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Monday, 22 February 2021 01:19 - - {{hitsCtrl.values.hits}}
Two popular international banks last week confirmed their “underweight” position on Sri Lanka and its sovereign bonds flagging-off concerns over debt sustainability and external position amidst domestic and global challenges.
“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,” Barclays Bank said in a coverage on Emerging Asia Sovereign Credit titled ‘Sri Lanka: Drained faster than expected’.
“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,” it added.
Standard Chartered Bank (SCB) in a global research credit alert titled ‘Sri Lanka – Coming down to the wire’ opined that Sri Lanka’s reluctance to engage with IMF has increased investor concerns about debt sustainability.
It said that delay in confirmation of the $ 1.5 billion People’s Bank of China swap line could raise investor concerns whilst noting the medium-term debt sustainability is worsening on high interest costs, elevated debt, weak growth outlook. However SCB said bilateral support from China, multilateral funding and FDI are potential sources of external financing.
Barclays in its report said 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. 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,” it said.
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. 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,” Barclays opined.
Its views were following testing a variety of scenarios using its model to determine recovery values. “Recovery values are likely to be in the 60s, assuming the country reaches an agreement with the IMF on a program by H2 21.
“But our recovery estimates fall to the low 50s if the IMF is not involved. We assume exit yields will rise if the Government prolongs any debt adjustments,” it said, adding: “These estimates assume that all bonds are treated uniformly in a debt exchange.”
“We maintain our Underweight recommendation on Sri Lanka amid a lack of visibility or clarity on when an adjustment could take place,” Barclays added.
It said Sri Lanka’s foreign reserves declined sharply in January. The Government reported that reserves fell to $ 4.8 billion (from $ 5.7 billion end-December and $ 7.4 billion at end-August). This drain is much larger than we expected and should be seen against the $ 400 million of swap lines repaid by the Central Bank on 1 February.
The $ 4.8 billion of reserves translates into 3.2 months of import cover, based on 2020 imports, which were unusually low given the import curbs. On a pro forma basis that assumes no new inflows or outflows in February, the import cover ratio is likely to decline to 2.9 months. That level would be critical, but does necessarily imply an imminent default on debt repayments because of the import curbs in place.
“Nevertheless, the decline in reserves is concerning because it has occurred more rapidly than we expected and ahead of large debt repayments during Q2-Q3 (total of $ 2.6 billion). In addition, there is no concrete evidence that the country will receive new inflows. Sri Lanka’s limited access to capital markets means its ability to secure loans or funding from bilateral and multilateral sources is critical to arrest the decline in reserves,” Barclays said.
The Central Bank Governor’s recent comments implied a sanguine view on the balance of payments, citing his forecasts for 2021 of Port City lease payments ($ 1 billion), remittances ($ 7.5 billion, 10% of remittances are expected to be directed to the Central Bank by the local banks), exports ($ 13 billion); and tourism receipts ($ 1.75 billion).
“In our view, rebuilding foreign reserves is key for the Government to restore investor confidence. According to press reports, the Government is negotiating swap lines with the central banks of China and India, and has held discussions with India over possible foreign direct investments. But we note that a pickup in FDI-related inflows is likely to result in higher imports of capital goods, which would weaken the import cover ratio. Assuming imports increase to levels similar to 2019, current foreign reserves ($ 5.8 billion) only provide 2.9 months of cover,” Barclays said.
“This implies that any increase in imports from 2020’s low levels would need to be accompanied by an increase in foreign reserves to avoid a further deterioration in the external position. Short-term external debt service in 2021 is roughly $ 4.5-4.8 billion, of which $ 3.3 billion is comprised of marketable debt securities (Sri Lanka sovereign bonds and Sri Lanka Development Bonds),” it added.
The Central Bank has been in talks with People’s Bank of China (PBoC) for several months to finalise a $ 1.5 billion swap line, but progress remains slow. A swap line with the PBoC would represent an upside surprise to our baseline view. However, progress on the $ 700 million foreign-currency term financing facility is expected from China Development Bank that has been reported because we expect this to be applied to loans from China that are due in coming months.
Central Bank of Sri Lanka Governor W.D. Lakshman suggested that the country is in negotiations to secure credit lines that will span 1-8 years and cost 6-7%. Importantly, and repeatedly, the Governor has noted that an IMF program is not being considered because it “would bring undesirable conditionality”.
“In the background of the limited progress in securing new sources of funding, the rupee has depreciated 4.8% YTD against the USD (falling as much as 6.6% against the dollar in late January) and the 5y Sri Lankan Treasury bond yield has risen 45bp since mid-January,” Barclays said.
SCB in its report too provides a similar assessment.
It said investors remain concerned about Sri Lanka’s external financing risks in the absence of engagement with the IMF and a consequent lack of market access. FX reserves declined sharply to $ 4.8 billion in January, and are likely to decline further to $ 4.5 billion by end-February following the recent settlement of India’s $ 400 million swap line.
