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Bond default an opportunity for Sri Lanka

Sri Lanka External Debt and Economy Crisis-adobe=2022

Times are tough but the sovereign still has a chance to prove itself to investors and regain its credibility

A week ago, Sri Lanka made history. It missed the 30-day grace period for making about $78m in coupon payments on two of its sovereign bonds maturing in 2023 and 2028.

The default was the nation’s first since its independence from Britain in 1948, and the first in Asia Pacific in a century. This may sound dire, but it also presents Sri Lanka with an opportunity to redeem itself.

The situation in the country is tough, with long water and electricity cuts, and petrol stations running out of gas, pushing citizens to take to the streets to protest against the government’s economic mismanagement.

But history has shown that the democratic socialist republic is resilient. After all, it bounced back from nearly three decades of civil war to become the darling of investors. The country can similarly rise from the ashes of its economic crisis to restore its faith with global investors — so long as it plays its cards right.

The country has a lot of factors in its favour. For instance, its $12.6bn in offshore bond debt isn’t that high. As a percentage of its gross domestic product of about $83bn, the debt stacks up to about 15%, a reasonably palatable amount.

It helps that the South Asian nation has kept its doors open for investors, creating some much-needed goodwill and confidence.

For instance, Sri Lanka repaid its $500m 5.75% bond on January 18 — before saying it will stop meeting its debt obligations amid a liquidity crunch. Its bonds had been trading at par until earlier this year.

That willingness to pay — and clarity in its communication with financial markets — has helped with sentiment. The country should continue its efforts to engage with bondholders meaningfully to retain their faith in this period of crisis.

Restructuring hopes

Where Sri Lanka can really make an impact, though, is the way it deals with the inevitable restructuring of its outstanding bonds.

Debt restructuring can be a taboo — but not if Sri Lanka’s ministry of finance and central bank make their intentions clear, and put in efforts to break debt shackles while correcting debt imbalances.

It is here the International Monetary Fund can play a significant role. Sri Lanka already has IMF’s support, but bondholders are closely watching every step the government takes with the IMF. Involvement of the multilateral means stronger policy measures, which should help push the country towards recovery.

Even though Sri Lanka’s dollar bond debt is relatively small, its external debt is high at about 64% of GDP. The total debt to GDP is close to 100% — something that needs to be handled urgently.

The island nation should also shoulder the responsibility for its heavy expenditure on expensive infrastructure projects linked to China’s Belt and Road Initiative and try to resolve matters with the IMF’s help. According to news reports, Sri Lanka has also defaulted on about $100m of Chinese debt on top of the dollar bonds.

Tidying up messy domestic politics needs to be among the key priorities, too. The country shouldn’t delay taking important decisions.

For instance, on Monday, the new Sri Lankan president Gotabaya Rajapaksa appointed eight new ministers in his cabinet, but did not immediately select a finance minister. On Wednesday, news emerged that new prime minister Ranil Wickremesinghe will double up as finance minister, leading the bailout talks with the IMF. He will certainly have his work cut out.

There are still many headwinds, no quick wins, and a recovery process that will take time and may very well be painful. Most of Sri Lanka’s bonds have fallen below 40 cents to a dollar, indicating the potential recovery rate for now.

The restructuring exercise may make international capital markets out of reach for Sri Lanka for a few years. But if the nation manages to wade through the restructuring successfully by tackling its issues systematically, even if slowly, it can ensure a solid comeback to markets.

Lessons learnt

With several emerging markets economies with similar unsustainable debt inching towards possible defaults, the situation in Sri Lankan can teach a lot of lessons.

The key takeaways? Exercising prudence around borrowings, while constantly planning for worst-case scenarios. Wars and pandemics are unforeseen, but sovereigns should be in a position to tackle them head-on when they emerge.

In Asia, Pakistan is in a precarious situation with a possible default likely in a quarter if the government doesn’t gather enough resources by raising prices or get IMF help. Earlier this week, JP Morgan strategists added the Maldives to a list of countries with high repayment risks.

The World Bank is also expecting a dozen developing economies to default on their debt next year.

Such defaults will dampen investor sentiment. But they also give countries a chance to rectify their past mistakes when moving forward with a clean slate. Sri Lanka, and other nations, should grasp that opportunity to regain their credibility.

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