ECONOMYNEXT – Sri Lanka should structure a dollar syndicated loan targeting local banks to raise some of the forex deposits in banks, which can be used to settle the next maturing sovereign bond.
Getting the central bank to engage in buy-sell swaps and giving proceeds to the government to repay debt is kind of a circular debt operation.
Sri Lanka’s banks are now participating in Indian and other syndicated loans with their foreign currency deposits.
It is perfectly fine to invest part of the NRFC or RFC deposit money or equity balances in the offshore banking units of banks in foreign debt.
Since Sri Lanka government’s rating is low it is better to hold some money in higher rate foreign bonds or loans. But it must be understood that even US government finances are not in a good shape under the single policy rate/abundant reserve regime.
But in any case, geographical diversification is good for depositors to mitigate risks provided banks are careful about the issuer.
However, some part of the deposits can be loaned to the Sri Lanka government as in the past.
Why Syndicated Loans?
There were Sri Lanka Development Bond sales in the past, but they were mostly short term. Due to lack of dollarization (which is an option) and lack of agencies like primary dealers, there is no ready market for them or people to go find money.
Instead of announcing auctions and waiting for bids to come, Sri Lanka’s new debt management office should appoint lead managers and go through the way other syndicated loans are done with co-lead managers who get a small fee.
That process leads to active negotiation and structuring.
The loans should also be amortizing. That will lead to longer term loans.
If banks alone hold the syndicated loans, there can be an option to repay in rupee securities if there is a need.
Recent experience has shown that it is easy for banks to get paid in rupee securities and they will use other deposits and loan repayment (reducing domestic credit) and buy dollars.
That can be clauses in the loans if the banks are willing.
Since the availability of dollars is directly linked to the amount of domestic credit given by banks, they can easily purchase dollars by offsetting domestic credit and imports, without creating new money.
The central bank on the other hand creates new money when they buy dollars.
Illiquid ISBs
Countries like Sri Lanka should avoid selling sovereign bonds that lack liquidity. While the rupee bond market has deepened, even some of the rupee bonds remain thinly traded.
In the past, market participants suggested consolidating bond issues to improve liquidity which has worked.
If liquidity is a concern in the domestic market with multiple issues, it is an even bigger problem for sovereign bonds.
There are only two or three market makers who quote for Sri Lanka sovereign bonds in the Bloomberg system.
And some Sri Lanka bonds get no quotes at all.
That is why it is easy for Sri Lanka and other countries whose bonds have thin liquidity, to lose market access when some shock happens.
Sri Lanka should try to settle recent upcoming bonds (the interest coupon bond for example) with syndicated loans which are not subject to quick loss of market access.
That will reduce the outstanding Sri Lanka sovereign bonds. Once defaulted bond investors will be jittery. The cost of a sovereign default is not higher coupon rates as academics say, but the loss of market access at the drop of a hat.
Ecuador is a good example. Ecuador basically lost market access during Covid with very good fiscal metrics, rock bottom GFN, due to jittery investors. As the country is dollarized, all payments were made till the restructure.
Can Sri Lanka Default on Syndicated Loans?
Sri Lanka can default on syndicated loans also if rates are cut (rates are questionable even now) and inflationary open market operations are conducted to maintain a ‘single’ policy rate.
The original Latin America crises, after the IMF’s Second Amendment to its Articles – as the US tightened monetary policy from 1979 and Lat Am did not – came from commercial bank loans, not bonds.
Syndicated loans are no proof against inflationary open market operations and currency crises from an activist central bank.
But there will be more time to collect dollars and repay them unlike bullet repayment bonds.
After the Latin America defaults, well meaning people in the US, under procedures like the Brady Plan promoted bonds as a better solution than syndicated loans which banks could refuse to roll-over and demand repayment.
But instant loss of market access when liquidity was lost for the bonds was the result whenever rates were cut with inflationary open market operations and forex reserves of those countries fell.
Then the vulture funds emerged and that led to hair cuts.