SCB estimates Sri Lanka’s external financing needs at $ 4.3-5.6 billion in 2021. Media reports suggest that Sri Lanka plans to fund this largely through bilateral support from China (via the People’s Bank of China swap line), FDI and other multilateral funding. Based on the scenario analysis, reserves could decline substantially (to $ 3 billion) if bilateral inflows disappoint.
While Sri Lanka should be able meet its external financing requirements with bilateral support from China, FX reserves could decline to $ 4 billion by end-2021. Moreover, beyond 2021, Sri Lanka has $ 4-5 billion of Government external debt service annually until 2025, leading to continued external financing pressure.
More importantly, concerns about medium-term debt sustainability are increasing amid rising debt levels and constrained revenues, SCB said adding it expects public debt-to-GDP to rise to 110.5% by end-2021 from 105% at end-2020 (including sovereign guaranteed debt), keeping interest costs-to-revenue high at 55% in 2021. This is one of the highest levels among EM HY sovereigns (albeit lower than 70% in 2020), despite a sharp increase in revenues, higher dependence on T-bills and lower interest rates.
“Our estimates suggest that the Government needs to run a primary surplus of 2% of GDP or more to stabilise debt; this seems challenging in the near term given the current revenue strategy and the muted growth outlook,” SCB said.
Following are excerpts of SCB report.
We still think IMF engagement is needed to resolve Sri Lanka’s economic and debt sustainability challenges. To return to a sustainable debt trajectory, the country also needs a credible medium-term economic plan for fiscal consolidation and structural reforms to boost growth to its potential 5% and to build revenue resilience.
While a structural reform program would improve debt sustainability only in the medium term, engagement with the IMF would give investors comfort that the government is on the economic reform path. An IMF program would also likely unlock other multilateral assistance.
Markets are pricing in a high probability of restructuring, with most of the curve (apart from the 21 and 22 maturities) trading at a cash price of 57-62. We remain Underweight the Sri Lanka complex, even after the recent price correction, as we see the risk-reward as unfavourable.
The market is focused on news of bilateral support from China. If that materialises, the short-end bonds (21 and 22 maturities) could rally. While the belly to long end of the curve may also rally slightly, one-time bilateral support would not ease Sri Lanka’s medium-term debt sustainability challenges, in our view, as a similar situation is likely to arise in 2022.
In fact, if Sri Lanka meets its external financing requirements via reserves, and continues with its current policies of import suppression and yield curve control, this could exacerbate its economic challenges and weigh on the eventual recovery. On the curve, we prefer to own the long-end bonds, which are trading at low cash prices, as short-end bonds face substantial event risks.
External financing is the key near-term challenge for Sri Lanka, given the drying-up of financial account inflows and large refinancing requirements. FX reserves declined to $ 4.8 billion (around three months of import payments) as of January from $ 5.7 billion in December 2020 due to $ 700 million of debt service (including SLDB maturities) and the use of reserves to support the rupee.
FX reserves are likely to fall further to $ 4.5 billion by end-February following the settlement of India’s $ 400 million swap line in early February.
Sri Lanka faces a pre-determined short-term drain of $ 6 billion on its FX reserves in 2021, based on disclosures as of end-December 2020. Of this $ 6 billion, Government external debt service amounts to $ 4 billion ($ 1.3 billion of interest and $ 2.7 billion of principal service).
January and July are large outflow months, with $ 500 million in January (already serviced) and a $ 1 billion bond repayment in July. The rest of the debt service is evenly spread throughout the year.
In addition to external debt service, the Government has $ 1.3 billion of Sri Lanka Development Bond (SLDB) maturities to be funded, with large maturities in January ($ 195 million) and May ($ 694 million). The Government has found it difficult to refinance SLDB maturities locally given tightening dollar liquidity conditions; this led to a shortfall of $ 450 million in 2020. In January, only $ 43 million of the $ 195 billion was refinanced, resulting in a shortfall of $ 152 million.
Given the tight external financing situation, we expect Sri Lanka’s import restrictions to continue in 2021. We lower our 2021 C/A deficit forecast to $ 1.2 billion (1.3% of GDP) from $ 1.4 billion (1.6% of GDP) to account for higher remittance inflows, partly offset by a wider trade deficit. We still expect the C/A deficit to widen in 2021 versus 2020; we revise our 2020 estimate to $ 0.85 billion, or 1.1% of GDP.
The Government plans to finance its C/A deficit and capital account-related FX outflows through a combination of FDI, FII, and debt flows from commercial and official sources. In the absence of an IMF program, Sri Lanka is likely to find it difficult to issue sovereign bonds, its main mode of financing BoP deficits from 2016-19.
We look at various inflow and outflow scenarios to simulate Sri Lanka’s FX reserve position at the end of 2021.
We see two potential outflow scenarios, based on our current projections, upcoming debt maturities, and the likelihood that some SLDBs and private-sector debt will be rolled over. Scenario 1 is our ‘core’ scenario, based on our C/A deficit forecast of $ 1.2 billion (1.3% of GDP).
In Scenario 2, we assume a larger C/A deficit of $ 1.8 billion (2.1% GDP), primarily driven by a higher trade deficit assuming an average Brent crude oil price of $ 60/bbl and a pick-up in imports due to increased domestic activity. Scenario 2 also assumes a large ($ 800 million) shortfall in SLDB rollovers given the current lack of $ liquidity domestically, and a $ 400 million shortfall in private-sector external debt rollovers.
