ECONOMYNEXT – Sri Lanka has reached a deal with bondholders involving hair cuts of 28 percent on bonds and 11 percent on interest arrears with the principal on some securities called macro-linked bonds to 15 percent if GDP grows at higher speeds.
What are the basic terms?
Sri Lanka could exchange 12.550 billion dollars of bonds into new instruments with a hair cut of 28 percent or 9.036 billion dollars maturing from 2029 to 2038. Two bond tranches maturing in 2034 and 2035 would be standard bonds with a coupon. Some of its could be made into bonds where improving governance would lead to a fall in coupons.
Such bonds called Environmental Social Governance (ESG) have been issued in different contexts by governments in the past. Sri Lanka’s Verete Research the proposal to bondholders.
Related Sri Lanka bondholders agree on 28-pct hair cut; GDP-gains capped at 15-pct
What happens to the past due interest?
Past due interest will be turned into new bonds paying a fixed 4.0 percent coupon. This is comparable or lower than current US Treasuries for similar maturities.
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In an April proposal, bondholders did not agree to a hair cut on past due interest. In July, an 11 percent haircut has been agreed.
What are macro-linked bonds?
Macro-linked bonds are a new type of instrument whose principle will go up (or down), based on whether Sri Lanka’s dollar GDP will grow at speeds higher or lower than projected by the International Monetary Fund in a debt sustainable analysis.
The hair cut on macro-linked bonds could reduce to 15 percent if Sri Lanka’s GDP grows fast and increase to 40.4 percent if the economy grows below 3.1 percent as forecast by the IMF.
Value recovery instruments (VRIs) or state contingent debt securities (SCDIs) have been issued by defaulting governments, including in the current default wave. The difference in Sri Lanka’s new bonds is that the benefit will accrue to the holder of the bond who exchanges the defaulted bonds rather than a third party.
Why do bondholders want macro-linked bonds?
For two reasons.
Bond holders believe Sri Lanka’s economic growth will be higher than projected by the IMF in a debt sustainability analysis.
They also believe the IMF projections are too low and are either deliberately pessimistic (to help Sri Lanka and squeeze more out of creditors) or cautiously conservative. In either case, it will squeeze the 4.5 percent of GDP window for foreign debt service from 2027-2032 and will force bondholders to take bigger haircuts than Sri Lanka can actually afford.
Many of Sri Lanka’s bondholders say they have bought the bonds at par. They are not hedge funds but ‘real money’ funds. As a result, they cannot hold securities that are not index eligible and are forced to sell the VRIs at early stages at low prices. From the country’s perspective it is irrelevant whether the gains go to hedge funds or the owners of the bonds.
Why do bondholders agree to hair cuts and not bilateral creditors?
Sovereign bonds are already trading at severe discounts and they want more liquid short-term instruments. It does not really matter whether they bought the bonds at low prices or not, since their secondary market value is already low and coupons are in default.
If Sri Lanka’s debt is made easier to service due to compliance with IMF’s debt sustainability analysis, confidence will return to Sri Lanka’s bonds. It does not matter whether this is actually so. All that matters is for markets to believe that the IMF plan is credible and then bonds will trade close to par.
Could Sri Lanka have avoided going into macro-linked bonds?
Highly unlikely. Some bondholders were said to have been prepared to wait till 2028 to show that the actual GDP growth would be higher than the IMF prediction and therefore the actual debt service window at 4.5 percent would allow for bigger payments.
Whether this is a credible threat is not known but they could certainly have delayed the restructure and prevented Sri Lanka’s rating from being upgraded to above Selective Default.
It is very important to clean up the default fast, for new FDI and stock market investments to come even if Sri Lanka does not want to return to capital markets.
What happened to Greece is a case in point. Compared to Spain and Portugal, which were also in trouble, Greece dragged their feet and refused to make corrections, blamed Germany and made a bigger mess. Spain, which also had an economic bubble from low interest rates compared to its past, on the other had raised taxes and cut wages, and prevented further downgrades of its debt.
Sri Lanka’s central bank and political authorities bit the bullet and saw it through without much fuss making quick policy adjustments. Sri Lanka however avoided broad domestic restructure on a working debt market which would have led to an induced default. Sri Lanka’s selective restructure led to a steepest single day fall in yields ever seen.