So none of these solutions, syndicated loans, bonds, hair cuts is a substitute for sound money, but syndicated loans which are amortizing give longer window to repay.
High Savings Rate, Deflationary Policy
Sri Lanka has a high savings rate and does not have to borrow abroad.
The lesson from East Asian countries with central banks that ran deflationary policy (domestic assets of those agencies were negative because central bank bills were sold to banks) is that they could build reserves to spare. (Asian savings glut).
Some of these central bank banks also engaged in sell-buy swaps (deflationary swaps) to withdraw liquidity, and they do not print money through buy-sells like Sri Lanka’s central bank is doing now, which is dangerous.
Instead the Treasury should raise a syndicated loan and settle the next maturing sovereign bond. Some of them are amortizing so that is better.
The Treasury can also finance infrastructure with dollar borrowings in the banks which are people’s savings as was done in the past.
The central bank should not borrow dollars through buy-sell swaps (which are inflationary for one thing), and give to the Treasury.
If dollars from central bank domestic swaps are used to repay maturing debt, the forex risk is transferred to the balance sheet of the monetary authority and therefore people’s money is at risk.
The forex risk should remain with the Treasury.
The Treasury can also buy dollars from the domestic market for rupees raised from rupee securities, and settle maturing foreign loans and reduce its dollar exposure if it wants to.
An effective monetary law (a true central bank constitution in the classical style) or currency competition or both will also eliminate forex risk altogether, but that is another story.
If the parliament controls the central bank’s operating framework and compels it to run neutral or deflationary policy, domestic rates will collapse.
The Paradox of Sound Money
It seems like a paradox that rate keeping slightly higher with deflationary policy should lead to low interest rate while open market operations to cut rates, leads to very high nominal interest rates eventually.
Through monetary history it has been the same experience. Classical economists have warned time and again that it is not possible to cut rates with open market operations as the modern central bankers in the age of inflation believe.
Simply put, that is because reserve is not capital. It is just a medium of exchange.
Deflationary policy, low rates with plenty of capital leads to high growth rates. This is because ultimately growth depends on the volume of savings and capital that is invested. If capital is destroyed through inflation (depreciation) growth will slow.
RELATED : Sri Lanka should sell floating rate bonds to balance long term risks
This column has previously suggested selling long term floating rate rupee securities. It was also suggested that a small amount of floating rates Consols (perpetuals) could be issued for which will reduce the GFN.
GFN is pretty useless as the experience of Ecuador showed. Ecuador’s GFN was next to nothing. Whether or not bonds can be rolled over is a matter of confidence (and liquidity and depth) and not really whether the GFN is some specific number.
RELATED : Sri Lanka should be careful in over-relying on GFN at the expense of stability: Bellwether
CONFIDENCE MATTERS: Singapore has a GFN over 20-pct of GDP. Ecuador lost ‘market access’ at a very low GFN, but restructured without much pain due to dollarization. Confidence matters, not econometrics. Under flexible policies instability is almost guaranteed.
But Sri Lanka is living in the IMF program and has to follow its rules. They are well-intentioned rules. They cause no harm.
The space from long term bonds could be used to convert some of the central bank held bonds to bills to run deflationary policy.
Sri Lanka faces considerable danger at the moment, with an IMF program where the QPC on domestic assets does not fall (no deflationary policy) except for the coupons.
In the first half of 2025 the coupons on the central bank’s step-down bond portfolio were 95 billion rupees and the swaps were 109 billion rupees up to June.
If that is the case in the period ahead there will be problems with net foreign assets and meeting the Net international Reserve target. These are also tied to confidence.
That is matter for the government to look into when the next IMF discussions take place.
Otherwise, all the fiscal gains made, the pain that people have gone through can disappear in a flash.
There is no real substitution to sound money either through a true monetary constitution or currency competition. But there are short term steps that can be taken to reduce risks, until the public and policy makers can come up with permanent solutions.
(Colombo/Aug19/2025)
