Sri Lanka default: A bad bank would help the nation fix its finances

Before injecting fresh funds, the govt needs to take non-performing debt related to tourism, real estate and other troubled industries off banks' books

By Andy Mukherjee
 

Sri Lanka is getting an early release from debtors’ prison. Or so you would think from the jubilant mood in its bond market. There is hope that the bankrupt Indian Ocean island will also be able to cut a deal with China, its largest bilateral creditor, after Zambia recently managed to win over Beijing’s support for its restructuring.
 

However, workers are gripped by anxiety about jobs and incomes. The threat of losing duty-free access to crucial European markets looms over the ready-made garment industry, the economy’s No. 1 export. Households’ pension savings have taken a blow from the government’s debt recast; trade unions are alarmed by talk of new employment rules. 

 

Putting too much of the burden of adjustment on any one stakeholder could backfire. Striking the right balance between the interests of labor and capital will be important if the economy is to grow out of its problems.

One set of constituents is feeling relatively secure. From the capital market’s perspective, the recent recast of the sovereign’s domestic liabilities has gone off well. Banks are relieved to have been spared harsh haircuts, and the monetary authority is slashing interest rates to take advantage of declining inflation. Thursday’s 200-basis-point rate cut, the second reduction in two months, should reduce the strain on the administration, which is financing its deficits with short-term treasury bills. One-year borrowing costs have plunged by 1,300 basis points since May.

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Yet, it’s too early to celebrate what is still just the start of a deeper and more controversial restructuring, without which the South Asian economy may neither have the balance-sheet strength or the dollar income to avoid becoming a serial defaulter.

The most obvious candidate up for overhaul is the financial system. Sri Lanka needs a bad bank. Yes, lenders have dodged the bullet of having to accept losses on their local-currency treasury securities. But last year’s near-8% plunge in the nation’s output has left them with a heap of bad loans. Of late, Commercial Bank of Ceylon Plc’s provisions against soured credit have swallowed up 85% of the largest private-sector lender’s net interest income.

The $3 billion rescue accord with the International Monetary Fund has scope for recapitalizing the banks. However, before injecting fresh funds, the government needs to take nonperforming debt related to tourism, real estate and other troubled industries off banks’ books by coming up with its own version of Danaharta, the agency Malaysia established during the 1997-98 Asian financial crisis.

If it does that, and insulates the bad bank from frivolous litigation, the financial system will be healthy enough to start making new loans. The economy will avoid a prolonged balance-sheet recession, in which the compulsion to pay down debt depresses consumption and investment.

That will still leave Sri Lanka with the problem of rekindling growth, and that is where things might get tricky.

After last year’s jump in poverty amid shortages of food, fuel and medicines, the island’s 22 million people still enjoy a per capita income of more than $3,500 annually. That makes them 50% richer, on average, than in neighboring India. Still, the outlook for future growth is not too rosy.

Also Read: Sri Lanka's economy shrinks by 11.5% in first quarter amid financial crisis

The biggest hard-currency earner is the garment-export industry. Even when the nation ran out of dollars to import raw materials and fuel last year, it tried to insulate the suppliers to brands like Nike and Uniqlo. Apparel factories were able to ratchet up exports to a record $6 billion to benefit from a post-pandemic boom. That surge has faded, and fears of a loss of competitiveness are creeping in as new orders disappear.

There is a growing clamor in the industry for more relaxed labor contracts, including ones that allow for seasonal work. This would be an awful time to put the onus of an industrial recovery on workers. They have already been forced to accept a sharp erosion in pension benefits over the next 15 years as part of the government’s recent domestic debt restructuring plan. Real wage income is yet to recover from last year’s cost-of-living crisis and a big chunk of it is going to predatory manpower agents sourcing labor for dwindling job opportunities.
 

It isn’t employee productivity but access to consumers that may determine the fate of the apparel industry and its 350,000 workers. The European Union has been threatening to cancel a 2017 arrangement of duty-free imports from Sri Lanka because of its human-rights record, particularly the systematic abuse of an anti-terror law during and after a 26-year-long civil war between the majority Sinhalese and minority Tamil populations. Losing preferential trade access to its second-largest market after the US would be a body blow to garment makers. It makes much more sense for President Ranil Wickremesinghe’s administration to urgently repeal the Prevention of Terrorism Act of 1979 than to seek further economic sacrifices from workers by pushing for a new set of labor laws.

Amid all this, the No. 1 priority should still be to bring China to the negotiating table. At the end of last year, Sri Lanka's government owed creditors $75 billion. Of this, $41 billion are domestic obligations to banks, the central bank and superannuation funds, among others, and about $20 billion of them have been restructured. Foreign official and commercial lenders account for the remaining $34 billion, and getting them to give up a part of their claims is taking a long time. 

The stumbling block is China, which has so far stayed away from discussions currently under way with the Paris Club lenders. From Sri Lanka’s perspective, it’s encouraging that Zambia recently won a restructuring deal — two-and-a-half years after its default — and the resolution included the People’s Republic. However, since Beijing did not agree to any haircuts, creditors only extended the maturities of their claims. That, too, reduced the present value of the debt load by about 40%. It’s a possible template, considering the South Asian nation is targeting a 30% write-down. It remains to be seen, however, if private creditors will get on board with the plan. 

To the bond market, the road ahead may have started looking like a short one. But without a bad bank to unclog the financial arteries, a liability-reduction plan palatable to its biggest bilateral creditor, and a repeal of the draconian anti-terror law to satisfy Western buyers, Sri Lanka’s release from its debt trap may just be a temporary reprieve. It may not amount to enduring freedom.

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Disclaimer: This is a Bloomberg Opinion piece, and these are the personal opinions of the writer. They do not reflect the views of www.business-standard.com or the Business Standard newspaper