the root causes of the economic crisis. The IMF’s lending rules require that a county’s debt sustainability is restored, and therefore Sri Lanka simultaneously commenced the process of restructuring its public debt. In accordance with the norms of the global sovereign debt restructuring architecture, Sri Lanka hired globally renowned financial advisors Lazard Frères and legal advisors Clifford Chance to support the process of restructuring the debt.

International Sovereign Bonds (ISBs) account for USD 12.5 billion of face amount of debt, out of total central government external face amount of debt of USD 37 billion as of end 2023. Accordingly, these bonds were included in the perimeter of debt restructuring. The holders of ISBs organised themselves into two groups to negotiate the restructuring of the ISBs. The larger group, controlling approximately 50% of the aggregate outstanding amount, comprised some of the largest international holders of ISBs, which formed the Ad-Hoc Group, represented by a steering committee advised by financial advisors Rothschild & Co, and legal advisors White & Case. The second group comprised Sri Lankan domestic financial market holders of ISBs, controlling approximately 12% of the aggregate outstanding amount. The local consortium is advised by Newstate Partners and Baker McKenzie.

2 Process of Debt Restructuring

The first step in the process of debt restructuring is the preparation of the Debt Sustainability Analysis (DSA) by the IMF. The DSA informs the level of debt relief to be obtained through the process of debt restructuring with the goal of restoring debt sustainability. Sri Lanka is among the first countries where debt restructuring was based on the IMF’s new DSA framework, the Sovereign Risk and Debt Sustainability for Market Access Countries (MAC SRDSF). According to Sri Lanka’s DSA as per the MAC SRDSF model, the following targets would need to be achieved in order to restore debt sustainability in the country.

i. Public Debt to GDP should reduce from 128% of GDP in 2022 to less than 95% of GDP by 2032

ii. Gross Financing Needs (GFN) as a percentage of GDP should reduce from 34.6% in 2022 to less than 13% on average during the period 2027-2032

iii. Foreign currency debt service as a percentage of GDP should reduce from 9.2% of GDP in 2022 to no higher than 4.5% of GDP per annum during the period 2027-2032

Accordingly, in order to restore debt sustainability, Sri Lanka would need to negotiate with its various groups of creditors in order to obtain debt relief in a manner that would enable the above targets to be met.

It is also necessary for Sri Lanka, in line with the commitment made by Sri Lanka to its creditors at the start of this process, to ensure comparability of treatment (COT) between different groups of external creditors. This is a complex process since different creditors provide debt relief through different adjustments.

Official creditors for instance typically provide debt relief in the form of grace periods, maturity extensions, and interest rate reductions without providing a nominal haircut on principal. Most bondholders on the other hand prefer to include some nominal haircut on principal, whilst typically having shorter maturity periods and a market compatible interest rate structure. The magnitude of debt relief is therefore decided on the collective cashflow relief provided through the combination of grace periods, interest rate reductions, maturity extensions, and nominal haircut, if any. Sri Lanka’s debt restructuring has to ensure that the present value of the cashflow relief provided through these different methods of restructuring, is largely comparable between the different external creditors.

The Paris Club Secretariat plays a key role in assessing comparability of treatment in different debt restructuring scenarios1.

Sri Lanka’s external debt restructuring process includes the following creditor groups, each of which required separate negotiations whilst ensuring comparable treatment amongst them all;

i) Official Creditor Committee of official bilateral lenders (Co-chaired by France, India, and Japan):
USD 5.8 billion (as of end-2023)

ii) China Exim Bank: USD 4.2 billion

iii) Other Official Creditors (Kuwait, Saudi Arabia, Iran, Pakistan): USD 0.3 billion

iv) International Sovereign Bonds: USD 14.2 billion2

a. International sovereign bondholders: Ad-Hoc Group

b. Domestic sovereign bondholders: Local Banking Consortium

v) China Development Bank: USD 3.2 billion3

vi) Other Commercial Creditors: Under USD 0.2 billion

Any debt restructuring agreement reached by Sri Lanka, including the ISB restructuring, would need to pass two tests:

i) Ability to meet the debt relief targets as set out in the DSA in order to restore debt sustainability,
as assessed by the IMF

ii) Ensure comparability of treatment between different groups of creditors, as assessed by the Paris Club Secretariat

The restructuring of Sri Lanka’s official bilateral debt has been addressed in a separate press release4.

