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Thilina Panduwawala is an economist at Frontier Research and writes a Sri Lanka-focused newsletter. Chayu Damsinghe is head of macroeconomic advisory at Frontier Research.
Sri Lanka’s plans to include macro-linked bonds as a restructuring sweetener for creditors that will have to swallow some harsh losses has garnered a lot of attention recently, including from MainFT. Rightly so, because they’re fascinating instruments.
In short, the proposals link repayments to Sri Lanka’s GDP performance during the IMF program, which stretches until 2027. The headline haircut and coupon rate on the macro-linked bonds apply if Sri Lanka only reaches the IMF’s easy-to-reach (for complex reasons) growth benchmarks, with reduced haircuts and higher coupons if the economy does better than the IMF envisages.
But the MLBs are still a sticking point, according to an oblique government’s statement in April. Reading the details of the bondholder proposal, it’s easy to see why.
In their March 2024 proposal, the creditor committee of bondholders had suggested that all restructured Sri Lankan bonds could be MLBs, except for the Past Due Interest (PDI) bonds. The MLBs would have a one-time single test based on Sri Lanka’s average nominal GDP in US dollar terms for 2025-2027, with four upside scenarios and two downside scenarios in their updated April proposal.
Sri Lanka’s own March 2024 proposal carried two major nuances on MLBs compared to the plan lined out by bondholders.
First, the Sri Lankan government proposed that only 27 per cent of its restructured bonds would be variable MLBs, with the rest being standard, plain-vanilla bonds. Second, it proposed a more complex adjustment test than that proposed by bondholders, involving both US dollar nominal GDP and real GDP growth during the IMF program period.
What difference does two variables instead of just one linking to GDP make? A world of difference. (zoomable version)
Both inflation and exchange rate movements can obviously nominal GDP denominated in US dollars, causing significant deviation from real GDP growth.
This is what happened to Sri Lanka in 2023, as the former rose to $84.4bn from $77bn in 2022, as 17 per cent inflation and a 11 per cent currency appreciation offset the 2.3 per cent real GDP contraction. This $84.4bn GDP is already higher than the $84.2bn “IMF baseline scenario” average for 2025-2027 used in the bondholders’ MLB scenarios.
The IMF clearly underestimated Sri Lanka’s ability to see currency strengthening post-crisis. Even using IMF assumptions for an average real GDP growth of 2-3 per cent and 5 per cent inflation, a lower depreciation path can give Sri Lanka an average nominal GDP of over $90bn for 2025-2027 — triggering the higher repayment scenarios.
Six straight quarters of current account surpluses and multilateral loans drove the Sri Lankan rupee’s appreciation. While a rapid recovery in tourism and remittances have helped keep these surpluses going, weak imports are a crucial factor. In other words, the currency is surprisingly strong because of weak domestic demand. Domestic political economic factors also mean that policymakers are quite keen on currency stability, as you can see in recent statements by the central bank and government.
By adding real GDP performance as a second variable, Sri Lanka’s own MLB proposal tries to avoid a scenario where an appreciated rupee alone forces higher repayments to bondholders, especially if the appreciation is in practice caused by a weaker economy. Given the austerity needed to adhere to the IMF programme, that’s pretty feasible.
Here’s what the different repayment schedules would look like if the Sri Lankan rupee goes above 400 to the dollar by 2027 and pushes up nominal NGDP to above $96bn, but IMF real growth forecast becomes reality.
While the government proposal moves to the first upward scenario, the bondholder proposal moves payments to the highest upward scenario.
The bondholders seem to have persisted with the one-time, single test of only using average dollar GDP for 2025-2027 in their negotiations since April. This admittedly makes it much more likely for the bonds to be index-eligible — which would be a boon for the bonds — but runs the significant risk of Sri Lanka having higher debt repayments later.
But the MLBs are not structured to adjust repayments downwards for GDP contractions after 2027. So you could have a situation where total repayments on all existing external debts rise to about $4.5bn from 2029 onwards (even assuming no more borrowing), and then any subsequent recession or sharp devaluation would cause external repayments to once again smash through the 4.5 per cent of GDP ceiling dictated by the IMF for the 2027-32 period.
From 2027 onwards, the real test for the MLBs will be Sri Lanka’s ability to refinance the rising repayments — IMF assumes over $1bn in debt issuance from that point — in particular if repayments go over $4.5bn by 2029. Failure to refinance would deplete Sri Lanka’s FX reserves and risk a return to the dark days of 2022.
If debt sustainability really was the priority then the macro-link bonds would be tied to Sri Lanka’s FX earnings or FX reserves during 2029-2032
But given the complexity of such an MLB, bondholders would benefit from at least reconsidering Sri Lanka’s proposal for a two-limbed MLB that links to both nominal dollar GDP and real GDP growth. After all, the very idea of MLBs is at stake here, in addition to Sri Lanka’s future.
Source: Economy - ft.com
