This article aims to answer the most Frequently Asked Questions (FAQs) on debt restructuring.
What is sovereign debt restructuring?
Sovereign debt restructuring is the process used by countries to change the terms on the loans they have borrowed to make it easier to repay. Debt restructuring can include one or more of the following:
- Principal haircut – a reduction on the principal or face value owed (e.g. if the Government raised a bond with a principal value of $ 1,000 million, it can be reduced by, say, 20% to $ 800 million. This is a principal haircut of 20%)
- Interest reduction – a reduction on the interest rate (e.g. if the Government raised a bond at 10% interest rate, it can be reduced by 10% to reduce the interest burden)
- Maturity extension/reprofiling – an extension of the date of maturity of the bond (e.g. if the bond was to expire in December 2025, the maturity can be extended to December 2030)
- Grace periods, moratoriums, and payment holidays – a suspension of payments (interest or principal) for a certain amount of time, providing liquidity relief. The treatment of the unpaid amounts can vary depending on the mechanism, from cancellation to rescheduling
Are all types of debt being restructured?
No. Not all types of debt will be/are restructured. Only the following types of debt will be/are restructured:
- Domestic debt – debt owed by the Sri Lankan Government to certain domestic lenders (e.g. pension funds, the Central Bank), while excluding other domestic institutions (e.g. commercial banks)
- External debt
- Bilateral debt – foreign currency debt owed by the Sri Lankan Government (both the Central Government and State-owned institutions) to governments of other countries
- Commercial debt – foreign currency debt owed by the Sri Lankan Government (both the Central Government and State-owned institutions) to private foreign and domestic lenders
The following types of debt were excluded from the debt restructuring:
- Multilateral debt – debt owed by the Sri Lankan Government to multilateral lenders like the World Bank, Asian Development Bank (ADB), International Monetary Fund (IMF), etc.
Note: There are three different ways in which domestic/external debt can be defined generally: (i) governing law, (ii) residency, and (iii) currency. It is worth noting that Sri Lanka originally defaulted on debt obligations issued under foreign law. Later, Sri Lanka switched to all foreign currency obligations to include the Sri Lanka Development Bonds (SLDBs) which are US Dollar-denominated debt instruments issued under domestic law. Subsequently, Sri Lanka also added domestic currency obligations for restructuring.
Why is multilateral debt not being restructured?
Multilateral institutions such as the IMF and the World Bank benefit from a ‘preferred creditor status’ which means they are usually excluded from sovereign restructurings. This is not a legal concept but a widely accepted practice.
There are several reasons for this status: (i) multilateral institutions lend at very low (concessional) rates even when a country has lost access to commercial financing, playing the role of lender of last resort; (ii) the status supports the low funding costs of multilateral development banks, enabling them to lend to vulnerable countries at low rates.
What are ISBs and SLDBs?
International Sovereign Bonds (ISBs) are used to borrow money in US Dollars and issued to global investors. Issuances take place outside Sri Lanka (mostly in Singapore). Given that the bonds are issued outside Sri Lanka, ISBs are governed by foreign law, usually English or New York law. That is why the Hamilton Reserve Bank filed a case in a New York court of law for Sri Lanka’s defaulting on an ISB that was due in July 2022.
SLDBs are issued to borrow money in US Dollars, but issuances take place in Sri Lanka. Thus, most SLDBs were bought by Sri Lankan banks. It is similar to banks buying Treasury bonds (T-bonds), except that these are issued in US Dollars. Banks have to provide US Dollars to the Government to buy SLDBs.
Given that SLDBs are issued in Sri Lanka, the governing law for SLDBs is Sri Lankan law. The restructuring of SLDBs was a less complex process because they are governed by domestic law and most SLDB holders were Sri Lankan banks.
Why did Sri Lanka have to restructure its debt?
As Government revenues reduced due to the tax changes made in 2019 and 2020, it became evident that the Sri Lankan Government would face difficulties meeting its debt repayment obligations. Sri Lanka also faced severe external imbalances and a low level of foreign exchange reserves, namely US Dollars.
This level of foreign reserves barely covered the import of fuel, food, and medicine, and prevented de facto the payment of foreign currency debts. The IMF accordingly classified Sri Lanka’s public debt as unsustainable and defined debt targets needed to restore sustainability.
What is the OCC?
The Official Creditor Committee (OCC) is a committee of bilateral lenders formed in May 2023 to discuss the Sri Lankan authorities’ request for a debt treatment. The OCC is chaired by India, Japan, and France. The committee includes Paris Club creditors and other official bilateral creditors. China is not a member of the OCC, but along with Saudi Arabia and Iran, attends OCC meetings as an observer.