3 Negotiations with the Ad-Hoc Group of Bondholders: Macro-linked Bonds

Technical negotiations on debt restructuring began once the IMF’s DSA was published with the IMF Board’s approval of the Program in March 2023. Subsequently, Sri Lanka through its debt advisors shared indicative restructuring treatments with each of its different external creditor groups. These indicative restructuring terms proposed a basis for restructuring debt in a manner that would reach the DSA targets and also address any concerns regarding Comparability of Treatment.

The Ad-Hoc Group (AHG) responded to Sri Lanka’s indicative treatment with a counter-proposal that was subsequently published in the public domain in October 20235. This proposal introduced for the first time the concept of Macro-Linked Bonds (MLB). The AHG took the view that the IMF’s macroeconomic framework, including the GDP estimations that underpin the DSA targets, were overly pessimistic.

The AHG position remains that Sri Lanka will outperform the IMF framework, primarily through a less depreciated FX rate trajectory, and such outperformance will create additional debt service payment capacity, which should be shared between the creditor(s) and debtor. The MLB is designed as an instrument that enables such sharing of upside without compromising debt sustainability, whilst also sharing the downside risk.

The AHG’s view is that in reality, Sri Lanka’s USD GDP will be higher than projected by the IMF, and thereby the DSA targets to restore debt sustainability could in their opinion be reached with a lower level of debt relief. For example, with a higher than anticipated USD GDP figure, the denominator in the public debt/GDP would be higher, thereby enabling the DSA target to be reached with a smaller downward adjustment to outstanding debt (the numerator).

A well-designed MLB with appropriate thresholds and adjustments would provide a mechanism for sharing of upside whilst ensuring the country’s long term debt sustainability is maintained. However, as in many cases, it is the details of such thresholds and adjustments that matter. Sri Lanka rejected the AHG’s October 2023 proposal6 due to concerns regarding the ability of the proposal to meet the DSA targets, concerns regarding asymmetry of sharing of upside but not downside, and concerns regarding the nature of the test which determines any adjustment. Subsequently, Sri Lanka, through its advisors, shared further counter-proposals with the advisors of the AHG, which did not meet their requirements.

4. Restricted Discussions in March 2024

On the 27th-28th March 2024, the Government of Sri Lanka and the Steering Committee members of the AHG held restricted discussions in London on the restructuring of ISBs7. At such meetings, the parties discussed a fresh proposal submitted by the AHG in March 2024 and a counter-proposal submitted by Sri Lanka, which also included GDP-linked instruments. Sri Lanka’s March proposal was found to be compliant with the DSA as assessed by the IMF, whilst the AHG proposal was not.

Whilst the London negotiations failed to reach a consensus, it was possible to distil four outstanding areas that required resolution;

i.The choice of baseline parameter: Sri Lanka insisted on using the IMF macro baseline as the
baseline whereas the AHG used its more optimistic “alternative baseline”.

ii. Inclusion of downside risk: Whilst the AHG only included one downside scenario (where there would be a larger debt relief in case Sri Lanka’s actual macroeconomic performance was below the baseline), Sri Lanka proposed to include additional downside scenarios to ensure appropriate balance of risks

iii. Choice of trigger: The AHG insisted on a single trigger (nominal GDP in USD terms), Sri Lanka preferred to have a dual test which would give Sri Lanka protection in case GDP growth was purely due to currency over-valuation. The AHG did however agree to Sri Lanka’s request to increase the period of the trigger from 2 years to 3 years, giving Sri Lanka more protection.

iv. Share of upside: The AHG proposal saw most of any potential upside being allocated to bondholders, whereas Sri Lanka suggested a more even share of upside.

5. Joint Working Framework June 2024

Immediately following the finalisation of a memorandum of understanding (MOU) with the Official Creditor Committee (OCC) and restructuring agreements with Exim Bank of China on 26th June 2024, the AHG and Sri Lanka resumed restricted negotiations on the 27th – 28th of June in Paris. The AHG had submitted a new proposal which made further adjustments to address Sri Lanka’s concerns on the four outstanding points. During the negotiations in Paris, further adjustments were agreed in a Joint Working Framework, as follows:

i. Choice of baseline parameter: The IMF baseline from the June 2024 second review of the IMFsupported Program would be applied.

ii. Inclusion of downside risk: Additional downside scenarios were included, providing Sri Lanka with further debt relief in case of an adverse macroeconomic outcome.

iii. Choice of trigger: Sri Lanka had concerns regarding the AHG’s preference for a single trigger due to a perceived risk of nominal USD GDP increasing only based on currency appreciation as opposed to real GDP growth. In the absence of real GDP growth, there could be a risk of higher payouts being triggered without concomitant increase in government payment capacity. Therefore, a “control variable” which captures real GDP growth as well, was agreed.

iv. Share of upside: The upside thresholds and payouts were adjusted to ensure a more balanced share of upside between creditor and debtor.

