Photo courtesy of South China Morning Post
The country’s available foreign reserves can be used either to repay foreign creditors or to finance imports of essential goods and services required by its citizens. This is the dilemma Sri Lanka faces today. Redeeming the full value of the bond using the limited foreign exchange reserves available would provide an exceptional gain to those who currently hold those bonds. But it will come at a great cost to the citizens of the country who will face shortages of essentials like food, medicine and fuel.
Under these circumstances, it is in the best interests of all of its citizens that the government defer payment of the $ 500 million International Sovereign Bond (ISB) due January 18, 2022, until the economy can recover and rebuild completely.
Just as a person with co-morbidities is more likely to develop serious illness if infected with COVID-19 and more likely to require hospitalization and even treatment in an intensive care unit, Sri Lanka was vulnerable to economic shocks though. before COVID-19 hits. The country was already facing several macroeconomic challenges. Moderate economic growth. An untenable budgetary situation. Although a rigorous consolidation program was put in place to put public finances back on a more sustainable path, sweeping tax changes implemented at the end of 2019 reversed this process, with negative consequences for tax collection. Public revenue. Weakness of the external sector due to high repayments of external debt and insufficient foreign exchange reserves to service these debts. COVID-19 has only exacerbated these macroeconomic challenges. And as a patient who gets over the worst of COVID-19 has a long road to recovery; Sri Lanka’s economy faces many challenges getting back on track.
The outbreak of COVID-19 in early 2020 has only worsened an already grim macroeconomic situation. The country has lost the confidence of international markets and the sovereign’s ability to renew its external debt has become difficult, if not impossible. Under these circumstances, there was a strong case for sovereign debt restructuring. But the response from the government and the Central Bank of Sri Lanka (CBSL) was a firm “no”. The argument was that Sri Lanka had never defaulted on its debt and was not going to do so now. The official position was also that the government had a “plan” to repay its debt and therefore there was no reason to engage in a debt restructuring exercise. However, Sri Lanka faced high debt sustainability risks: the debt-to-GDP ratio at 110% was one of the highest in history and interest payments on government revenues at over 70%. % were one of the highest in the world.
Fast forward to 2022. The country’s foreign exchange reserves have declined to $ 3.1 billion. Usable reserves are much lower. CBSL has sold more than $ 200 million of the country’s gold reserves to service its debts. In the first week of 2022, CBSL announced new swap facilities and its commitment to repay the $ 500 million International Sovereign Bond (ISB) due in January. According to Central Bank statistics, in addition to the BSI payment, there are predetermined outflows of foreign exchange reserves amounting to $ 1.3 billion in the first two months of 2022. In addition, on the basis of Based on trade data for the past 5 years, the country has on average a trade deficit of around $ 2 billion to finance in the first quarter of the year (see Table 1). With expected tourism flows threatened by the appearance of the Omicron variant and the continuing decline in workers’ remittances, funding this external current account deficit will add further pressure on available foreign exchange reserves. India, which accounted for around 20% of recent tourist arrivals, is now forcing returnees to the country to self-quarantine. This will probably further curb tourist arrivals.
In this context, the country faces a trade-off between using its limited foreign reserves to repay its debt or using it to finance essential imports. $ 500 million is enough to finance imports of fuel for five months or pharmaceuticals for a year or dairy products for a year and a half or fertilizer for two years.
Table 1: Summary of the performance of the external sector Q1 – 2017 to 2021 (millions $)
Therefore, it is in the best interests of the country and its citizens that the government postpone paying its debt and use its limited foreign reserves to ensure an uninterrupted supply of essential imports. But it requires a plan. To minimize the cost to the economy, the government must immediately engage its creditors in a debt restructuring exercise. This will require a Debt Sustainability Analysis (DSA) by a credible agency to identify the resources needed for debt relief and the economic adjustment needed to put the country back on a sustainable path. This will be essential to bring creditors to the negotiating table and assure them that the country is able and willing to repay its debt obligations in the future.
The cost of not restructuring is much higher. A non-negotiated default (if and when the country runs out of options to service its debt) would result in a greater loss of production, loss of access to finance, or a high cost of future borrowing for the sovereign . It could even spill over into the national banking sector, triggering a banking or financial crisis.
The consequences are clear. What will we choose? Sri Lankan sovereign bondholders have been anticipating debt restructuring for over a year and a half and the losses have been reflected on the market basis.  Foreign exchange reserves at the end of December 2021 reached 3.1 billion US dollars with the inclusion of the swap with the People’s Bank of China which had been excluded in previous months.  Given that the IMF has just completed its Article IV review, this assessment has likely already been undertaken.
Dr Roshan Perera is a Principal investigator to Advocata Institute and the former director from Central Bank of Sri Lanka. Dr Sarath Rajapatirana is the Chair of the Academic Program of the Advocata Institute and the former Economic Advisor to the World Bank.