The macro-linked bonds (MLB) proposed by the Ad Hoc Group of Bondholders to Sri Lankan authorities have only considered the fiscal space of the Sri Lankan Government while neglecting its debt servicing capacity, a top sovereign debt expert said.
In a thread in X (formerly known as Twitter),senior fellow at the Council on Foreign Relations (CFR) and Sovereign debt expert Brad Setser said that the bondholders' proposal of MLBs for Sri Lanka, suffers from two major problems where one is obvious while the other is more subtle.
He said that the obvious problem is that coupon rates of Sri Lanka dollar bonds rise from 3% to 9% if the country’s GDP goes from $ 90 billion to $ 100 billion.
He said that the debt servicing capacity at best increases linearly with GDP, although Sri Lanka historically hasn't been the best at collecting revenues while debt service effectively increases by a factor of 3 while debt servicing capacity at best rises by 10%.
“That's a pretty serious design flaw in a macro-linked bond, debt service should rise in with debt servicing capacity,” he said.
Moreover, he said that the other serious problem is more subtle which Keynes called the transfer problem as external debt service is paid out of export revenues (not fiscal revenues) and in foreign exchange and servicing external debt (covering the coupon at least) takes export proceeds. “So with over $ 10 billion in new bonds (counting the interest capitalisation) paying a 9% coupon (plus the coupon on any bonds issued to cover early amortisations), Sri Lanka needs to run a trade surplus to cover the $ 1 billion in interest payments (give or take) on the new bonds,” Setser said.
He said that the obvious way dollar GDP recovers (triggering the higher debt service payments) is if the exchange rate appreciates but that makes it harder to generate a trade surplus needed to generate the foreign exchange for payments.
“This is why countries with heavy external debt burdens need a weak exchange rate -- they have to run trade surpluses to repay their debts,” he added. Therefore, he said that the bondholders committee and their advisors seem to have been thinking entirely in fiscal space when developing the proposal. Further, he said the early amortisation schedule, the payment-in-kind feature that claws back all the upfront debt reduction and the rapid payment of past due interest are some other problems that arise from the proposal.
“I personally don't think the proposal even works as the basis for negotiations, though that is ultimately Sri Lanka's call,” Setser said.
In a statement issued on Wednesday (18), the Finance Ministry said that while acknowledging the MLB proposal by the bondholders, the proposal has not received a favourable response from the Government of Sri Lanka.