Ghana is a prime example of what happens in a full domestic debt restructure, where interest rates are still above 20 percent after broader re-structure involving active buyers. Ghana also has continued monetary instability seen in the exchange rate and inflation, unlike what the Sri Lankas’ central bank has achieved (so far) by keeping a strong exchange rate and undershooting its domestic anchor.
How does the latest deal compare with the original proposal of the bondholders?
The bondholders originally proposed a deal involving a 20 percent haircut, which would become bigger if GDP was lower than the projected by the IMF.
But the interest coupons (to be paid in cash as well as in kind) were very high compared to the interest rates in the final one. In this one, a cap on reversing haircuts has been set at 15 percent.
The impact of interest coupons can be seen in the accumulation of 1.8 billion dollars from the time Sri Lanka defaulted in April 2022 to March 2024.
Haircuts are politically useful but may not have any practical effect. Reduced interest coupons have immediate as well as long term value.
The interest rates proposed (including in the April proposal) are around or below the US Treasuries yields. The macro-linked bonds will pay a high coupon at the tail end of the bond.
Having said that, the criticism of haircut reduction by Sri Lanka’s opposition may have strengthened the hands of Sri Lanka’s negotiators.
Have deeper haircuts actually helped countries?
Though inflationist international macro economists and countries like Argentina make a big deal of haircuts, that do not seem to prevent repeated defaults as the central bank run out of reserves again and again and the currencies collapse, due to a policy rate enforced by printing money.
To go back in history, before the collapse of the Bretton Woods in 1971 which was followed by IMFs’ Second Amendment in 1978 leading to un-anchored monetary policy, defaults were very rare. Before the Second Amendment gave extensive discretion to central bankers (against the legal provisions of monetary laws in many countries) to destroy money on spurious statistical doctrines, government securities for the most part were indeed ‘gilts’.
The initial defaults in the 1980s were all bank debt. Before the 1980s the IMF had no default framework as the world operated on a tighter monetary standard and defaults were rare except in war time or in some big calamity.
As peacetime defaults became common in the 1980s in countries with monetary instability, a more formal framework emerged in part due to US involvement in default workouts though its courts had earlier strengthened their hands.
In terms of anecdotes, Argentina, the country with the original sterilizing central bank, imposed haircuts of up to 75 percent but defaulted repeatedly as its currency collapsed again and again.
The current President is trying to dollarize the nation but is facing opposition from macroeconomists and others.
Juan J Cruces, Christoph Trebesch who made a more formal study of 180 restructurings which were successful, have found that countries with deeper haircuts tended to pay higher interest for a few years and also take longer time to re-access markets.
However empirical studies and statistics should not be confused with logic or reason. Countries that seek deeper haircuts may tend to be those in bigger trouble or have different debt sustainability analysis applicable to poorer countries. They may also be countries with deeper policy problems.
The authors themselves warn that countries in default should not try to minimize their haircut. As a result, it cannot be assumed that countries with lower haircuts will do better and avoid future defaults (or vice versa).
If there is monetary instability, all bets are off in any case.
The results “do not imply that countries in default should try to minimize their haircut,” the authors said.
“Instead, we provide indicative evidence for the existence of a trade-off: achieving a high degree of debt relief now can have benefits in the short-run, but may also imply worse borrowing conditions in the future.
“Further work could complement our findings. In particular, we see the need to study the mechanisms behind our results. Moreover, it could be insightful to assess the determinants of high or low haircuts.”
What is the next step?
A consent solicitation exercise has to be carried out to rope in the rest of the bond holders.
What about Sri Lanka banks which have positions in ISBs?
It is not clear at the moment. Sri Lankas banks have asked for bonds to be repaid in rupees. Any such exercise has to be done within the Debt Sustainability Analysis.
When will the rating be upgraded?
The new bonds will have to be rated by rating agencies when they are issued removing the SD rating. Sri Lanka could also request for a review of the sovereign rating based on improvements to the economy so far.
BW – (Colombo/July04/2024 – Corrected The authors themselves warn that countries in default should not try to minimize their haircut.)