Sri Lanka Bondholders Back $12.6 Billion Debt Restructuring

In a significant development, Sri Lanka's bondholders have agreed to a $12.6 billion debt restructuring plan, marking a crucial step in the country's efforts to overcome its economic crisis. The agreement, reached in September 2024, offers a 30% haircut on external debt restructuring (EDR) and comparable treatment for domestic bondholders, demonstrating a shift in bondholders' willingness to negotiate and compromise.

Sri Lanka's economic crisis, exacerbated by COVID-19 and high commodity prices, led to a 9.2% GDP contraction in 2022 and a further 4.2% in 2023. This, coupled with a severe balance of payment crisis, pushed Sri Lanka into its worst-ever economic crisis. The default and subsequent negotiations have been a test for bondholders, who initially showed reluctance to include a domestic debt restructuring (DDR) due to substantial real erosion in value to debt holders as inflation spiralled. However, as negotiations progressed, bondholders recognized the need for a comprehensive solution to ensure debt sustainability and safeguard financial stability.

International institutions like the IMF and World Bank played a pivotal role in Sri Lanka's debt restructuring process. The IMF's involvement was crucial, as it provided a $2.9 billion bailout package in 2022, conditional on Sri Lanka implementing a comprehensive reform program. This included debt restructuring, fiscal consolidation, and structural reforms. The World Bank, on the other hand, emphasized the need for deep reforms and debt restructuring to stabilize Sri Lanka's economy. In its 2022 report, it highlighted the importance of addressing Sri Lanka's debt crisis and implementing reforms to build resilience. These institutions' support and guidance helped Sri Lanka navigate its debt crisis and reach the $12.6 billion debt restructuring agreement.

The 30% haircut on external debt restructuring (EDR) in Sri Lanka's debt restructuring plan significantly reduces the country's debt burden. Assuming a pre-restructuring debt-to-GDP ratio of 120% (as of 2022, according to the World Bank), the haircut would decrease this ratio to around 84%. This reduction in debt-to-GDP ratio provides Sri Lanka with more fiscal space, enabling the government to allocate resources towards economic recovery and social protection programs.

However, excluding the banking sector and private bondholders from Sri Lanka's domestic debt restructuring (DDR) process may have significant long-term economic and social impacts. By leaving out the banking sector, the government has ringfenced it to avert a more damaging economic crisis and deeper output losses. However, this disproportionately directs the economic cost to the savings of workers contributing to pension funds, particularly those in the Employers Provident Fund (EPF). The 30% haircut or higher taxation for EPF savers, combined with a substantial erosion of real savings from the crisis, could lead to long-term economic hardship for these workers. Additionally, the lack of comparable treatment for private bondholders may create resentment and undermine public trust in the government's handling of the debt crisis.

In conclusion, Sri Lanka's bondholders' agreement to the $12.6 billion debt restructuring plan is a critical step in the country's economic recovery. The 30% haircut on external debt restructuring (EDR) significantly reduces Sri Lanka's debt burden and provides more fiscal space for economic recovery and social protection programs. However, the exclusion of the banking sector and private bondholders from the domestic debt restructuring (DDR) process may have long-term economic and social impacts that need to be addressed. With the support of international institutions like the IMF and World Bank, Sri Lanka can navigate its debt crisis and build a more resilient economy.