This article was compiled by Professor Udara Peiris.

Udara Peiris joined Oberlin in the fall of 2022. He was previously a tenured Associate Professor of Finance at HSE University (at the department ICEF) in Russia and has taught at the University of Warwick, and the University of Oxford (both in the UK). He was a research advisor to the Central Bank of Russia, consulted the Government of Sri Lanka, and presented his research at institutions including the IMF, Federal Reserve System, Bank of England, and Reserve Bank of Australia. His research has a strong policy focus and covers the nexus between the macroeconomy and the financial markets.

The announcement made by the Ministry of Finance of the suspension of external debt payments on Tuesday, though overdue, was professional and comprehensive in its scope. Now that this process has commenced, I believe attention and discussion should now turn to the issue of restructuring rupee denominated Government debt. 

This is something which has received far less attention than the external currency debt, but an issue that is more important for 1) effectively controlling inflation, 2) creating a banking environment that can support rapid post-crisis growth, and 3) sharing the costs of the crisis fairly and avoiding some of the most painful fiscal consolidation policies the IMF will require.

Former Central Bank Governor Dr Indrajit Coomaraswamy recently warned against restructuring domestic debt citing the adverse impact it would have on domestic bank balance sheets. However, without a comprehensive restructuring plan that involves external debt, domestic debt, State-owned enterprise (SOE) debt, and bank recapitalisations, macroeconomic targets will be harder to reach and the burden of the current crisis will continue to borne by those most vulnerable. 

Our immediate priority must be restructuring external debt, and as this process has now commenced, discussions and policy should be developed to deal with rupee denominated Government debt.

While the concerns of restructuring domestic debt of Dr Coomaraswamy are well founded, I believe that restructuring domestic Government debt needs to be part of the current overall discussion on debt restructuring to benefit the public through supporting public finances and the commercial banking system. 

I believe that the creation of an “Asset Management Company” or “bad bank” can greatly assist in this domestic restructuring process, and mitigate some of the severe fiscal consolidation measures that may need to be implemented in Sri Lanka in the coming months.

Given the limited fiscal space, the Government has to issue additional debt without further expanding money supply, restructuring rupee debt will allow the Government to keep interest rates low and initiate productive public investments and continue to provide much needed social welfare support. 

For commercial banks, restructuring would reduce the magnitude of Government capture of the domestic banking system and its adverse impact on the generation of productive private credit, and allow it to support a post-crisis economic recovery. Currently SOEs crowd out the market for new investment and innovation and until these unprofitable SOEs are put on a more commercial footing, they will hinder economic progress more generally. 

Central Bank rate hike and domestic debt

Last week, the Central Bank raised the policy rate by 7% as a means to contain aggregate demand and curb inflationary pressures. Although this is a much-needed response, it is unlikely to have a significant impact on the latter. The central Government has issued around Rs. 2 trillion worth of domestic currency debt in 2021, and this additional supply of debt has been taken up by the Central Bank purchasing almost Rs. 1.2 trillion worth of direct treasury liabilities. 

The impact on the monetary base in this period has been minimal because of the effort to maintain an artificially strong exchange rate has resulted in a drain of reserves and a corresponding contraction of the monetary base of Rs. 0.9 trillion. Now that the exchange rate is left to freely float, any expansion in rupee treasury debt may require additional Central Bank purchases, thereby expanding the monetary base.  

Furthermore, existing stocks of Government debt will need to be rolled over resulting in the following problem: the monetary base needs to increase to rollover previous debt, requiring further increases in the policy rate, causing the yields and Government debt financing costs to further rise, resulting in further increases in the deficit and the financing needs of the Government.

This vicious cycle counteracts the positive affect of higher short-term interest rates in contracting money growth – in effect, the policy will result in further contraction of domestic credit, including credit towards productive investments. 

To be clear, I believe the rise in short-term rates is necessary, however without any corresponding response or adjustment of the fiscal stance with respect to rupee debt, interest rates rise will not be particularly effective in curbing inflation, and may hurt investment at a time when it needs to be further encouraged. 

Commercial banks and rupee debt

The size of commercial bank exposure to liabilities issued by the Government has grown by Rs. 2 trillion since the end of 2018, and in November 2021 was approximately 39% of commercial bank assets. Of this approximately 9% is liabilities issued by State-owned enterprises. 

The magnitude of Government liabilities on bank balance sheets in Sri Lanka should be put in the context of the UK, where following WW2, approximately 40% of banking assets were Government securities – a number which only fell towards the late 1970s and coincided with a period of rapid growth and private credit extension. 

In the region, the Bangladeshi banking system, for example, has less than 17% of its assets in Government securities. In Sri Lanka, the impact of Government liabilities is two-fold. First, direct Treasury liabilities (Bonds/Bills) result in banks comfortably operating with a large source of passive income which dents their both risk-taking appetite and financial innovation – both critical for genuine growth in the productive capital base of the country. 