The upside/downside trigger is calculated based on average USD GDP during the years 2025-2027. In 2023, USD nominal GDP was USD 84.4 billion. Taking Sri Lanka’s nominal USD GDP average annual growth in the last 10 years, it was 1.5% per year. Taking the last 5 years pre-pandemic (i.e. 2015-2019), it was 2.4% per year (in 2015 GDP was USD 79.4 bn and in 2019 it was USD 89 bn).

Hypothetically, if USD GDP were to grow by 4% each year during the period 2024-2027, the resulting upside trigger, average USD GDP during 2025-2027, would be USD 95 bn.

6. Conclusion

The Joint Working Framework negotiated with the AHG provides a fair balance of risk sharing and sufficiently addresses the concerns of Sri Lanka and the requirements of bondholders. The MLB structure, following the adjustments made through the evolution of the proposed instrument, enables the appropriate sharing of upside between creditors and the debtor, whilst also ensuring that in this process, the debt sustainability of the debtor sovereign is not compromised.

These terms require formal confirmation by the Secretariat of the Official Creditor Committee and the IMF staff in order to confirm conformity with comparability of treatment requirements and compliance with Sri Lanka’s IMF program debt sustainability targets.

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Jayampathy Wickramaratne PC, responds to President on constitutional article 83

ECONOMYNEXT – Jayampathy Wickramaratne, President’s Counsel had responded to a statement made by President Ranil Wickremesinghe that Article 83 (b) of the constitution which has reference to a six year term was left alone not due to any ‘lapse’ on his part.

A Cabinet sub-committee headed by Premier Wickremesinghe was appointed to oversee the Nineteenth Amendment process.

The changes to the Constitution, were made by a team of legal officers of which he was member, overseen by a Cabinet sub-committee headed by then Prime Minister Ranil Wickremesinghe.

“Presidential candidate Maithripala Sirisena signed a memorandum of understanding with a group of 49 political parties and organisations headed by the Venerable Maduluwawe Sobitha Nayaka Thero at Viharamaha Devi Park, in which he pledged to abolish the Executive Presidency altogether,” Wickramaratne explained.

“However, the very next day, he signed another MOU with the Jathika Hela Urumaya, in which he pledged not to make any constitutional change requiring a Referendum. Mr Sirisena’s election manifesto also stated that no constitutional reform necessitating a Referendum would be initiated.”

The Attorney General also made sure that there were no changes that required a referendum, he said. As a result Article 83 (b) was left as it was.

The full statement is reproduced below:

On President Wickremesinghe’s statement that not amending Article 83 was a lapse on my part

The President stated in Galle on 19 July 2024 that not reducing the upper limit of the term of the President and Parliament from six to five years while preparing the Nineteenth Amendment to the Constitution was a lapse on my part due to my inexperience.

I wish to set the record straight.

Presidential candidate Maithripala Sirisena signed a memorandum of understanding with a group of 49 political parties and organisations headed by the Venerable Maduluwawe Sobitha Nayaka Thero at Viharamaha Devi Park, in which he pledged to abolish the Executive Presidency altogether.

However, the very next day, he signed another MOU with the Jathika Hela Urumaya, in which he pledged not to make any constitutional change requiring a Referendum. Mr Sirisena’s election manifesto also stated that no constitutional reform necessitating a Referendum would be initiated.

Soon after being sworn in, President Sirisena appointed Mr Ranil Wickremesinghe as Prime Minister. Constitutional affairs was Gazetted as a subject under Prime Minister Wickremesinghe. A Cabinet sub-committee headed by Premier Wickremesinghe was appointed to oversee the Nineteenth Amendment process.

The five-member team that prepared the initial draft comprised three retired officials who had served in very senior positions in the Legal Draftsman’s Department, myself and another lawyer.

The entire drafting process was carried out on the basis that the Bill should not be placed for approval at a referendum, in keeping with President Sirisena’s electoral pledge. While the terms of the President and Parliament were proposed to be reduced from six to five years, the upper limit of six years was not touched as that would require a Referendum.

Article 83 of the Constitution mandates that a Bill that seeks to amend or is inconsistent with particular Articles listed or the said upper limits would be required to be passed by a two-thirds majority in Parliament and approved by the People at a Referendum.

