The Government last week presented its Domestic Debt Optimisation (DDO) plan, a source of much concern among the public. However, the plan was not as dire as expected by many, but questions over whether the plan has sufficient provisions to overcome the debt crisis continues to be debated.
On Wednesday (28), the Central Bank of Sri Lanka (CBSL) presented the plan to the Cabinet, which was consequently approved. The DDO plan appears to provide the additional push required by Sri Lanka to achieve International Monetary Fund (IMF) targets, which are forecasted to be achieved in short order following external debt restructuring.
The DDO plan has excluded Treasury bonds (T-bonds) owned by the banking sector – which is about 36% of the total Treasury bonds issued as of end-2022 – and has included the restructuring of Treasury bonds held by superannuation funds such as the Employees’ Provident Fund (EPF) and the Employees’ Trust Fund (ETF) – which is about 43% of the total Treasury bonds issued by end-2022 – and the restructure of Treasury bills (T-bills) held by CBSL.
What is in the DDO plan?
In terms of restructuring Central Bank Treasury bills – which are about 62% of the total Treasury bill stock as of the end of 2022 – bills will be converted to Treasury bonds, which will help to reduce Gross Financing Needs (GFNs). However, the impact of this adjustment will be reflected in the balance sheet with depleted and negative capital of the Central Bank, while recapitalisation may be needed to mitigate the adverse impact of negative equity on CBSL’s credibility and independence. Also, the new Central Bank Act should be passed in Parliament for the restructuring to happen.
Treasury bonds of superannuation funds are proposed to be exchanged for longer maturity T-bonds (2027-2038), with a step-down coupon structure of 12% (until the end of 2025) and 9% till maturity.
While authorities may consider increasing income tax to 30% from the current special treatment of 14% for superannuation funds that do not meet the minimum participation requirement, the limit is set at 50% for outstanding bonds maturing in 2023 and 100% for bonds maturing between 2024 and 2032.
Why were banks not included in DDO?
According to the presentation by CBSLGovernor Dr. Nandalal Weerasinghe to the Cabinet, the banking sector has already borne a significant burden of the fiscal adjustment and the economic crisis in several ways, while the sector also pays a higher tax rate than other corporations as the total tax burden on the banking sector has increased about 39-48%.
Through such huge tax payments, the banking sector is helping the Government’s fiscal consolidation efforts and the burden on the banking sector is being borne by not only the shareholders but mainly the depositors through lower returns on savings.
Further, banking sector Non-Performing Loans (NPLs) have increased substantially from 11.3% at the end of 2022 to 13.3 % by the end of May 2023 and the total impairment on the existing loan portfolio is Rs. 916 billion.
There is already a need for high provisioning and capital enhancement in the banking sector, which would affect the sector’s performance and profitability.
Further, the presentation noted that foreign currency debt restructuring would also result in a notable impact on the banking sector and would create a significant loss to the sector as some domestic banks were expected to contribute to debt restructuring through the ad hoc bondholder committee comparable with the ISB holders.
Holdings of International Sovereign Bonds (ISBs) and Sri Lanka Development Bonds (SLDBs) in the banking sector contributed to about 17% of the total Government security holdings.
DDO plan good for the economy
Speaking to The Sunday Morning, First Capital Chief Research and Strategy Officer Dimantha Mathew said that the DDO plan by the Government was broadly in line with what was expected and once the CBSL holdings of Treasury bills and superannuation funds had been restructured, other financial instruments would not be overly impacted.
However, he added that the restructure of SLDBs by CBSL had not been predicted.
“I think it’s good for the economy because, with this [restructure], there is no real impact on the economy or next year’s GDP growth,” Mathew said.
Even prior to the DDO plan, SLDBs mainly held by the banks were settled by converting them into rupee bonds or settling them in rupees.
Under the DDO plan, if SLDB holders want the instruments to be settled in US Dollars, they can have an ISB-like option of a 30% nominal haircut with a six-year final maturity in 2029, a fixed interest rate of 4%, and payments starting in 2024.
The bilateral debt-like option has a 15-year final maturity in 2038 with a fixed interest rate of 1.5% while providing a nine-year grace period where the first payment starts in 2033.
With both options, past due interest and interest accrued up to the settlement date will be settled in Sri Lankan Rupees.
“I think banks will go for rupee bonds,” Mathew said, adding that banks would not be overly impacted due to the restructuring of SLDBs as some banks had already impaired part of the SLDBs and had the option of converting them into rupee bonds.
Further, he said that with the increase in the interest rate, all investments had moved from production to investments and gone into Government securities.
Therefore, he noted that if private investments into T-bills and T-bonds were impacted by the DDO, next year’s growth forecast would have to be revised to a contraction, as there would be no production growth without investment.
Mathew noted that the overall yield curve would rapidly drop in the next week, eliminating the premium which had been attached over the last one-year period.
Is DDO enough to fulfil IMF requirements?
An economic analyst from an independent think tank in Colombo, who wished to remain anonymous, said that Sri Lanka would have to look at whether this restructuring was enough to overcome the crisis and prevent the country from going through another debt restructuring process.
If additional debt restructures are needed in future and if Sri Lanka has to add pressure on the banking system, “everything will be jeopardised,” the analyst said.
According to the expert, comparable treatment of all bondholders is questionable when the entire burden is upon one set of bondholders, mainly the EPF and ETF.
“The overall feeling is that this DDO plan may not be adequate to fulfil the actual requirement,” the analyst said, adding that the maturity extension may help in bringing down the Gross Financing Needs (GFNs) to 12.7%.
The presentation by the CBSL stated that Sri Lanka would be able to achieve a GFN of 14.2% with only external debt restructuring between 2027-’32 and that Sri Lanka could achieve a GFN of 12.7% of GDP in the same period by adding DDO to the external debt restructuring.
The impact of the DDO is 1.5 percentage points to the GFN. “Although it positively impacts the public debt stock, the DDO is mostly aimed at bringing GFNs downwards (as GFNs incorporate both local and external components),” the presentation illustrated.
It will not directly have an impact on reducing the overall debt because there is a primary balance requirement.
“It will help if we plan to finance the interest payments by financing through issuing other Government instruments, but it should be after the restructuring period,” the analyst added.
DDO success depends on maintaining primary surplus
Speaking to The Sunday Morning, Frontier Research Product Head (Macroeconomic and Thematic Research) Chayu Damsinghe said that the DDO did not have much of an impact on whether the Government could actually meet IMF projections.
“If we are making a projection on what GFNs or debt targets might look like, regardless of DDO, we can easily make a reasonable projection that shows that Sri Lanka will meet the targets,” he added.
Moreover, he opined that the CBSL and the Finance Ministry may have had different scenarios for the DDO, including the banks, as they had announced a five-day holiday, but may have later decided to keep the banks out of the DDO.
He said that plans to include banks in the DDO were evident, since in the Q&A sheet of the creditor presentation held in March the Government had said that all the T-bonds would be included in the debt restructuring.
“If banks were to have been excluded from the beginning, why did the Government allow 12 months of uncertainty, if all it wanted to restructure was just the Central Bank T-bills and the superannuation funds? The interest rates could have fallen much earlier,” he added.
Damsinghe said that the question of whether the Government could maintain the primary surplus as the IMF wished would decide the success of the DDO plan, rather than just restructuring bonds held by superannuation funds and Central Bank T-bills.
He noted that the DDO would not create a huge amount of debt space but would be roughly neutral in managing debt.
Further, he said that although the overall shape of ISB-like and bilateral creditor-like options given to restructuring SLDBs were similar to what had been offered to external creditors, the actual terms of those options may be different.