Sri Lanka's future with the global financial architecture
Where will the debt go?
Disclaimer: This piece is written purely as personal opinion and analysis, and not meant to be a “forecast” of Sri Lanka’s future - rather, an exploration of the factors underlying the current debt situation of the country in a series of possible hypotheticals. This doesn’t reflect the work done at Frontier Research, which has anyway tended to be more specific in its expectations of the future.
There’s no question that Sri Lanka’s debt crisis is still ongoing. Despite strong improvements on key macroeconomic measures including the primary balance, inflation, and the currency, the economy is still barely sputtering along. While the potential for improvement very much exists, sociopolitical realities on the ground continue to be a reminder of the pain that has continued to exist alongside the topline improvements, particularly in an election year that is bound to add complexity to everything going on..
However, while domestically the focus has very much been on these domestic factors, the fact of Sri Lanka’s external debt crisis still remains unresolved. Sri Lanka is making progress with varied aspects of its debt restructuring, most recently reaching an Agreement in Principle with its official creditors, though there is more to go. However, plenty has been said and likely will continue to be needed to said about how Sri Lanka’s overall debt story can go in the future.
What factors drive Sri Lanka’s debt restructuring requirements?
The IMF’s DSA effectively restricts Sri Lanka’s debt deal only under a few targets, which I WILL repeat here for ease of reference.
First, is that during the IMF programme, a certain amount of external financing is needed to close financing gaps (US$ 17 bn) - this largely comes from the fact that any debt deal is expected to provide either relief or new funding to this extent (this becomes important in a bit).
Second, the public debt stock is required to fall to 95% of GDP by 2032 and decline afterwards - in the first 2 years, this is mostly through nominal growth and afterwards through a primary surplus and real growth
Third, central government gross financing needs should be lower than 13% on average between 2027-2032 - this is a whole other problem I’ve talked about before, so will only roughly relate to this here.
Fourth, FX payments are required to be limited to 4.5% of GDP across 2027-2032
In an Alphaville piece a few months ago, Brad Setser and Theo Maret have argued on the leniency of these IMF targets for Sri Lanka (more to do with the MAC DSA than on any Sri Lanka specific point) and I’ll extend my point from that foundation. In short, Brad and Theo give the following point -
Complex models should not trump common sense: countries that dedicate more than a third of projected revenue to interest payment are not likely to be sustainable and regain market access.
- Brad Setser and Theo Maret
Fundamentally, the problem here is that the IMF’s DSA for Sri Lanka puts it under a whole different set of conditions and features than for countries like Zambia, and this create a whole lot of space for Sri Lanka to “maintain” higher debt and payments and still be considered. Brad later takes up an extension of the same argument on how the IMF’s DSA can easily sidestep the specific issues that countries face (external debt in SL’s case) and end up justifying sustainability on a series of not particularly realistic assumption.
I will not rehash much of what Brad and Theo have said and recommend both excellent articles be read instead. However, what I will try to do is put some additional context, both historical and hypothetical, on how I would see Sri Lanka’s debt deal looking like. For this, I’ll assume Sri Lanka will not go Zambia’s way and see another year or so of delay before a finalization and somehow that there will be a deal confirmed soon enough.
What sort of external debt deal will Sri Lanka end up with?
As Brad and Theo have said, Sri Lanka’s debt targets allow for a pretty lenient debt deal to come through - one that relies a lot on multilateral support to meet the programme period debt relief, bilaterals to handle decent maturity extensions, and for haircuts on commercial credit likely to be compensated with varied mechanisms.
That last point bears a second review, given that all the talk of GDP warrants, innovative new contingent clauses, and upfront payments like in Zambia’s case can all reasonably fall within the IMF’s targets (I’m not too sure how alternate scenarios within contingent scenarios get captured in the main DSA and whether it’s possible to actually squeeze even more out of Sri Lanka by structuring the warrants in a particular way). In any case, Sri Lanka has shown SOME awareness of this - rejecting pretty directly the proposal for a macro-linked bond proposed by a group of bondholders. However, there may still be a lot of space to pay more than Sri Lanka could/should.
In any case, a deal that is less than favourable to Sri Lanka’s medium to longer term debt sustainability doesn’t necessarily affect a lot of things too negatively in the short-term. As long as comparability questions don’t come up too strongly (big ask, of course) even an unfavourable debt deal shouldn’t be too problematic immediately. One factor that CAN affect this even in the short-term is the size of any upfront payments - the MLB proposal had for example, 40% of past due interest paid upfront (though this has to be balanced against the programme period relief which is again, part of the challenge that can possibly affect CoT as well).
A strong positive here is how much domestic (and seemingly international financial) sentiment has become tied up in Sri Lanka as a positive story, particularly on a macroeconomic front and especially compared to the chaos of 2022. Once final data of Sri Lanka’s likely incredible primary surplus in 2023 comes out (personally think this could be as much as a 1.5 bn USD overperformance, driven both by a late pickup in revenue and curtailment of expenditure both recurrent and capital), that could again add to this story. The optimism that a finalized debt deal will bring out can easily help sustain the short-term positively EVEN IF upfront payments are higher than expected.
