The Sri Lankan economy has begun to show signs of recovery from its worst economic crisis since independence following the US$2.9 billion International Monetary Fund (IMF) reform program that commenced in late March 2023.

Sri Lanka’s foreign exchange buffers have improved thanks to the first instalment of the IMF loan, supplemental funding from the Asian Development Bank and the World Bank and rising migrant worker remittances and tourist arrivals. This has permitted the government to lift restrictions on essential imports. Inflation is gradually dissipating and long queues at fuel stations and mass street protests have ended. But the government’s arduous task of achieving durable economic stability and putting the economy on a sustainable growth path is yet to begin. A challenge the country continues to face is the massive sovereign debt overhang.

When the IMF approved Sri Lanka’s Extended Fund Facility (EFF) the country’s stock of public debt was US$82 billion — 128 per cent of GDP — with domestic and foreign debt accounting for approximately equal shares. Annual interest payments were eating up nearly two thirds of government revenue and domestic debt accounted for the bulk of this interest burden.

A group of institutional investors — accounting for a large share of Sri Lanka’s outstanding US$12.5 billion in international sovereign bonds — had already informed the IMF that they were ready for restructuring debt subject to concurrent restructuring of domestic debt. Despite this, the EFF, initially focussed solely on foreign debt, giving the misleading impression to the Sri Lankan public that that there would be no restructuring of domestic debt as part of the EFF.

It was only after the implementation of the EFF had commenced that the restructuring of domestic debt began. The IMF emphasised ‘satisfactory progress’ in restructuring foreign debt as a key milestone for releasing the second tranche of the EFF loan in September or October 2023. At the same time, the holders of international sovereign bonds reiterated equal treatment of foreign and domestic creditors as a prerequisite for their participation in debt restructuring. The government, therefore, announced the domestic debt optimization (DDO) program on 29 June 2023 as an appendage to the original EFF.

A unique feature of the DDO program compared to domestic debt restructuring programs in most other countries is its partial coverage. It covers only public debts of three broad categories — Sri Lanka Development Bonds worth US$1.4 billion, treasury bills held by the Central Bank worth US$7.1 billion and treasury bonds held by the Employee Provident Fund (EPF) worth US$8.8 billion. Together they account for about 40 per cent of total domestic debt.

Domestic debt in the form of treasury bills and treasury bonds held by domestic commercial banks — 5 per cent and 18.7 per cent respectively of total domestic debt — are excluded from coverage. Treasury bills held by commercial banks and the public are normally excluded from domestic debt restructuring. But the exclusion of treasury bonds held by the banks is unusual.

Placing the entire burden of domestic debt restructuring on ‘captive’ institutions — the Central Bank and the EPF, which is managed by the monetary board of the Central Bank — is an easy option for the government. But the favoured treatment of commercial banks and domestic government security holders compared to the EPF is an inequitable distribution of the burden of debt restructuring. The savings of salary owners in the EPF are meant to provide a reasonable post-retirement income. Their current real incomes have already been cut by high inflation and higher taxes — now the DDO will cut their future incomes as well.

The government has given a number of justifications for the exclusion of the banking sector from the DDO. These include the higher incidence of recent increased corporate and value-added taxes on banks compared to other corporations, weak bank balance sheets and the possible negative impact of debt restructuring on bank balance sheets. But ‘ring fencing’ of the banking system within the debt-restructuring program is only a palliative for the deep-rooted balance sheet fragility of the banking system. This needs to be addressed as part of the proposed structural reforms in the EFF in order to safeguard financial sector stability.

Contrary to the initial expectations of the government and the designers of the EFF, restructuring domestic debt is necessary for Sri Lanka to come out of the crisis. But it is important that the government undertake debt restructuring across the board, with contingent reforms as part of the overall EFF to preserve confidence in the banking system.

The proposed partial DDO is highly inequitable. It passes on most of the burden of adjustment onto salary owners and ordinary people while sparing the banking sector and treating international creditors and individual domestic creditors generously. This is not a recipe for social and political harmony, which is necessary to shape a broader social consensus on reforms.

The DDO strategy of placing the burden of domestic debt restructuring on the Central Bank, while ignoring balance sheet fragility of the commercial banks, is not consistent with the EFF objective of safeguarding financial stability, a prerequisite for durable recovery and sustainable growth. There is convincing evidence from debt crisis research that a banking crisis could magnify the lost output of a debt default, or could even derail the reform process.

Prema-chandra Athukorala is Emeritus Professor of Economics at the Crawford School of Public Policy, the Australian National University.