It is essential to note that Article 83 itself is included in the list of provisions requiring a Referendum. The several drafts prepared were all shared and discussed with the Cabinet sub-committee.

The draft finally approved by the Cabinet sub-committee was then sent to the Legal Draftsman, who took over as required by law and made some changes. It was then sent to the Attorney-General, who took the view that certain clauses, especially some that reduced the powers of the President, would require a Referendum. Prime Minister Wickremesinghe had several meetings with the Attorney General to discuss the matter. I participated in one such meeting. Several changes had to be made to the Bill because of the Attorney-General’s position.

Prime Minister Wickremesinghe presented the Bill to Parliament. When it was challenged in the Supreme Court, the Attorney-General argued on behalf of the Government that no provision required a Referendum. The clauses that the Supreme Court held to require a Referendum were either amended or withdrawn in Parliament.

In light of the above, I regret that President Wickremesinghe has thought it fit to place the entire blame on me for not reducing the upper limits of the President’s and Parliament’s terms.

I reiterate that the entire amendment process was based on avoiding a Referendum following President Sirisena’s pledge at the Presidential election.

(Dr) Jayampathy Wickramaratne, Presidents Counsel
20 July 2024.

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Sri Lanka banking system foreign assets turn positive in May: analysis

ECONOMYNEXT – Net foreign assets of Sri Lanka’s banking system turned positive in May 2024, official data showed, amid a steady reduction in the negative reserve position of the central bank helped by the current interest rate structure and domestic credit.

In May the combined net foreign assets position of commercial banks and the central bank was about 311 million US dollars by May, up from a negative 178 million US dollars a month earlier, central bank data show.

It was made up of positive 1.9 billion US dollar foreign assets position in overseas banking units and a negative 811-million-dollar position which gave a positive NFA position of about 1.13 billion US dollars for banks.
The central bank still had a negative position of about 821 million dollars by May, down from about 4.5 billion US dollars in last currency crises triggered by deploying liquidity tools (printing money) to cut rates.

The central bank has been collecting reserves for several months, except in June after a confidence shock from the flexible exchange rate and some injections made to keep rates down.

Analysts have warned that under flexible inflation targeting, where there are anchor conflicts, external imbalances will re-emerge when private credit recovers and money is printed to cut rates.

Printing after giving Reserves for Imports

Sri Lanka’s central bank ran up a negative foreign assets position, by spending dollars borrowed from the International Monetary Fund and from other central banks including in Bangladesh and India as well as domestic banks and spending them to suppress market interest rates and finance imports.

An ‘age-of-inflation’ (or age-of-BOP-deficit) central bank that spends reserve for imports, simultaneously prints money into banks, injecting excess rupee reserves to maintain an artificial policy rate, preventing the outflow of real resources to other countries being reflected in bank balance sheets.

The printing of money after spending reserves, or the sterilizing of an outflow, allow banks to give loans without deposits and trigger forex shortages.

To collect foreign assets, a central bank has to do the opposite, and sell its domestic asset portfolio down against dollars purchased from banks, at an appropriate interest rate, which will moderate domestic credit.

Modern IMF-prone reserve collecting central banks are able to mis-target rates beyond their reserves mostly with the aid of Central bank swaps.

Sri Lanka’s central bank also borrowed reserves from domestic banks through swaps, in a somewhat similar operation to the way Lebanon’s central bank borrowed dollars to show reserves instead of buying outright against domestic assets.

Borrowed Reserves

Central bank swaps were invented by the Federal Reserve to mis-target rates and avoid giving gold reserves as macro-economists printed money to target growth in the 1960s and the printed dollars boomeranged on itself from other Bretton Woods central banks that focused on stability.

RELATED Central bank swaps symptomatic of Sri Lanka’s IMF return tickets and default: Bellwether

By March 2022, before rates were hiked, negative reserve position of Sri Lanka’s central bank was around 4.0 billion US dollars.

The negative position worsened to around 4.5 billion US dollars by the third quarter of 2022, helped by credits from Reserve Bank of India, which allowed Sri Lanka to run arrears on Asian Clearing Union balances.

In addition to the swaps, Sri Lanka also had borrowings from the International Monetary Fund which contributed to the negative foreign assets position.

The IMF borrowings came from serial currency crises triggered in the course of money printing to enforce rate cuts and target growth (potential output) and generate twice to three times the level of inflation found in monetarily stable countries through ‘flexible’ inflation targeting.