Second, the liabilities issued by loss-making state-owned enterprises whose debt is unlikely to be repaid in a present-value sense. If SOE liabilities were, instead, issued by a private enterprise, they would have been written down or termed non-performing reflecting their true economic value. Instead, SOE liabilities are perpetually rolled over, reducing liquidity in the banking system and preventing any systematic discussion of restructuring of these liabilities. 

I believe that, together with comprehensive restructuring of external debt, domestic debt should also be restructured, and the negative impact on domestic banks can be contained through the establishment of an Asset Management Company (AMC), colloquially known as a “bad bank”. Here I will examine both these categories of debt, and argue that the creation of an AMC is a necessary and critical part of a wholistic approach to restructuring Sri Lankan Government debt.

What is an AMC?

AMCs are funded special purpose vehicles (an ‘SPV’ capitalised by the Government and/or private sector) that purchase (in exchange for cash or asset of sufficient liquidity) assets/loans from (typically originating) banks. 

These assets typically have limited (trading) liquidity in the secondary market, and are often issued by an entity that is insolvent. Usually, these assets are written down to fair value on bank balance sheets, but in cases where doing so can have a dramatic impact on bank capital, banks often “roll over” these assets. 

They prefer maintaining the nominal value of the assets, at the cost of reduced liquidity, to writing down their values and impacting capital. An AMC changes the composition of bank assets towards more marketable/tradeable ones, and provides a value to the assets sufficient so as not to damage bank capitalisations. 

How have AMCs been implemented?

AMCs have often been implemented following major economic and financial crises, such as the Asian financial crisis in the late 1990s and the euro area sovereign debt crisis starting in 2010 where they were used in Ireland, Spain and Slovenia. The AMCs in the latter case were typically capitalised with Government debt which was in turn used to purchase impaired assets from banks at a price close to, but below, real economic value. 

The banks could then use the Government debt to access Central Bank liquidity. These AMCs have generally had a positive impact in contributed to repairing and unblocking the investment channel in these countries. Sweden, an early adopter of AMCs in 1991-93, and Korea in 1997-8 (Korean Asset Management Company – KAMCO) benefited from an integrated approach to bank and asset resolution, along with a broad programme for recovery, in the face of financial crises.

The path to an AMC in Sri Lanka

In an earlier 14 January FT article ‘Debt Restructuring and a Path to Confidence and Hope’, I detailed how external debt can be restructured. Without restructuring domestic debt, the cost of the renegotiation will not be appropriately shared among domestic capital holders. Although AMCs are typically created to purchase privately issued debt, I believe they can be designed in such a way to be helpful in the process of restructuring domestic treasury and SOE debt.

An AMC can be capitalised or funded with newly issued long-maturity debt (as with the AMCs ‘NAMA’ in Ireland or ‘Sareb’ in Spain following the 2008 crisis), alongside a commitment to renegotiate existing Treasury securities. Banks that currently hold Treasury securities could sell these to the AMC in exchange for the new long-maturity debt. 

This would effectively result in a debt swap with the commercial banking sector, and any negative impact on bank capital can be supplemented with direct state investments to the equity of the banks. Private holders of previously issued Treasury debt would enter the restructuring process with an eventual haircut on their debt. 

This would fairly distribute the costs of Government debt restructuring over a broader set of creditors whilst protecting the banking system. Importantly, by increasing the maturity profile of the debt, it would reduce the interest/coupon payments to Government revenue ratio (standing by some estimates at an unsustainable 80%), and would limit the need for monetary financing of rupee liabilities and imposing a regressive inflation tax on the general public. For Government liabilities held by the Central Bank, a similar debt exchange can be implemented.

For SOE loans and debt, an AMC can purchase them at a discount, again in exchange for newly issued long-maturity Government debt. Once the AMC has acquired SOE debt, these assets can be rolled over through the issuance of additional capital from the Treasury, or through raising capital directly from private investors, until a comprehensive restructuring of SOEs can take place (or privatisation). 

To increase the likelihood of the latter case, the assets purchased by the AMC should be at a discount sufficient to be attractive to private investors post restructuring. This dual approach of subsequent funding through both the Treasury and private sector will have additional benefits of limiting the impact on the Government balance sheet, and provide market-based discipline on the badly needed restructuring of the SOEs. 

It goes without saying that the AMC would need to be professionally managed, be independent of both the Central Bank and Treasury, and have significant oversight over the restructuring of SOEs.

Equitably sharing the cost of the crisis

The proposals in this article are predicated on the need to share the cost of the current crisis as broadly as possible. Although there are many technical issues that need to be fleshed out in these proposals, it does present a possible way forward. The current situation is patently unfair where ordinary people pay for this crisis inordinately through rapid increases in import prices, dramatic increases in inflation, and painful shortages of necessities. 

Without a comprehensive restructuring plan, the next phase of the debt crisis may result in substantive fiscal consolidation resulting in significant increases in taxes and the reduction of public and welfare services (as was seen in many countries that saw similar debt crisis episodes as Sri Lanka) – something which will be catastrophic to people that are already reeling from the crisis.