Theo Maret, a research analyst at Global Sovereign Advisory and a writer of the sovereign debt newsletter, along with Brad Setser, a senior fellow at the Council on Foreign Relations and a former Treasury Department official, have shed light on Sri Lanka’s current financial situation. They believe that the ongoing debt restructuring of Sri Lanka may not be comprehensive enough, leading to future defaults. One of the main culprits behind this problem is the International Monetary Fund’s (IMF) insufficient targets.
The IMF argues that Sri Lanka’s debt will be sustainable if the country reduces its public debt to 95% of GDP by 2032. However, these targets seem unambitious considering the country’s debt-to-GDP ratio was below 80% before the pandemic. Furthermore, there are no explicit targets for the external debt stock, which goes against the principles of the IMF’s founders.
The IMF’s new debt sustainability model focuses on “gross financing needs” rather than the net present value of Sri Lanka’s external debt. According to this model, as long as Sri Lanka keeps its gross financing needs below 13% of GDP, its debts are considered sustainable. However, Sri Lanka’s underlying issue has always been its low tax collection ability. Its revenues averaged just 11.5% of GDP in the decade prior to its default and dropped even further after an ill-advised tax cut before the pandemic. The IMF’s program projects that revenue will rise to around 15% of GDP, still a meager amount considering the country’s significant public debts.
Doing some basic debt math with a 5% average interest rate on Sri Lanka’s debt and a debt-to-GDP ratio of around 100%, it suggests that Sri Lanka will spend approximately a third of its revenue on interest payments alone in the coming years. This calculation is optimistic, as Sri Lanka’s average debt costs were closer to 8% in the past decade. In that scenario, more than half of Sri Lanka’s revenue would be consumed by interest payments. In comparison, only a few countries, including Pakistan, Egypt, Ghana, and Malawi, spend more than a third of their revenue on interest payments, and some of them are already undergoing debt restructurings.
Moreover, Sri Lanka is expected to reenter the international bond markets in 2027, assuming it secures $1.5 billion in bond market funding. If this funding doesn’t materialize, Sri Lanka could face a drain on its foreign reserves while losing access to its IMF lifeline.
The IMF’s targets for Sri Lanka seem inconsistent when compared to its targets for Zambia, which shares similar debt metrics. Zambia appears to be stronger with a larger export sector and higher annual revenue collection (around 20% of GDP). Despite this, the IMF has set more demanding targets for Zambia. This raises questions about the IMF’s market-access model’s ability to accurately set debt restructuring targets for lower middle-income countries with volatile revenue and export bases.
Additionally, the market-access debt sustainability model creates an incentive to manipulate domestic debt as a means of adjustment. Initially, Sri Lanka’s debt restructuring plan only addressed external debt, given its default on such debt due to depleted reserves. However, under pressure from bondholders, Sri Lanka is now also optimizing its domestic debt. This move aims to reduce the contribution of domestic debt service to gross financing needs rather than address any significant vulnerability. It allows Sri Lanka to prioritize debt service to foreign creditors within the IMF’s lenient targets.
In light of these challenges, the onus falls on Sri Lanka to negotiate a deal that reduces the stock of external debt and limits the burden of servicing it. However, this is a challenging task, as most restructurings try to include as much debt service as the IMF program allows. Adding to the complexity, Sri Lanka is negotiating with multiple external creditor groups, including the Paris Club and China’s official policy banks, as it wasn’t eligible for the G20’s Common Framework.
In conclusion, Sri Lanka’s ongoing debt restructuring faces challenges due to the IMF’s insufficient targets, inadequate revenue collection, and the complexity of negotiating with multiple external creditor groups. To secure a sustainable financial future, Sri Lanka must take a decisive approach to reduce its external debt and ensure a manageable debt-servicing burden.
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