IMF SETS SEVERAL SCENARIOS FOR SRI LANKA TO FULFIL DEBT SUSTAINABILITY

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The visiting International Monetary Fund (IMF) delegation announced on 30 June, that their discussions in Colombo, with the Government of Sri Lanka (GoSL), from June 20 to 30, were successfully concluded.

In addition, President Gotabaya Rajapaksa had taken steps on 30 June to extend the services of the current Governor of the Central Bank of Sri Lanka (CBSL), Dr. Nandalal Weerasinghe, who is playing a leading role in representing Sri Lanka in these negotiations, by a full term of six years commencing 5 July 2022.

According to the IMF announcement, the two sides have held constructive and productive discussions over the recent 10 days on future economic policies of Sri Lanka and their implementation.

These discussions will continue virtually in the next few weeks to reach a Staff Level Agreement (SLA) and thereafter seek the IMF executive board approval for a 36-month USD 3 billion Extended Fund Facility (EFF) from the IMF in the near future. Such a facility will be supported by further assistance from the World Bank and ADB. Once an SLA is reached (likely in early July), the next stage prior to seeking IMF Executive Board approval will be to develop a comprehensive debt restructuring plan for discussions with creditors.

According to IMF, the objectives of the new programme for Sri Lanka, sponsored by the IMF, focus on five key policies to unlock economic growth as follows:

  • – Restore macroeconomic stability and Debt sustainability,
  • – Protect the poor and vulnerable,
  • – Underpin financial stability
  • – Address corruption risks and
  • – Accelerate structural reforms

The key to arriving at the SLA is for the two sides to agree on the macro-economic and debt sustainability goals to be achieved by Sri Lanka in the next ten-year period (2023-2032) on a short, mid and longer-term basis.

In this context, the discussions focused on correcting macroeconomic imbalances, restoring public debt sustainability and planning a comprehensive economic programme to realise the growth potential of Sri Lanka.

Negotiations have made significant progress during the operation, including the need to reduce the growing fiscal deficit while ensuring adequate protection for the poor and vulnerable via possible direct cash transfer mechanism.

As the level of government revenue remains low at about 8% of GDP, effective tax reform is urgently needed to achieve these objectives. Accordingly, in addition to the recent tax amendments, more tax reforms are to be carried out in the interim 2022 budget to be presented in the coming month of August. In addition to that, it can be concluded that the 2023 budget to be presented in November covering a full financial year will further reform the structure of state revenue and expenditure. Most of global analysts expect the country to record a deficit of some 15% of GDP in 2022, well above the budget target of 8.8% for 2022 thereafter easing to 7.3% in 2023. “Weaker economic activity is likely to reduce direct tax revenue, while a sharp slowdown in imports due to the FX shortage may also reduce indirect tax revenue. We see total government revenue remaining at around 8% of GDP in 2022,” stated Standard Chartered Bank in its latest research note to clients a few weeks ago.

Given such a backdrop, further discussions are to be held between the two parties in this connection.

Other challenges that need to be addressed include control of galloping inflation, acute balance of payments pressures, reducing widespread corruption risks even in the midst of a crisis and initiating growth-enhancing reforms.

Debt Sustainability

The most important of these agreements is to meet the debt sustainability goals of Sri Lanka. For the IMF programme to be successful, debt sustainability pre-condition set jointly by the IMF and Sri Lanka must be met.

For that, economic growth, exchange rate, interest rate, inflation and primary account surpluses should show clear progress.

According to IMF, to properly assess and evaluate the debt sustainability of any country, it is important to cover all debt, irrespective of origin, that pose a risk to its public finances.

In accordance with the current discussions with the IMF, the currently high debt ratio (Debt to GDP %) needs to be reduced to a minimum below 100 per cent level from the current 137%, both in the short and medium term, in order for Sri Lanka to achieve the level of debt sustainability it needs. Also, over the next ten years (2023-2032) this key ratio will have to decline to 80 per cent.

Financial adviser Lazard will use an IMF/World Bank Debt Sustainability Assessment (DSA) Model to assess the need for debt treatment. The key parameters of the treatment will be enshrined in a Memorandum of Understanding (MoU) between the Paris Club Members such as Japan and EU with a minimum 75% consent and non-Paris Club Members that comprise both India and China. They have reportedly been provided with several scenario analysis that include variables such as targeted growth, minimum required debt reduction, composition of debt reduction, etc. on achieving future debt sustainability of Sri Lanka.

Paris Club

The Paris Club comprises the major creditor countries whose role is to find coordinated and sustainable solutions to the payment difficulties experienced by debtor countries.

“Obtaining Chinese consent (which represent 10% of total external debt) to Sri Lanka’s debt restructuring process might be the hardest challenge for Lazard as China is still negotiating with Sri Lankan authorities to keep its debt servicing activities live via their refinance process,” experts said. Sri Lanka has, however, decided to turn down Chinese refinancing offers while giving equal treatment to all creditors.  

“Chinese support will come in due time. Check precedents … you will see it is never a matter of days or weeks” former Lazard officials have been quoted as saying.

Agreement on an MoU with all debtors could clear the way for IMF Executive Board approval of the EFF by the end of 2022.

