Sri Lanka’s Bond Deal Should Not Set A Precedent, says Council on Foreign Relations

COLOMBO (News 1st); An American think tank specializing in U.S. foreign policy and international relations says that Sri Lanka’s bond deal should not set a precedent.

Brad W. Setser, of the Council on Foreign Relations notes that rather than reducing the risk of future debt trouble, Sri Lanka’s macro-linked bonds set up the risk that Sri Lanka will fall back into debt trouble in 2029 or 2030.

An American think tank specializing in U.S. foreign policy and international relations, Council on Foreign Relations notes that Sri Lanka’s macro-linked bonds (MLBs) are, in fact, not really macro-linked bonds.

Brad W. Setser, of the Council on Foreign Relations says that after 2027, Sri Lanka’s macro-linked bonds are standard fixed-income instruments which provide no help in the event of future shocks.

He adds that the final restructuring terms are just left open until just after Sri Lanka’s IMF program ends, and the creditors and Sri Lanka have agreed that the final terms will largely be a function of Sri Lanka's dollar GDP between 2025 and 2027, noting that new bonds thus aren’t true state-contingent instruments.

"Payments after 2027 aren’t linked to real GDP growth, tourism inflows, or the price of Sri Lanka’s oil imports. Theorists who extol the advantages of state-contingent instruments shouldn’t be fooled. Bond traders still need to worry about the risk that the payments will reset up based on Sri Lanka’s economic performance between 2025 and 2027—a period when risks are low because Sri Lanka is more or less fully funded by the official sector. Good performance over the next few years thus creates more risk of trouble after 2028, as external debt service ratchets up during a period when Sri Lanka is expected to be back financing in the international bond market with a debt to GDP ratio of around 100%," he added.

Brad Setser says the new bonds are thus structured to game the IMF's fiscal targets and increase the return bondholders get out of Sri Lanka’s debt exchange rather than to insulate Sri Lanka against future risks.

He claims that innovation in the macro-linked bonds is that the terms of the exchange aren’t fixed until after Sri Lanka’s current IMF program has expired.

In the latest proposal, there is also a bit of downside protection for Sri Lanka. The bonds reset only if the real economy has in fact grown from 2024 to 2027. If GDP falls to $85 billion (well below the IMF’s conservative forecast), the stock of new bonds falls from $9 billion to $7.5 billion.

The risk here should be obvious—a strong Sri Lankan currency could drive nominal dollar GDP higher during the program period (when official inflows and limited debt service provide a stable source of foreign exchange on top of exports) even in the absence of any true increase in Sri Lanka’s external payment capacity. 

Conceptually, dollar GDP isn’t even the actual source of increased external debt service capacity, as a high calculated dollar GDP can reflect an overvalued exchange rate that makes it harder to generate the actual foreign exchange needed to service external debt, a classic consideration that was left out of the IMF’s “fiscal only” market-access debt sustainability framework.