ECONOMYNEXT – Sri Lanka’s private creditors are not looking for authorities to impose a haircut on domestic debt but a re-profiling to ensure that gross financing targets are met, sources with knowledge the situation said.
According to a letter purportedly sent by India to the IMF which is now in the public domain, Sri Lanka expects to maintain its gross financing need (GFN) made up of deficit financing and old debt roll-overs remain below 13 percent of gross domestic product in the period 2027-32.
The annual foreign financing has to be below 4.5 percent of GDP, leaving 8.5 percent for domestic debt.
The financing requirement has shot up to over 30 percent of GDP now, based on recent disclosures, which has to be gradually brought down through re-structuring, GDP growth and lower new accumulation of debt with a smaller deficit.
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However, there are concerns that the GFN target cannot be met given the domestic debt volumes and current interest rates without a domestic debt re-structuring.
To the extent that domestic debt is not re-structured foreign investors would be required to take a bigger hit.
Private investors are prepared to consider a menu of options involving maturity extension as well as some principal reduction provided, if they have confidence in final outcome of the re-structuring plan, sources said.
Investors are not looking for a principal hair cut on domestic debt, but a re-profiling (extending maturities) to meet the 8.5 percent GFN requirement of the IMF deal and a plan to address current high interest rates which tend to balloon debt in the future, sources said.
Sri Lanka – and countries with impossible trinity or dual anchor monetary regimes now called flexible exchange rates- where money and exchange policies conflict generally have high nominal interest rates and inflation, which are absent in single anchor regimes (clean floats or hard pegs).
Hard pegs for example have interest rates marginally higher than the anchor currency – usually 50 to 100 basis points.
Sri Lanka’s interest rates, which have to be hiked periodically after liquidity injections trigger forex shortages, have tended to collapse shortly after a successful float and the approval of an IMF deal, negative private credit, reduced losses of energy utilities, and a lower budget deficit from tax hikes.
Interest rates can fall to single digits about 3 years after a currency crisis.
However, this time the currency depreciation is steeper than in previous crises (from 182 to 370 to the US dollar) and there has been no explicit float to restore the credibility of the peg to the market, though external stability has been restored after phasing out liquidity injections.
In December bought 102 million dollars more than it sold in running a peg at 360/370 to the US US dollar but confidence in the currency peg has not been restored in the market.
Exporters are still not selling forward actively.
In past crises rates usually start to fall a few months into the IMF program and domestic banks which have curtailed private credit are flushed with liquidity from the foreign asset purchases of the central bank, pushing call rates to the bottom of the corridor.
Banks usually pile into government bonds as private credit turns negative, and make capital gains as rates fall about a year into the IMF program.
In this currency crisis cycle due to domestic debt re-structuring concerns and high risk perceptions, cash plus banks have deposited money in the central bank window.
The central bank recently closed the window to encourage banks to buy bills or lend in the interbank market.
Authorities have said a domestic debt re-structuring will hurt banks.
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Some Sri Lanka banks have bought longer term bonds at very low rates and are most at risk. Banks are expecting regulatory forbearance and staggered accounting relief to cope.
Sri Lanka has already hiked taxes, to reduce the budget deficit and President Ranil Wickremesinghe has also announced spending-based consolidation, departing an earlier plan of expanding the state under revenue based fiscal consolidation, allowing retirements to reduce the public sector.
He has also announced privatization plans. Sri Lanka’s nominal tax revenues have climbed partly due to inflation and negative real rates (a phenomenon known as High Inflation and Financial Repression) which delivers a real or dollar based hair cut on domestic debt. (Colombo/Jan31/2023)