The road to economic recovery in Sri Lanka has been long and challenging. After navigating through its worst economic crisis in history, the country is now beginning to witness signs of revival. Thanks to a comprehensive US$2.9 billion reform program initiated by the International Monetary Fund (IMF) in late March 2023, the Sri Lankan economy is gradually regaining its strength. Coupled with additional funding from the Asian Development Bank, the World Bank, increasing remittances from migrant workers, and a rebound in tourist arrivals, Sri Lanka’s foreign exchange reserves have significantly improved.
With enhanced foreign exchange reserves, the government has been able to ease restrictions on essential imports, leading to a reduction in inflation and the elimination of long queues at fuel stations and mass street protests. However, one substantial challenge still looms over the country’s recovery – its massive sovereign debt.
The State of Sri Lanka’s Debt
When the IMF approved the Extended Fund Facility (EFF) for Sri Lanka, the country’s public debt stood at US$82 billion, equivalent to 128 percent of GDP. Interestingly, the debt was divided almost evenly between domestic and foreign debt. The government faced difficulties in meeting interest payments, with a large portion of its revenue being allocated to servicing these debts. Notably, a significant share of these interest payments was associated with domestic debt.
A Call for Debt Restructuring
A group of institutional investors held US$12.5 billion of Sri Lanka’s outstanding international sovereign bonds. They expressed their willingness to restructure their debt but stipulated that domestic debt should also be restructured concurrently. Initially, the EFF concentrated solely on foreign debt, leading to public apprehension that no restructuring of domestic debt was contemplated. It was only after the implementation of the EFF that the government initiated efforts to restructure domestic debt. The IMF made it clear that “satisfactory progress” in restructuring foreign debt was a crucial milestone for releasing the second tranche of the EFF loan. Additionally, international bondholders insisted on equal treatment for foreign and domestic creditors as a requirement for their involvement in debt restructuring. In response, the government introduced the domestic debt optimization (DDO) program on June 29, 2023, as an extension of the original EFF.
The Domestic Debt Optimization Program
Sri Lanka’s DDO program, unlike those of most other countries, exclusively targets three categories of public debts: Sri Lanka Development Bonds, treasury bills held by the Central Bank, and treasury bonds held by the Employee Provident Fund (EPF). These debts constitute approximately 40 percent of the total domestic debt. It is important to note that the program excludes treasury bills held by commercial banks and the general public, as well as treasury bonds held by domestic commercial banks. While the exclusion of treasury bills held by commercial banks and the public is a common practice, the exclusion of treasury bonds held by domestic commercial banks is unconventional.
Inequity in the Restructuring Plan
In opting to focus solely on “captive” institutions such as the Central Bank and the EPF for debt restructuring, the government has taken the path of least resistance. However, this unequal treatment of commercial banks and domestic government security holders compared to the EPF is an inequitable distribution of the burden of debt restructuring. The EPF’s savings are intended to provide a reasonable post-retirement income for salaried individuals who have already been financially impacted by high inflation and increased taxes. The DDO program would further diminish their future incomes.
The Exclusion of the Banking Sector
The government has put forth several justifications for excluding the banking sector from the DDO program. These include the heavier burden of increased corporate and value-added taxes on banks compared to other corporations, the weakened balance sheets of banks, and the potential negative effects of debt restructuring on these balance sheets. However, ring-fencing the banking system within the debt-restructuring program only serves as a temporary solution to the underlying fragility of the banking sector. Addressing this fragility must be an integral part of the proposed structural reforms to safeguard the stability of the financial sector.
The Need for Comprehensive Debt Restructuring
Contrary to initial expectations, restructuring domestic debt is crucial for Sri Lanka to overcome its economic crisis. However, for lasting stability, it is imperative that the government adopts a comprehensive approach to debt restructuring, including contingent reforms within the broader framework of the EFF. This comprehensive approach will help instill confidence in the banking system, among other necessary measures.
Striving for Equity and Social Consensus
The current proposed partial DDO program lacks fairness as it disproportionately burdens salary earners and ordinary citizens while sparing the banking sector. The program also extends generous treatment to international and individual domestic creditors. Such an approach does not foster the social and political unity necessary to obtain broad consensus on reforms.
Safeguarding Financial Stability
The strategy of shifting the burden of domestic debt restructuring onto the Central Bank, while disregarding the fragile balance sheets of commercial banks, contradicts the EFF’s objective of safeguarding financial stability. Research on debt crises demonstrates that a banking crisis can intensify the economic losses resulting from a debt default, or even derail the reform process.
In conclusion, Professor Prema-chandra Athukorala from the Australian National University emphasizes the need for comprehensive debt restructuring to ensure Sri Lanka’s enduring recovery and sustainable growth. The current approach of the DDO program unfairly burdens certain sectors of society, overlooks the fragility of the banking sector, and risks social and political unrest. A comprehensive and equitable solution is essential to achieve long-term economic stability in the country.