Sri Lanka has been grappling with a debt crisis for several years, and to resolve it, the country must engage in discussions with creditors to reach an agreement on reducing its debt burden. This process, known as debt restructuring, involves negotiating terms that will ease the financial pressure on the nation. In September, Sri Lanka successfully reached a new agreement with private creditors, and today, we’ll delve into one of the key elements of this restructuring.
When it comes to restructuring sovereign bonds, the common approach is to issue new bonds, often with reduced terms. Sri Lanka is now preparing to issue two types of new bonds. The first is the traditional bond, where the interest rate is fixed. The second is a more innovative type of bond, whose interest rate fluctuates based on certain future factors. There are two categories of these adjustable-rate bonds: one is linked to economic growth, where the interest rate can rise or fall in response to the country’s economic performance. The other is linked to governance, meaning the interest rate adjusts based on future governance decisions.
Governance-linked bonds are a relatively new concept, introduced by Veritas Research, and have since gained global acceptance among creditors. These bonds offer a country the opportunity to reduce its debt by committing to improve its governance practices. Unlike regular bonds with a fixed interest rate, governance-linked bonds adjust according to the country’s progress in addressing corruption and improving administrative transparency. If governance improves as promised, the debt burden is reduced.
The rationale behind this innovative debt instrument is based on the belief that better governance reduces the risk of default on future debt payments. Creditors, therefore, see the link between governance improvements and the lower risk of repayment, which justifies a reduction in the interest rate. This method benefits both creditors and the country: creditors are assured that the country’s debt risk is lower, while Sri Lanka can reduce its debt burden by committing to governance reforms.
Some may question how foreign creditors can influence the governance policies of a sovereign nation. However, it’s important to understand that these governance-linked bonds are not terms imposed on Sri Lanka by foreign entities, but rather a proposal from Sri Lanka to its creditors. Improving governance, reducing corruption, and enhancing administrative efficiency are key priorities for Sri Lanka, which stands to benefit from lower debt payments as a result.
The mechanism of governance improvement is an internal commitment of the Sri Lankan government to reduce corruption and enhance administrative efficiency. The issuance of these bonds signals Sri Lanka’s dedication to addressing the structural issues that have historically increased the cost of borrowing. By improving governance, the country not only reduces the risk of default but also creates an opportunity to lower its debt interest rate.
The introduction of governance-linked bonds was first agreed upon between Sri Lanka and its creditors in April, and was reaffirmed in agreements made in June and September. However, to fully capitalize on the potential of these bonds, the Sri Lankan government has yet to present a concrete mechanism for governance improvements that would be tied to these bonds. If there is any delay in this process, the opportunity to benefit from these bonds may be lost.
Therefore, Sri Lanka must move forward with determination to reduce corruption and improve governance. This commitment, when formalized and integrated into the bond agreements, offers a unique opportunity to lower the future debt burden. However, if the government does not act swiftly, the country risks losing this advantage. The path forward is clear: Sri Lanka must take action without delay to secure the financial relief offered by these governance-linked bonds.
