Restructuring of defaulted ISBs. A new debt trap on risky hedging deals? Who is responsible for national risks?


Article's Purpose and Background

The purpose of this article is to raise public concerns over 

  • the design of Eurobonds issued in derivative/hedging form in exchange for defaulted International Sovereign Bonds (ISBs) in contrast to the standard government practice of plain vanilla debt instruments, 

  • their legality and 

  • the authorities responsible for possible financial and economic losses including new default events possible in the future, given the complex derivative nature of Eurobonds.
The article shows that the so-called ISBs restructuring after wasting 32 months in default on 12 April 2022 is nothing but the extension of repayment time from 2022-2030 to 2030-2038 with greater financial risks due to the exchange of hedging contracts for defaulted ISBs with foreign investors where financial benefits and national wonders promised by the authorities from time to time are great lies.

The short background of the article is as follows.

1. The Ministry of Finance (MOF) press release issued by Dealer Manager, Citigroup Global Markets Inc, on 18 December 2024 disclosed details of 15 new securities issued in exchange of defaulted ISBs. New securities were issued for 97.86% principal amount of outstanding ISBs in default, as follows.

  • 8 Rupee Treasury bonds with a total face value of Rs. 155,728.6 mn issued to local holders of defaulted ISBs (at an exchange rate of around Rs. 83.34 for one US$ of ISB principal amount). It appears that these bonds have been exchanged for defaulted ISBs of total principal amount of about US$ 1,868.5 bn held by local institutions (nearly 14.8% of defaulted ISBs) at a significant haircut in the reference Rupee amount. This article does not cover these bonds.

  • 7 US$ securities (termed as New Eurobonds) as listed below. This article covers only these bons.

2. The MOF issued a press release on 13 December 2024 to inform the public of the closure of invitations to ISB holders for the exchange of new securities for defaulted ISBs. 

  • The press release stated that;

    • An official invitation was made on 26 November 2024 in pursuant to the agreement in principle reached on 19 September 2024 with two representative groups of bond holders who held nearly 50% of outstanding/defaulted ISBs. This was the official offer to exchange defaulted ISBs for new bonds/securities.

    • It is expected to exchange about 98% of defaulted ISBs for new securities.

  • The press release also carried a statement or reaction from the President as the Minister of Finance on the national importance of preliminary results of the exchange without indicating what were those results. The statement is copied below.

3. The MOF press release on 26 November 2024 stated that;

  • The invitation involved in an exchange of US$ 12.55 bn of defaulted ISBs outstanding as of 25 November 2024,

  • Terms and conditions for the invitations were approved by the Cabinet of Ministers which was formed on 18 November 2024,

  • Under the baseline scenario of the invited exchange of bonds, Sri Lanka will achieve approximately US$ 9.5 bn of reduction in debt service payments over the 4-year IMF program period, 31% reduction in the coupon rate to 4.4% and extension of the maturity profile of over 5 years.
4. The MOF press release on 19 September 2024 stated that,
  • Agreement reached in principle on restructuring of approximately US$ 14.2 bn of ISBs as at end of 2023,

  • Expectation of benefit from an upfront reduction of debt stock approximately US$ 3.2 bn which could increase up to a maximum of US$ 4.6 bn in case of an economic downturn or decrease down to a minimum of US$ 2 bn if Sri Lanka's economic performance exceeds expectations by a significant margin,

  • Under the baseline debt treatment scenario, debt service payments over the IMF period would be reduced by approximately US$ 9.5 bn, the average maturity of bonds extended by over 5 years and interest rate reduced from 6.4% to 4.4% on average,

  • Bond holders would be consenting to a present value concession of 40.3% in the baseline scenario calculated on the discount rate of 11%, and

  • Sri Lanka would have obtained over US$ 17 bn of debt service relief from restructuring of all debt under the default during the IMF programme period.

Public Concerns

The MOF has not disclosed relevant documents including the principle agreements entered into with the two bondholder committees to the public for information and transparency. Further, full descriptions of new Eurobonds including interest rate determination are not disclosed in the MOF press release issued by the private Dealer Manager (I am unable to understand how the Dealer Manger uses MOF letter heads to issue press releases). Therefore, concerns raised here as follows are very broad in national interest.

  • New Eurobonds are issued on bids submitted by investors (i.e., ISB holders victimized by the default) based on the invitation of the Sri Lankan government. These bonds are complex derivative instruments that require specific laws of Sri Lanka.

    • The MOF press release dated 26 November 2024 states that terms and conditions for the invitations or bond issuances were approved by the Cabinet of Ministers formed on 18 November 2024. However, how the Cabinet got legal powers to approve these bonds is questionable. The Cabinet is not a lawmaker alternative to the Parliament.

    • The new Public Debt Management Act contains provisions for debt contracts based on market as well as non-market sources. However, the new Public Debt Office is not involved in this bond issuance.

    • There is no information whether the approval of the Parliament has been obtained under public finance control in the Constitution.

    • The New York law applicable to the exchange of Eurobonds for defaulted ISBs is not a law of the Sri Lankan land.

  • It appears that 6 out of 7 new Eurobonds (except 4.00% Bond) are derivative instruments whose annual interest payments are linked to unrelated external variables or risk events. In that sense, these are hedging contracts whose financial returns or gains are contingent on external risk events linked to the instruments.

