Emerging Asia Economics Update: Can Sri Lanka avoid default?
Falling foreign exchange reserves, a declining currency and a high level of foreign currency debt mean the risk of a sovereign default in Sri Lanka is growing, a London based an economic research consultancy firm Capital Economics stated in its latest emerging Asia economics update. “While the country should be able to muddle through for the next few months, it faces a crunch point early next year when more bond repayments are due.
A default is now looking the most likely option,” it stated. Sri Lanka’s external position has been precarious for some time, but the country has been pushed into crisis by the pandemic. A collapse in tourist arrivals (which previously brought in foreign currency receipts worth more than five per cent of GDP) has led to a sharp widening of the current account deficit and put downward pressure on the rupee.
The currency has weakened eight per cent against the dollar since the start of the year. (See Chart 1.) A shortage of foreign currency has made it increasingly difficult for the Government to service its substantial foreign currency debts, which we estimate are equivalent to over 45 per cent of GDP. This strain has been exacerbated by falls in the currency which have pushed up the local value of dollar debt. The central bank used USD 1 billion of its foreign exchange reserves to pay off a maturing bond in July.
That took reserves down to USD 2.8 billion or less than two months of imports. (See Chart 2.) The authorities have taken a number of steps to ease the balance of payments strains including selling foreign exchange reserves, rationing food imports and raising interest rates by 50 bps. They have also made it harder for citizens to move money abroad by limiting outward remittances to USD 20,000 per person for six months. The Central Bank also received USD 0.7 billion from an IMF SDR allocation in August. These measures should give Sri Lanka enough space to muddle through for a few more months.
However, a crunch point is approaching in the first-quarter of next year when almost USD 2 billion of US dollar- denominated bonds mature. Another USD 2 billion of US dollar bonds mature in July. (See Chart 3.) Sri Lanka’s CDS premiums imply roughly a 30 per cent chance of default over the next year. A new Central Bank Governor, Ajith Nivard Cabraal, has been appointed to help tackle the crisis. Cabraal was Governor from 2006-15 under President Mahinda Rajapaksa (who is now prime minister).
The new Governor has said he will release a “roadmap” of more measures soon and will focus on “stability first, then growth”. One option is a sharp tightening of monetary and fiscal policy. Fiscal consolidation would help to free up resources to go towards meeting debt repayments, while interest rate hikes should provide some support to the currency. Tighter policy would also weigh on import demand, which would improve the current account position. However, stamping down on domestic demand when the economy is still reeling from the pandemic would further weigh on living standards and would be very unpopular politically.
Another option would be to turn to the IMF for assistance. However, the Finance Minister recently ruled out the possibility of asking for a new bailout. The IMF would insist on tighter fiscal policy in order to put debt on a sustainable path, which as mentioned above the Government would find politically unpalatable. The current Government would also be against the reforms and oversight that the IMF would demand as the price of further support. Sri Lanka could instead ask China for more help.
Chinese support has tended to come with fewer conditions than IMF bailouts, but it’s uncertain how much China would be willing to lend given the precarious economic situation Sri Lanka finds itself in. Sri Lanka is also wary of becoming too dependent on one country. A final option would be for Sri Lanka to default on its debts. This would lock the country out of global financial markets for some time and thereafter, see higher borrowing costs. What’s more, the diverse array of creditors to Sri Lanka could make a debt relief programme difficult to achieve. Sri Lanka will want to try to maintain cordial relations with China and so may try to push a greater share of losses on to private bondholders.
As some countries in Africa and Latin America have recently found out, this brings with it the increased threat of disorderly defaults and prolonged legal battles. But the costs of default may be judged to be better than the economic and political costs of the alternatives. The global pandemic arguably makes the traditional benefits of defaulting more compelling – freeing up money to spend on the pandemic response, including healthcare.
The fact that around half of Government debt is owed to foreigners makes default an even more attractive option. In any case, concerns about the impact of default on market access can be overstated. Governments usually only lose market access during the debt restructuring phase. Being locked out of foreign capital markets for a period is unlikely to be a huge deterrent given the difficulties Sri Lanka already has accessing international capital markets.
Sri Lanka is rated as highly speculative by international ratings agencies. And while default is likely to lead to a further jump in borrowing costs, academic research suggests that the “defaulters’ premium” is sizeable initially but fades to about 100 bps after five years. There is also the question of the recovery rates in any eventual restructuring. Our research has found the best gauge of potential recovery rates in any restructuring is the size of public debt as a share of GDP around the time of default. A government debt ratio of around 105 per cent of GDP means the recovery rates on Sri Lankan debt are likely to be in the region of 50 per cent, the report concluded. .
(See Chart 4.)