“We believe an inflection point will be reached in Q2 21, based on our view that growth will be weak and the fiscal and external positions will remain under pressure” -Barclays Singapore
Sri Lanka’s external debt dynamics are extremely challenging over the next six months and urgent action is needed to address them and mitigate collateral damage which can have wide-ranging social and political ramifications-Pathfinder Economic alert
Recent developments are again casting doubt on Sri Lanka’s external position and increasing investor concerns about the country’s ability to repay foreign-currency bonds. A Barclays Bank Singapore, Barclays | Emerging Asia Sovereign Credit report said
We maintain our Underweight rating and believe the country will reach a critical point in Q2 21 in terms of dealing with its foreign debt.
“Investors are increasingly concerned about Sri Lanka’s ability to repay its foreign debt and are reassessing the timing of a credit event; bond prices have fallen to the mid-to-high 50s. In our view, the outlook for Sri Lanka’s debt is skewed by uncertainty about “when” and “if” the IMF will be involved, and so far the government has not stated clearly that it intends to approach the IMF” the report said.
We believe an inflection point will be reached in Q2 21, based on our view that growth will be weak and the fiscal and external positions will remain under pressure. Also, by this time the government will have better visibility of its finances and foreign currency drawdowns.
We believe restructuring its debt without an IMF program would be more costly for investors. The report stated further
Even with IMF lending support, we assign a very high likelihood to a restructuring with private sector involvement, albeit with a somewhat creditor-friendly outcome. On the other hand, if the government restructures without the IMF’s involvement, we expect the outcome to include harsher exit yields (12% or higher) even if investors manage to agree to a deal that includes less punitive principal haircuts.
Meanwhile a Pathfinder economic alert published recently states the most imminent threat to macro-economic stability, which can affect the whole economy, comes from the Balance of Payments, the external payments in particular. Sri Lanka’s external debt dynamics are extremely challenging over the next six months and urgent action is needed to address them and mitigate collateral damage which can have wide-ranging social and political ramifications.
Gross foreign external reserves amounted to USD 5.7 billion (including USD 400 million in gold) as at 31st December 2020.
Total debt-related payments during the next six months (February – July 2021) comprise: an ISB maturity of USD 1 billion; SLDB maturities of USD 980 million; and interest payments of USD 482 million. In addition, the Reserve Bank of India (RBI) SARC SWAP of USD 400 million would need to be repaid this month (February 2021). This is intended to be a short term facility and cannot be extended further without staff-level agreement on an IMF Arrangement. In normal circumstances, the expectation is that SLBDs would be rolled over. However, only 25 percent of the maturities of USD 200 million was rolled over at the last auction. This reflects the severe scarcity of Forex in the market. There is uncertainty, therefore, regarding how much of the maturing SLDBs of USD 980mn can be rolled over during the next six months. Any shortfall will deplete the external reserves. The shortage of foreign exchange is also likely to adversely affect the rollover of short term SWAPs with FCBUs which will be maturing over the next six months.
The upshot of all this is that there is a strong possibility that reserves will fall to extremely dangerous levels within the next six months (by July 2021). Unless there are significant inflows in the meantime,there will have to be severe compression of domestic absorption (consumption and investment), i.e., very painful austerity. Instead of a recovery, the economy could well experience further contraction. It becomes important, therefore, to examine the likelihood of inflows which would serve to offset the heavy debt-servicing burden over the next six months. Sri Lanka’s development partners (multi-lateral and bilateral) are expected to disburse USD 1.7 billion during the course of the whole of 2021. Some of this would be flowing in over the next 6 months. However, because this is project and programme lending, it would not be possible to utilize this funding to boost the external reserve position. Furthermore, the rating downgrades have meant that Sri Lanka is no longer able to access international capital markets at affordable rates (currently 15 percent) thereby curtailing a potential source of financing. Specific sources, which have been announced by the authorities to fill the external financing gap, include the following:
-Term loan from the China Development Bank :USD 700 million
– SWAP facility from the People’s Bank of China: Yuan 10 billion; equivalent to USD1.5 billion (this facility could have conditions that will constrain its capacity to bolster usable reserves)
– SWAP facility from the RBI: USD 1 billion (this facility is tied to Port development and removal of some import restrictions complicating the completion of negotiations).
The delay in the completion of these transactions seems to indicate that there are challenges in each of these negotiations. Even if all three of these facilities materialize, it is extremely unlikely that it would be possible to get sustained bilateral support of this nature in the magnitudes required to meet the country’s debt obligations of USD 23 billion over 2021-2025. Hence one needs another approach that unlocks a wider base for sourcing external financing.
The second option is to seek the support of the IMF. This will also serve to leverage a number of other sources of external financing. Over 70 countries have been assisted by the IMF through the Emergency Facilities established by the Fund to provide countries with fast-disbursing financing to address the impact of the pandemic. Sri Lanka would be eligible for up to USD 830 million, based on need, from the Rapid Financing Instrument. An arrangement with the IMF can also trigger direct budgetary support from the ADB (USD 500 million) and the World Bank (about USD 300 million). It can also pave the way for a rating upgrade and eventually regaining access to international capital markets. Anchoring policies to an IMF arrangement would also provide foreign investors with greater confidence to invest in the country. However, in the present global and domestic climate, it is unrealistic to expect that FDI will play a major role in filling the external financing gap, particularly in the short term. It is also noteworthy that it is difficult to utilize FDI to give a direct boost to gross official external reserves as much of it would flow out of the country in the form of imports and other payments incurred by the foreign investor. However, in the medium term, FDI can increase the capacity to service debt by contributing to an increase in the production of tradable which would earn or save foreign exchange. For IMF support to be secured, there has to be a clear medium term plan to achieve debt sustainability.
The Fund’s Articles do not permit it to lend to countries where it cannot certify that the debt is sustainable. At present, the IMF could find it difficult to certify that this is so. All options would need to be considered including fiscal adjustment, as well as a market- friendly re-profiling of Sri Lanka’s external debt through an extension of maturities and some relief on coupon payments. This would serve to create some space both in the Government Budget and the Balance of Payments for growth-oriented stabilization.
It is noteworthy that the IMF is currently advocating and supporting a growth-oriented approach to stabilization with a back loading of adjustment. It must be pointed out, however, that Sri Lanka does not have a painless glide path to stabilize the economy. Kicking the can down the road would only serve to increase the severity of the austerity when it is inevitably imposed.
It is crucial that there is early and decisive action as a very disruptive hard default, involving hair-cuts for creditors, could well be looming on the horizon. There are signs that Sri Lanka is facing solvency rather than liquidity challenges. As experienced in other countries, such a default usually means soaring interest rates, a collapse of the currency and severe belt-tightening, which tends to impact the poor and vulnerable disproportionately with unpredictable social and political ramifications. The longer-term solution for achieving sustainable debt dynamics involves running a primary surplus in the budget and promoting an accelerated growth trajectory.
This involves not only stabilisation of macro fundamentals but also structural reforms to increase productivity/competitiveness of the economy. Increasing investment, including FDI, and boosting the production of tradable, particularly exports, need to be an integral part of this narrative.