Negotiations to finally end Sri Lanka’s $13 billion debt default could result in an innovative new type of bond that would link payments to economic growth and governance reforms, a long-standing goal emerging market bond investors.
The bankrupt South Asian nation and its creditors agreed in principle to replace debt, which it stopped paying in 2022 following a currency crisis, with so-called macro-linked bonds that would follow the country’s recovery .
The inclusion of GDP-linked payments in bonds that could be included in major indices is a big step forward in trying to develop debt structures that will attract international investors to riskier emerging countries that desperately need financing, analysts say.
The Sri Lankan proposal “sets a precedent by incorporating the reservation” into an obligation that could be simple enough to be included in the indices, said an independent observer of the discussions.
“For this new wave of instruments to be beneficial for everyone, you need to have a decision point and certainty afterwards” regarding payment levels, they added.
President Ranil Wickremesinghe’s government, which faces elections later this year, said last month it would continue discussions on the bond proposals “with a view to reaching common ground in the coming weeks”, a sign that an agreement could be concluded.
In exchange for a reduction of about a third of their original debt, creditors offered a new $9 billion bond with payments adjusted up or down in 2028 based on the average U.S. dollar GDP achieved. by Sri Lanka.
The country has proposed alternative ways of setting GDP-linked payments and is also evaluating a proposal from creditors for a separate governance-related obligation. This would reduce voucher payments if the country increases tax revenue collection as a proportion of GDP and adopts anti-corruption reforms.
As they emerge from default, countries like Ukraine and Uruguay have distributed stock warrants, which promise additional money based on factors such as changes in the price of raw materials produced by the country or GDP, in order to encourage creditors to swallow the debt. losses.
But these instruments, whose price and trading can be difficult to assess, often end up in the scrapyard.
The obligation proposed by Sri Lanka could be innovative because “it is not a mandate, but an adjustment to an existing obligation which would take effect from 2028. This is the difference with previous versions “, according to Thilina Panduwawala, senior macroeconomist at Frontier Research. , a Sri Lankan consulting company.
The proposals will still have to overcome skepticism among some investors stemming from the checkered history of attempts to link payments to volatile economic factors, particularly GDP.
Earlier this year, Argentina had to deposit hundreds of millions of dollars with a London court to appeal a ruling forcing it to pay 1.3 billion euros to its creditors for using faulty GDP data for mandates it issued after its chaotic 2001 default.
Last month, El Salvador raised eyebrows when it sold a bond with a warrant that would earn even more on top of a 12 percent yield if it failed to secure an IMF bailout within 18 next months.
Still, some see macro-linked bonds as a way to woo investors who have fled the riskier segment of the sovereign debt market in recent years in favor of the high interest rates offered in the United States and other countries. other developed countries.
Supporters of the new type of bonds believe they can bridge this gap and prove attractive to both creditors and debtors.
“It would be a very bad sign for our market if we don’t adopt” these bonds, said one investor in emerging market bonds. “Recoveries will be weak and people will feel misused, and that’s not really sustainable as an asset class,” they added.
In the lowest growth scenario proposed for macro-linked bonds, Sri Lanka’s US dollar GDP would average $78 billion per year over three years. This would mean bondholders would have to take an additional haircut of more than a third, meaning they would have lost more than half of their original claim.
However, if GDP averages around $90 billion, the new repayment amount of the restructured bonds will increase by a quarter. According to provisional data from the central bank, GDP may have already reached $84 billion in 2023.
“It’s not out of reach at all,” Panduwawala said. “As long as we don’t see another [large currency] depreciation over the next few years, we are likely to find ourselves in the higher US dollar GDP scenarios.
The proposal for a governance-linked bond has been less controversial so far, they said, although the government has yet to provide information on the size of such a bond, which will affect eligibility for the bond. ‘hint.
However, the potential reduction in the voucher offered for implementing the reforms does not really constitute a financial incentive in itself, Panduwawala said. But it would mean that if a future government deviated from its trajectory, “the opposition and civil society would be able to assess a precise cost”.
Meanwhile, Sri Lanka’s debt restructuring will have to survive the potential upheaval that could be caused by the country’s elections later this year, before the implementation of any new types of bonds that could help revive demand for debt from the poorer but fast-growing economies. .
“Some members of the opposition will want to review the restructuring agreements if they are in power,” Panduwawala said. “There is the question of whether, after the elections, there will be friction between a potential new government and bondholders. »
