Standard Chartered revises Sri Lanka credit outlook to stable from positive

Standard Chartered Bank has revised Sri Lanka’s credit outlook to stable from positive and is advising bond investors to await the conclusion of Sri Lanka’s $ 1 billion Sovereign issue prior to getting involved in the country’s debt market opportunities.

This advise is contained in SCB’s latest Asian sovereign credit coverage.

“While we believe that the medium-term structural positives for Sri Lanka remain intact, stress on the fiscal and external fronts will continue over the near term. We therefore revise our credit outlook to Stable from Positive,” SCB said. “We think the Sri Lanka bonds should trade broadly flat to Vietnam, on a duration-adjusted basis, given the improving macro fundamentals in Vietnam. At current valuations, we are Neutral on the Sri Lankan Bonds. For those looking to get involved in Sri Lanka, we recommend waiting for the new bond issuance, which is likely to come at a concession to the secondary levels,” the SCB report added. Here is the chapter on Sri Lanka in the Asian sovereign credit comparator of the Standard Chartered Bank.

Sri Lanka Credit fundamentals

Sri Lanka’s BoP position came under stress in H2-2011 when FX reserves depleted by USD 2.7 billion (30% lower than its peak in July 2011) and FX reserve coverage fell to 3.4 months of imports. This was due to its current-account deficit increasing to 7.6% of GDP in 2011 (2.9% in 2010) following strong import demand, pro-growth policies and high oil prices. Broad policy measures were introduced in February 2012 as the authorities tried to arrest the rapid credit growth, widening trade deficit and the pressure on FX reserves.

The measures included the abolishment of the Sri Lankan rupee trading band, the tightening of monetary and credit policy, the fuel and electricity price increase and the hike in petroleum tax.

While the BoP continued to record a deficit of USD 215mn in Q1-2012, it was an improvement over the USD 1.1bn in Q4-2011. We expect a BoP surplus of USD 0.9 billion for full-year 2012 (USD 1.06 billion deficit in 2011) on the back of sustained remittance flows, higher tourism earnings and FDI inflows. Disbursement of the final USD 430 million tranche by the IMF, the potential sovereign bond issuance (USD 500-1,000 million) and IMF loans (USD 500 million) will further support the BoP improvement. Also, private-sector credit growth (especially import-related credit growth) is slowing due to the 18% cap on banks’ lending growth, two policy rate hikes in H1 and the rupee depreciation (17% YTD).

Fiscal consolidation, which has been underway since 2009 on the back of tax reforms and spending restraint, saw slippages in 4M-2012.

The deficit increased to Rs. 285.8 billion or 3.8% of GDP (from 2.7% of GDP in the same period in 2011). That said, the increase in petroleum tax, the introduction of a commodity levy and rupee depreciation will help partially bridge the deficit gap in H2. On the other hand, higher commodity prices will trim the losses of state-owned enterprises (losses of c.1.5% of GDP in 2011). We expect the fiscal deficit at 7.0% of GDP (target at 6.2% of GDP).

On the external front, as of April 2012, Sri Lanka had c.USD 2.7 billion of short-term debt (including USD 698 million of marketable debt) as against FX reserves of USD 5.8 billion.

The roll-over risk is mitigated to an extent by the planned sovereign bond issuance and the fact that the bulk of the debt was issued by multilaterals at concessional rates. Going forward, ongoing support from the IMF and policy consistency will be crucial to reducing external vulnerabilities. While we believe that the medium-term structural positives for Sri Lanka remain intact, stress on the fiscal and external fronts will continue over the near term. We therefore revise our credit outlook to Stable from Positive.

Valuation and technicals

Sri Lankan authorities have implemented a number of measures in recent months that have helped stabilise FX reserves.

However, they will need to stay the course in order to prevent stresses building up again on the fiscal and external fronts. While there have been some comparisons with the Vietnam situation, we are slightly more comfortable with Sri Lanka given the better availability and transparency of data and the IMF’s involvement.

We think the SRILAN bonds should trade broadly flat to VIETNM, on a duration-adjusted basis, given the improving macro fundamentals in Vietnam. At current valuations, we are Neutral on the SRILAN complex. For those looking to get involved in Sri Lanka, we recommend waiting for the new bond issuance, which is likely to come at a concession to the secondary levels.