Has the debt restructuring agreement been finalised?
As of 18 April, when this FAQ was written, a domestic debt restructuring agreement had been finalised in June 2023 while the external debt restructuring was still ongoing. The Government reached agreements in principle to restructure its external debt owed to the Paris Club of Western bilateral lenders, to India, and to a Chinese State-owned bank in late-2023, but a formal agreement is yet to be announced.
Will debt restructuring reduce Sri Lanka’s external debt burden?
It is possible that the debt restructuring may reduce the debt burden of Sri Lanka if, for example, the Government is able to negotiate principal haircuts and interest rate reductions. However, the agreement is yet to be finalised, so it is too early to provide a definitive response. It is worth noting that the targets set forth by the IMF for achieving debt sustainability do imply a reduction of the debt burden in comparison to the baseline.
What is the IMF’s involvement in the debt restructuring?
The IMF’s modelling provides the baseline for the restructuring negotiations, as its debt targets and financing assumptions define the so-called ‘restructuring envelope’ that the Government needs to achieve by modifying the terms of ‘restructurable’ debt. Importantly, the IMF defines the overall debt relief that is required but does not force the Government to obtain it from specific creditors.
IMF lending policies are also linked to the restructuring process. In cases where debt is considered as unsustainable, the IMF will require a commitment from creditors that they will provide adequate debt relief before approving a programme, the so-called financing assurances. This requirement explains part of the delays before the start of Sri Lanka’s IMF programme, since China needed to provide a letter with the textbook wording to the IMF.
Is the IMF programme renegotiable?
There is not much room for manoeuvring once the overall targets are in place. However, it is possible to negotiate and bargain on methods to achieve the target. For example, if the target for tax revenues was to achieve 25% of GDP by 2025, the exact specifics of how the tax revenue is raised can be negotiated. For instance, it could be raised with an increase in marginal tax rates, a change in tax thresholds, an increase in VAT vs. an increase in income taxes, etc.
In specific cases, the IMF can grant waivers of nonobservance for some of the programme targets or modify them, but this is usually confined to events outside the authorities’ control, such as a climate shock.
Can Sri Lanka’s debt be written off as ‘odious debt’?
The legal doctrine of odious debt makes an analogous argument that sovereign debt incurred without the consent of the people and not benefiting the people is odious and should not be transferable to a successor government, especially if creditors are aware of these facts in advance.
Odious debt is not a well-recognised legal doctrine; it is a concept that has been discussed in academia and policy circles with no real-world application so far.
The debate of writing off Sri Lanka’s debt as odious debt centres around the premise that the debt was accumulated under authoritarian rule and can therefore be constituted as being odious. The threshold to commence discussions on authoritarian rule and odious debt is much higher than it is in the case of Sri Lanka, which, for all its flaws, remains a democracy.
Discussing odious debt is also a risky gamble for policymakers as it can increase the perception of political risks by investors for years to come, which can affect Sri Lanka’s future borrowing ability.
What are SCDIs?
State Contingent Debt Instruments (SCDIs) are instruments with pay-offs dependent on external variables, usually some economic indicators. For example, a bond can have a coupon which goes up from 3% to 5% in the years that the country’s GDP growth exceeds a certain threshold.
Can Sri Lanka issue SCDIs?
Sri Lanka can issue such instruments if it helps bridge gaps in the negotiations with creditors. However, it should take into account some important factors:
- Legal risk: Some countries have been sued in international courts for alleged data manipulation related to such instruments.
- Complexity: These instruments are difficult to value and flaws in the initial design can trigger outsized payments down the road.
- Impact on market access: State-contingent instruments might be complex for investors to value and trade, resulting in poor secondary market performance and making it difficult for the country to find a benchmark to facilitate the return to capital markets after the default.
- Repayment capacity: The underlying trigger should be designed to match the country’s repayment capacity to avoid scenarios in which debt repayments increase sharply but the country has little capacity to meet these payments.
- IMF and comparability constraints: The variable payoffs attached to SCDIs might be considered by the IMF or official creditors as a breach of IMF debt targets or a breach of comparability of treatment if the upside scenarios are not similarly included in the debt treatment of official creditors.
(Thowfeek and Moramudali are Directors of Arutha. Arutha is a Colombo-based policy think tank focused on economic research and communication with a special interest in public debt and taxation. Its economic civic education initiative, Default LK, was established during Sri Lanka’s first ever sovereign default in 2022. Maret is an Associate at Global Sovereign Advisory and writes a widely-read sovereign debt newsletter named Sovdebt Oddities)