What can Sri Lanka’s historical debt sustainability tell us?
Brad argues clearly that Sri Lanka’s debt won’t be sustainable in the future - a country like Sri Lanka shouldn’t be considered sustainable at public debt at 95% of GDP in 2032. I’ll offer a few alternative ideas to this - ways that Sri Lanka’s debt could still continue at a high level, even if not actually sustainable, even with the weak targets and a lack of focus on external debt, and all the problems made possible by both of these.
Here, taking a look at Sri Lanka’s past gives an interesting starting point. Sri Lanka has actually been able to maintain quite high debt as a % of GDP for quite some time. This has both been during periods of market access as well as prior to this when Sri Lana’s debt was quite concessional. Exploring some of these periods could give some sense of how the future could hypothetically go.
Across the periods in which debt was higher than 90%, this is not particularly driven by one factor alone. Large external inflows (mostly bilateral and multilateral) continuing to disburse into Sri Lanka, an increasingly large domestic debt market (including at points, monetization by the CBSL) - which included generally high rates from the domestic market at many points - kept the debt levels high. Nominal growth and paydown of central bank debt have generally coincided with periods of the debt ratio falling.
The key points here are the external rollovers being possible - driven more by the presence of low-cost bilateral and multilateral debt than by any underlying “sustainability” - and the strength and place of the domestic market in creating space for debt. For me, both these facts meant space for the economy to continue on an unsustainable fiscal path, since the costs were sidestepped - which then also helped some of the costs by bringing in periodic bouts of inflation driving nominal growth.
How will Sri Lanka’s engagement with the global financial system go?
I framed this article on the perspective of the global financial architecture on the basis that it is one that Sri Lanka might not have a lot of power (though it has more power to do so now than ever before) to change. Here, the question is will Sri Lanka’s debt be sustainable alongside however the global system evolves over the next decade or so.
One possible pathway for Sri Lanka is one of continued external rollovers, that allow Sri Lanka to see either real or nominal growth that brings down the debt ratios. Whether this happens through an improvement in global financial conditions injecting liquidity into the basket case of Sri Lanka, even at a high cost, or whether it’s supported by Sri Lanka maintaining tight fiscal policy and thereby, forcing external surpluses is less critical than the fact there are a few pathways towards external rollover that don’t create sustainability, but are allowed by some other mechanism. This is in essence, the post-GFC pathway for Sri Lanka resuming.
Another possible pathway for Sri Lanka is one where the domestic market overall continues to hold up more and more of the burden, but does so in a way that goes alongside the fiscal performance. Strong fiscal performance and primary surpluses to bring down domestic interest costs, lower rates to spur real growth, and the impact of the fiscal pathway reducing inflationary pressures. One possible pathway here is where the financial system borrows and onlends to the government - allowing for the government to remain locked out of markets but still access it at a reasonable enough cost. Parts of this pathway have been active since the 90s in particular, so there is some precedence for the Sri Lankan system trying this - though this time with fiscal performance driven external surpluses taking the place of extra external financing.
A third pathway for Sri Lanka is one driven more by nominal growth than real growth. This is admittedly fanciful given the newly inflation-targeting CBSL, but in the context of an inflation target that is slightly higher than the currently mandated 5% (lets say closer to 7%), nominal growth should be able to both push down existing debt stocks in real terms and also encourage the development of external surpluses by creating incentives towards it. This pathway has existed during some short periods post-2001 so again, there is some precedent.
I think the way to think of the IMF pathway is a combination of 1 and 2 - but where instead of external surpluses, Sri Lanka maintains external deficits financed through new debt. This is for me, where the seriously unsustainable scenario comes into play most directly. Sri Lanka definitely does have a bias towards consumption-led growth it has maintained in the past, so has enough time and restructuring happened to reverse this? My gut says that the system will seriously resist a move towards an investment-led growth model at varied levels.
Sri Lanka will probably see bouts of boom and crawl, but could a new paradigm be here?
However, none of these pathways are straightforward. As with Sri Lanka’s past, all of these pathways are probably possible in varied points. What all of this would mean is that the Sri Lankan system would likely remain fragile and shaky, even at points where the situation on the ground is both booming and when its crawling. My gut tells me that Sri Lanka will likely see shakiness this year particularly with the election worries and the comparability question on debt, improvement afterwards, and shakiness again in a few years.
However, how much this really hurts the long-term story very much depends on the continuance of the fiscal pathway as well as how the external balances move. If Sri Lanka actually maintains its twin surpluses for a few years, then all bets are on IMO - it’ll definitely be a wholly new paradigm. The question for me, is then what helps this continue. What creates enough buffers and what creates enough incentives (both being somewhat contradictory points). I have no real answers to this, but on the long-term, my positivity hinges on the fact that I continue to hold that Sri Lanka’s pathway so far has looked more like those others in Asia that pulled out of crisis and less like those in the Americas that didn’t. Perhaps time will prove me wrong, but so far, I’m hopeful.