The MoU will also provide the basis for negotiations with private creditors, as a Common Framework (CF) deal with bilateral creditors would require comparable treatment by external commercial creditors.

Eurobond or International Sovereign Bond (ISB) holders hold approximately 23% of Sri Lanka’s external debt, unlike other countries attempting a CF restructuring. If the investors are unwilling to accept the terms of the MoU, that too could delay the final outcome.

ISB holders hold approximately 23% of Sri Lanka’s external debt, unlike other countries attempting a CF restructuring. If the investors are unwilling to accept the terms of the MoU, that too could delay the final outcome. In order to succeed in the debt restructuring programme, financing assurances are only required from Public creditors.

Thus, it is currently forecast that at least 40 – 50 per cent of ‘haircut’ must be obtained and agreed to achieve this DSA targets.

Currently, the bonds maturing on 27 July are trading in the secondary market at a discount of around 40-50 per cent. Hence, it will not be too difficult to reach an agreement on ‘haircuts’ around that level for the relevant debt, according to the analysts.

More than 30 bondholders said they have formed a group to negotiate with Sri Lanka with Rothschild & Co as advisers after it defaulted on its foreign debt. Still, at least one holdout investor has sued the country in a US Court demanding payment.

Hamilton Reserve, a St Kitts and Nevis based bank, has filed suit in the Federal Court of New York Southern District, advised by lawyers Bleichmar Fonti & Auld, against Sri Lanka. This litigation is the first Court case to be reported since the announcement of the Sri Lanka Debt Restructuring Programme.

In this regard, some international legal commentators have argued that the legal proceedings could be successfully concluded, as there are flaws in the way the case has been filed.

Under the guidance of the Attorney General’s Department of Sri Lanka, Clifford Chance, one of the world’s pre-eminent law firms, the legal advisor to Sri Lanka’s Debt Restructuring Programme, has already taken steps to represent Sri Lanka in the case.

According to reports, Hamilton Reserve is entitled to ¼ of the one billion ISB maturing on 27 July, or 250 million dollars. It is said that this group has invested in the secondary market for the 500-million-dollar bond that matured last January. Accordingly, it is said that these Investors were encouraged to invest in the bond that matures on 27 July  based on the trust that had been created.

The then CBSL Governor, Nivard Cabraal, had stated that Sri Lanka would continue to pay its external debt obligations. It is reported that he had a special meeting with the investor group last January at the Shangri-La Hotel in Colombo.

Fuel and Electricity pricing

The revision of electricity tariff and fuel rates was also in the main focus of the IMF. Thus, the government has taken steps to revise the fuel charges to reflect its cost. In the meantime, instead of the present duopoly of fuel supply in Sri Lanka, other suppliers have also been given the opportunity to start fuel distribution.

Meanwhile, the Public Utilities Commission of Sri Lanka (PUCSL) is currently considering the increase of the average electricity tariff rates by 82 per cent within the next few months of this year although it will not cover the full losses of the Ceylon Electricity Board (CEB). Accordingly, the CEB expects that further tariff revision can be expected in the coming years. PUCSL has discussed these options with the IMF.

The PUCSL has recommended that electricity tariffs be increased in such a way that people can afford them, as a situation could develop in mass non-payment.

Financial Discipline

In addition, the changes that need to be made to strengthen the financial discipline of the State have also been focused on in these discussions. Among them, the new Central Bank Act, which was abandoned by the current government, will be re-implemented. The Act is expected to impose restrictions on inflationary money printing.

It has been recommended by the IMF that the policy interest rates be increased further to control the core inflation resulting from the money printing that has been going on until now. Core inflation is the change in prices of goods and services, except for those from the food and energy sectors.

The overall rate of inflation as measured by Colombo Consumers Price Index (CCPI) on YoY basis was 54.6% in June 2022 against 39.1% in May 2022. The food group inflation increased to 80.1% YoY in June (May: 57.4% YoY) while non-food inflation advanced to 42.4%YoY (May: 30.6%YoY). From the food category: sea food, vegetables, bread and rice are the key inflationary influences. From the non-food category, Transport, Restaurants and Hotels, Housing-Water-Electricity-Gas-other fuels are the key contributors to inflation.

The CBSL Governor has indicated that the current level of monetary tightening is appropriate and that current inflationary pressure is primarily driven by supply-side factors. The IMF, however, has maintained that further monetary tightening (most probably increase of further 200 – 500 basis points of policy rates) may be needed to contain inflationary pressure.

Chamber view

According to Ceylon Chamber of Commerce (CCC) President, Vish Govindasamy the IMF programme will need to consider the synchronisation of key policy levers across fiscal, monetary, investment, industrial and social development spheres. Trade and investment policy reform will be crucial in increasing foreign direct investments. A massive export push will be the key in getting growth back in the coming years after the estimated contraction of the economy by perhaps over 5-10 per cent this year.

A well-designed and properly targeted social safety net will be crucial to ensure social stability in what will be a difficult set of reforms across the board, including public sector and labour, causing pain to the people. However, we must build strong support among all stakeholders for these difficult yet essential reforms to be undertaken now; perhaps the best time ever.

By Ishara Gamage

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