We have looked at three potential inflow scenarios, assuming varying amounts of FDI and inflows from bilateral and multilateral sources. In terms of bilateral inflows, we assume inflows from China based on the recent statement from Sri Lanka’s Ministry of Finance and the CBSL regarding ongoing discussions on a $ 1.5 billion swap line with the PBoC.
We do not assume further inflows from India given the recent settlement of the Reserve Bank of India (RBI) swap line; however, Sri Lanka and India are still engaged in discussions on new swap lines. The three scenarios also assume different levels of FDI inflows.
The FX reserve position will depend on the C/A and on FDI and bilateral flows in 2021. If Sri Lanka can attract strong FDI flows and debt flows from China, it should be able to maintain its current reserve position. However, if strong FDI and debt inflows from China do not materialise, reserves could dip below two months of import cover ($ 3 billion), which would put Sri Lanka in a difficult situation.
Beyond 2021, Sri Lanka has $ 4-5 billion of external debt service annually until 2025. This means that it could face a similar situation again in 2022, even if it meets its 2021 debt-service obligations with financial support from China.
While external financing challenges are a near-term concern, we see medium-term structural debt sustainability as a bigger worry given the high interest burden on current debt. Government debt stood at an estimated 105% of GDP at end-2020 (including public-sector debt guaranteed by the Government) and could rise further to 110.5% in 2021, despite likely strong nominal GDP growth this year.
Moreover, interest costs – which we estimate at 6.3% of GDP, or 70% of revenue, in 2020 – are at record levels. Even after accounting for lower interest due to Sri Lanka’s ongoing yield curve control policy, interest costs are likely to remain high at 5.8% of GDP (or 55% of revenue) in 2021. With over 50% of Government revenues going towards interest costs, there is little left to fund health, education, and other social and development needs. This is unsustainable, in our view.
Sri Lanka’s lack of international market access has forced the Government to increasingly shift to domestic sources of financing, with domestic debt accounting for 52% of total Government debt as of end-2020, up from 41% in 2019.
The CBSL cut reserve requirements by 300bps and policy rates by 250bps in 2020, lowering the average interest cost on new domestic debt relative to previous years; however, overall interest expense still likely rose in 2020 as the debt stock increased. Rupee depreciation in 2021 could put further upward pressure on interest expenses.
The Government plans to follow a strategy of increasing the share of domestic borrowings and maintaining yield curve control to reduce its cost of debt. A majority of local debt is owned by captive contractual savings institutions like the Employees’ Provident Fund and banks (including Government banks).
The Government plans to tap excess liquidity created by the CBSL, which would enable these institutions to purchase more Government securities. In addition, the CBSL monetised Rs. 650 billion (4.2% GDP) in 2020, which we think will continue in 2021.
Our estimates suggest that Sri Lanka will require real GDP growth of over 5% per annum (nominal growth of 10%) and a primary surplus of 2% of GDP over the medium term to gradually reduce its debt burden and improve debt sustainability.
Even with our expected fiscal consolidation trajectory, debt sustainability concerns are likely to linger. We expect Sri Lanka’s public debt-to-GDP ratio to remain at 98-100% (excluding Government guarantees), based on our current forecasts for growth and fiscal consolidation through 2023.
Real GDP growth will be key; a medium-term rate closer to 4.0-4.5% seems plausible to us. We downgrade our 2020 real GDP growth estimate to -4.0% (from -3.0%), factoring in lower-than-expected growth in the first three quarters of the year. We continue to expect growth to rebound to 3.8% in 2021. The CBSL’s medium-term growth forecasts, at 6% from 2023, appear optimistic; the Government believes Sri Lanka can recover to growth levels similar to the post-civil war boom of 2010-14.
We are sceptical given the significant debt overhang and economic scarring from the prolonged impact of COVID on the services sector, especially tourism (which accounted for almost 5% of Sri Lanka’s GDP in 2019). We see growth closer to 4.5% in our medium- to long-term steady-state analysis. This is slightly above the average annual growth rate in the five years before the pandemic, but below 2010-14 levels.
The Government’s debt overhang has left limited fiscal space for public investment and increased financial market stress. While growth could be supported in the near term by base effects and exogenous factors, strong long-term growth will require investment, which the Government’s current debt load does not allow for.
Sri Lanka has used interest rate controls (e.g., rate caps on T-bill issuance) and capital controls (restrictions on capital outflows) to manage the current debt crisis.
However, the extended use of such strategies would weight on growth by suppressing the import multiplier and causing capital flight via the current account, putting further pressure on the exchange rate. Moreover, rising global commodity prices and UST yields pose challenges to CBSL’s yield curve control strategy.
Rising public debt is a problem on multiple fronts; it crowds out private investment and reduces room for future Government spending via rising servicing costs, even as additional debt delivers diminishing returns. Finally, elevated debt levels also raise the question of sustainability – the Government’s ability to repay debt in the longer run.