    • Interest rates of 6 Eurobonds are linked to future values of variables connected with macro-economy, governance, etc. whereas exact reference variables and conditions are not publicly disclosed yet. Therefore, interest payments are contingent on unknown future values of defined variables. In that context, these bonds are financial bets between creditors and debtors and, therefore, can be treated as hedging contracts. 

    • Therefore, I see no major difference in principle between Sri Lanka oil hedging contracts that ended in catastrophe in the past and these bond hedging contracts. Oil hedging contracts were designed to hedge oil prices or cost of oil imports whereas these Eurobond instruments are designed to hedge interest rates or cost of borrowing.

    • In general, public debt contracts are plain vanilla instruments with fixed interest rates or floating interest rates linked to a leading market benchmark interest rate or zero coupon bonds at discounts in order to avoid complex risks.

    • What is required for orderly debt service without confronting new risks of defaults as reported from defaulted nations in the past is the ability of the economy to generate a sufficient foreign currency/reserve surplus through the competitive trade. The benchmarks linked to new Eurobonds have no relevance to this ability as they have no regard to the ability of the Central Bank to build a sufficient foreign reserve on a permanent basis. In that respect, international credit ratings attached to new bonds may not be realistic to show the debt servicing ability as scheduled.

  • No experts can predict future risk events and debt service payments of hedging instruments in the future. Accordingly, how the MOF determined about US$ 9.5 bn of reduction in debt service payments over the 4-year IMF program period and 31% reduction in the coupon rate to 4.4% as financial benefits of these bonds is baseless. In that context, how the Minister determined substantial debt relief to restore the long-term sustainability of our public finances due to these bonds also has no basis.

  • There is no information whether Sri Lanka received a haircut or a reduction in the principal amount of ISBs on the exchange with new bonds although the haircut has been a major topic in public over the standard debt restructuring elements.

  • There is no information on ISB holders who have purchased bonds at deep discounted prices in the market just prior to default. It appears that they all receive new bonds for the face value of ISBs and make huge profit. It should be fair to exchange such ISBs at parallel purchased prices or at parallel haircuts as they can make profit when new bonds start trading at new prices. However, local ISB holders have been given significant haircuts based on price and exchange gains they secured at the time of purchase of bonds in early 2020/21.

  • It is unconventional to design debt contracts to promote macroeconomic performance and country governance through the surveillance of creditors at an additional cost to debtors. It is the duty of shareholders and not of creditors. The utilization of debt in a manner to service debt as per contracts is the responsibility of the debt managers where the default risk is duly assessed, priced and borne by the creditors. In that context, there can be parallel derivative contracts such as interest rate swaps and options or credit-default swaps with third parties by both creditors and debtors to hedge risks of debt contracts as they envisage. Therefore, the inclusion of such hedging options in the same debt contracts is unacceptable. This is against modern finance.

  • There is no public information whether any expert committee or a tender board assessed the agreements and bids independently to ensure the issuance governance or whether any prior audit has been carried out to assess the compliance with the due process and limits on risks. It is unknown of the minutes of the official meetings held with two bondholder committees. Therefore, the issuance of new bonds is subject to same concerns over issuances of ISBs in the past.

Concluding Remarks

  • I see a wide media campaign praising some individuals as national heroes with reference to the bond exchange programe stated above. However, the institutional literature reveals that same individuals borrowed through ISBs recklessly, misused funds through the foreign reserve, caused the foreign currency bankruptcy, defaulted foreign loans/ISBs on 12 April 2022 and led the negotiation during the past 32 months for the bond exchange for same defaulted ISBs. The protracted delay and its effects on the national economy and general public should not be under-estimated as the default was announced with expectation of debt restructuring with the help of the IMF within four months.

  • In the current context, the bond exchange programme is questionable on applicable laws and approving authority. Therefore, both default of ISBs and issuance of new bonds are likely to be unconstitutional acts of the relevant MOF and Central Bank bureaucracy.

  • The Minister of Finance has issued a sweeping statement on the benefits of new bonds to the national economy after obtaining the Cabinet approval for terms and conditions on invitations. Therefore, it appears that the Minister in his personal capacity will be found to be responsible for any risk events that may materialize in the future as Cabinet members will not take the responsibility as usual. So-called national heroes will not be found in 2030-38 in the country. It has now become a practice of legal inquiry to investigate into public decisions as to what the loss to the public and who is responsible for the lapse in avoidance of the loss. It is clear that both the default and the exchange of new bonds have caused immense loss to the public.

  • The government should officially disclose terms and conditions on new securities and relevant approvals under national laws as international consultants or dealer manager are not the Sri Lankan authorities to be responsible and accountable within national statutes.

  • An official review of the accuracy of statistics cited in the MOF press releases from time to time is necessary to protect the public trust in official statements and to avoid the release of unaccountable information to the public.

  • Overall, it appears that national heroes after wasting longer 32 months for debt rework negotiations with ISB holders have put the country back in another debt trap through hedging contracts without any plans for generating a sufficient foreign reserve to service new debt contracts, other than usual rollovers of same debt on due dates. As such, the country will restart from the point it defaulted in 2022. This is the source of the fear of another default of debt likely after 2028. The only benefit the country received is the deferment of the time to stay in default while negotiating and spending saved foreign reserves to fund the recommencement of the same flow of imports inclusive of vehicles.

(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures. All are personal views of the author based on his research in the subject of Economics which have no intension to personally or maliciously discredit characters of any individuals.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 13 Economics and Banking Books and a large number of articles published.)

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