The external sector started to balance only after ACU credits were stopped. It has since been turned into a swap and the central bank is paying it down steadily in the current interest rate structure.

Related Sri Lanka repays US$225mn to Reserve Bank of India in first quarter

Sri Lanka was unable to use a People’s Bank of China swap to mis-target rates and boost imports its use was barred after gross reserves fell below three months of imports.

Private and State Banks

Sri Lanka’s private and state banks also had negative foreign assets for many years, due to lending to the government through US dollar Sri Lanka Development Bonds and other credits. The dollar loans to the government were financed in part by foreign credit lines.

As downgrades hit the country, and forex shortages worsened from flexible inflation targeting/potential output targeting, banks could not renew their credit lines.

Some banks avoided rolling over Sri Lanka Development Bonds. After the default and debt restructure, they were repaid in rupees leading to banks covering their open positions. The dollars are banked abroad, leading a net foreign assets position.

An improvement of net foreign assets, reflects an outflow of dollars from the domestic economy to foreign accounts, similar to repaying debt for building foreign reserves.

The foreign assets position of banks excluding the central bank turned positive in February 2023 and reached around a billion US dollars by the year end and has remained broadly stable around those levels in 2024r.

RELATED Sri Lanka bank net foreign assets turn positive: analysis

The stabilization of the NFA position in banks may allow the central bank to collect more foreign reserves than earlier, analysts say, at the current interest rate structure as long as money is not injected overnight or term injections to mis-target interest rates claiming inflation was low.

Any confidence shocks from the ‘flexible’ exchange rate or liquidity spikes, would also reduce the ability of the central bank to collect dollars and lead to mini ‘capital flight’ style episodes from importers and exporters. (Colombo/July20/2024)

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New constitutional amendment a ‘necessary revision’: Sri Lanka President

ECONOMYNEXT – Sri Lanka’s President has said a proposed amendment to the country’s constitution was a ‘necessary revision’, which would not result in a postponement of elections.

“In 2015, we proposed a new constitutional amendment,” President Wickremesinghe was quoted as saying during a ceremony to open a court complex in Beligaha, Galle on Friday.

“Typically, I would have assigned this task to K N Choksy, a lawyer.

“However, since he had passed away, the responsibility fell to lawyer Jayampathi Wickramaratne. He was unable to make the necessary revisions. This oversight is regrettable, and I apologize to the nation for it.”

President’s Counsel Wickramaratne has explained that the leaving out Section 83 (b) of the constitution was a not an “oversight” but it was a result of instructions received from the then administration to avoid making changes that required a referendum.

President Maithripala Sirisena in his election manifesto has pledged not to make changes that required a referendum, and the drafting team was told not to make changes that would require a referendum.

Related Sri Lanka’s 6-year Presidential term: problem in drafting 19th amendment explained

Meanwhile President Wickremesinghe said the move to change the constitution should not lead to a delay in elections.

“Our country has upheld democracy since 1931,” he said. “Protecting democracy is crucial. The upcoming election is on schedule, with the Chief Justice and the Supreme Court confirming that it should be held within the specified timeframe, and we support this directive.

“Some critics argue that democracy is at risk during certain crises. However, our constitution, judiciary, and political system have worked to advance and protect it. The most significant threat to our democracy occurred in 2022, yet we have continued to progress through consensus.”

Sri Lanka became the first country in Asia and Africa to grant universal suffrage in 1931, Wickremesinghe said.

“Unlike in the United States, where some states did not extend voting rights to Black people, Sri Lanka is unique for maintaining democracy continuously since then.

“Despite facing wars and rebellions, Sri Lanka has preserved its democratic system, and democracy has remained intact despite numerous challenges.”

Sri Lanka got universal suffrage under British rule.

In Sri Lanka, power transitions smoothly and without conflict after elections, the president said, “a testament to the strength of our democratic process. Despite various debates and issues, democracy has never been compromised.”

Opposition parties and lawyers have charged that the legal process involving changing the constitution could potentially delay the upcoming Presidential elections.

“Article 83 of the Constitution of the Democratic Socialist Republic of Sri Lanka is hereby amended in paragraph (b) thereof, by the substitution for the words “to over six years,”, of the words “to over five years,” the gazette notice issued on the orders of Wickremesinghe says.

Download bill 523-2024-bill-constitution-EN

There is a discrepancy in the Article 83 with reference to a six year term, while the rest of the constitution, refers to a five year term. (Colombo/July19/2024)

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