CITI expects SL to suspend debt payments tandem with IMF deal

• Says biggest trigger for approaching IMF has been Sri Lanka’s external liquidity position unravelling faster than expected
• Claims FX depreciation and import controls are now leading to rising inflation expectations that feed into worsening inflation dynamics
• Says 2022 Budget will be an important policy document to reach some agreement with IMF
• Opines austerity measures inevitable

Global financial giant CITI expects Sri Lanka to suspend debt payments by year-end in tandem with a program with the International Monetary Fund (IMF), which it said was most likely.

Issuing an update following media reports to the effect that Sri Lanka is planning to negotiate an IMF program, CITI said: “We change our call and now expect Sri Lanka to suspend debt payments by year-end as it finalises an IMF program (a final deal may spill into 2022), versus our previous base case of still repaying the January 2022 bond in full and then finalising an IMF program not too long after.”

“If the news reports are correct, the Government’s decision to approach the IMF does not surprise us, but the timing isn’t clear,” CITI said, adding some senior officials like State Finance Minister Ajith Cabraal and Presidential Adviser P.B. Jayasundera are still publicly opposed to any such move, and an SDR allocation of close to $ 800 million allows further delays in reaching out to the IMF. 

“We think this was always going to be a political decision as well with some in the Government – State Finance Minister Ajith Cabraal, Presidential Adviser P.B. Jayasundera and CBSL Governor Lakshman – still publicly opposed to approaching the IMF,” CITI added. 

However, it said the protracted debt uncertainty is now impacting macro stability, and CITI thinks the new Finance Minister Basil Rajapaksa may help move the policy consensus toward pragmatism.  

“With the 2022 Budget under preparation, which will likely be an important policy document to reach some agreement with the IMF, we think austerity measures now look inevitable,” CITI said. 

“If the Government reaches a consensus on approaching the IMF, we think it is unlikely to repay the January 2022 bond in full in order to avoid a significant drain on external reserves as it reassesses the rest of the Eurobond repayments,” it added. 

“Aside from tax and other regulated price increases, private sector involvement (PSI) in a debt restructuring under an IMF program could be part of the package, with risk of some form of a principal haircut on dollar bonds beyond coupon relief and principal extension,” CITI said. 

Its base case prior to this news had been that Sri Lanka would seek IMF support soon after the January 2022 bond maturity. 

“We think the biggest trigger for approaching the IMF has been Sri Lanka’s external liquidity position unravelling faster than expected, notwithstanding the one-off SDR allocation and 2 billion renminbi CDB loan,” CITI said. 

It said official reserves fell more sharply than expected to $ 2.8 billion in July, local holdings of matured ISBs have not been adequately recouped into SLDBs in August given protracted FX shortages, the trade deficit has widened 32% year-to-date, and remittances have been losing momentum and declining sharply in recent months (down 27% YOY in June to July), which CITI think reflects fund flows out of the formal banking sector given a non-market aligned FX spot rate.

CITI’s report also said a worsening COVID situation has made any meaningful tourism recovery in the next 12 months difficult. It widened the current account deficit forecast for this year to 2.5% of GDP (vs 1.6% of GDP), largely on reported remittance weakness. Capital flows have also been below expectations with little concrete progress in asset sales/privatisation and follow-through flows after the Colombo Port City Economic Commission Bill was passed in May 2021. 

“We think the recent statements by Presidential Advisor P.B. Jayasundera that “if not for the pandemic, we would have now seen a cash flow”, and “...pressure must be applied on the Chinese”, as it relates to Colombo Port City, highlight the challenges to galvanising inflows,” CITI said. 

With the looming uncertainty over how large external debt repayments can be met, local and foreign investors are likely to delay deploying capital. CITI also doubts whether the recent 50 bp rate hike and 200 bp SRR hike are enough to boost confidence in holding the rupee, more so with local rates not being allowed to adjust fully as the Treasury yield caps are still in place.  

CITI said FX depreciation and import controls are now leading to rising inflation expectations that feed into worsening inflation dynamics. Some of the rupee vs dollar quotes in the banking system are as much as 10% weaker than those quoted by state-owned banks. 

“We think the former reflect the market better, and fuel inflation expectations, which alongside import controls and loose macro policies (notwithstanding the latest monetary tightening), are worsening inflation dynamics. We think expectations of protracted dollar shortages and import controls are fuelling speculative hoarding,” CITI said. 

CITI has raised its forecast for Colombo CPI inflation (currently at 5.8% in July) to 6.6% by year-end (vs. earlier forecast of 6.3 %), and said it maintains its view of another 25-50 bp rate hike by year-end and another 100-150 bp hike in 2022, but an earlier IMF deal could lead to frontloading more rate hikes by year-end.