ECONOMYNEXT – An offer to exchange Sri Lanka’s defaulted bonds with a new sovereign security which will pay less if the island’s future economic growth is lower than expected, is under consideration among investors, sources said.

Sri Lanka defaulted on its external debt in April 2022 after printing money to target what state economists said was a ‘persistent output gap,” after growth fell in the wake of two currency crises triggered in the process of injecting liquidity to target 5 percent inflation.

Sri Lanka’s private and official creditors have to re-structure debt, that will bring the gross financing need (GFN) or the total debt rolled over and new deficit financing down to 13 percent of gross domestic product from 2027 to 2032, under an International Monetary Fund backed plan to get the country out of bankruptcy.

Of that foreign debt service is 4.5 percent of GDP.

However, many private foreign creditors believe that Sri Lanka’s projected growth of around 3 percent in the few years by the International Monetary Fund are too pessimistic, according to sources with knowledge of the discussions.

A lower GDP number would also squeeze the 4.5 percent foreign debt service ceiling, pushing foreign creditors to take deeper losses than they would take if actual growth was higher.

If the macro-economic framework particularly the GDP and the foreign exchange projections, are “reasonable” bondholders would close a deal very quickly, perhaps as early as June 2023, sources said.

If there are disagreements over growth projections, negotiations could drag on for “years” as creditors waited to see whether actual growth would be higher than projections.

A way out of the potential deadlock would be to issue a new bond linked to economic performance, generally known as a State Contingent Debt Instrument or SDCI.

“By tying the payments of restructured debt contracts to future outcomes, SCDIs may reduce conflicts over current valuations and facilitate more sustainable agreements between creditors and debtors,” according to an IMF paper in which Sri Lanka’s Senior Mission Chief Peter Breuer was a co-author.

In past sovereign workouts, an SCDI called a value recovery instrument (VRI) which will pay more if a country outperformance projections, have been used.

VRI are not bonds, but warrants and had been shunned by most bond investors. They were traded close to zero at the beginning and were not index eligible. As a result, bond investors had to sell them, perhaps ate a loss usually to hedge funds, reducing their attractiveness.

“Fixed-income investors have typically steeply discounted these “equity-like” instruments given their nonstandard designs, illiquidity, and idiosyncratic risk profiles; hence they have often provided poor value for their cost to borrowers,” according to the paper.

What is now contemplated by some bondholders is not a VRI but a bond, which will start out with more optimistic assumptions. Its cashflows will fall if actual growth falls to levels projected by the IMF.

“In Surinam and Zambia the difference expectations or projections by the IMF and creditors have led to a deadlock in the re-structuring negotiations,” the source said.

“I hope we will be able to avoid it and we can find a compromise.”

Over 75 percent of Sri Lanka’s current bond holders are estimated to be long term investors who had bought bonds close to par including at launch, according to the source.

“That is why they are not going to agree to silly economic assumptions,” the source said. “That is why also in case there is no way to bridge the gap between expectations, the re-structuring could last years.”

Public IMF projections show a growth of around 3.1 percent in the next few years. When Sri Lanka started flexible inflation targeting cum output gap targeting, the country’s ‘potential output’ was calculated at over 5.0 percent. (Colombo/Mar22/2023)