SL Still Has High Levels of Foreign Debt Servicing – GS
By Paneetha Ameresekere
Over the next 18 months, Sri Lanka has US$ 2.5 billion bond maturities falling due, equivalent to 55 per cent of its gross foreign exchange (FX) reserves, one of the highest levels in emerging markets (EM) said Goldman Sachs, in a report published a week ago (20 July). Sri Lanka repaid a maturing US$ 1 billion sovereign bond, that took place yesterday (27 July).
Sachs, in its report dated 20 July, further said Sri Lanka has one of the highest US dollar bond spreads among EM sovereigns. Political uncertainty and the significant impact of COVID-19 led to a worsening of the country’s external vulnerabilities and multiple-notch credit rating downgrades, it said.
The ultimate goal for the Government of Sri Lanka (GoSL) should be to return to a sustainable debt trajectory, Goldman Sachs advised. Structural reforms are needed to diversify the economy and current account and to put the sovereign back on a more stable footing.
Moody’s and S&P downgraded the sovereign by one notch to B2/B in late 2018 following the dismissal of then Prime Minister Ranil Wickremesinghe, citing as a contributing factor to their decision the country’s political environment, which had reduced the prospects of reform. This heightened concerns that Sri Lanka would be unwilling to accept or adhere to structural reforms envisaged under an IMF programme (the most recent IMF programme had been approved in 2016 and expired in June 2020). As IMF conditionality lapsed, credit spreads continued to underperform in late 2019, and then began to widen significantly in March 2020 during the economic shock arising from COVID-19.
The impact was severe, as FX revenues – 70 per cent of which come from remittances, textile exports and tourism – dried up and external vulnerabilities became more acute, resulting in multiple-notch credit rating downgrades to the current ratings of Caa1/CCC+.
Near-term debt sustainability
With the COVID-19 pandemic ongoing, the question of Sri Lanka’s near-term debt sustainability is beginning to appear more pressing. Yield levels on Sri Lanka’s dollar bonds are above 15 per cent, indicating challenging conditions in the international capital markets for the sovereign, and the availability of external financing will be a key factor determining the pricing and direction of its dollar bonds, Sachs’ 20 July report said.
However, financing needs can be met with FX reserves and the drawdown of announced official loans, FX swap facilities and new IMF SDF issuance over the next few years. “For official bilateral and multilateral commitments, we take into account disbursement on existing commitments and new commitments announced so far this year. Our calculations show that Sri Lanka should comfortably meet its external financing requirements in 2021 and we estimate that effective FX reserves will be US$ 6.4 billion at the end of this year, similar to levels at the end of 2020. However, external funding needs would become more severe beyond 2021. Our calculations show that, without further external funding, effective FX reserves would fall to US$ 2.2 billion at the end of 2022 and would be negative by the end of 2023,” Sachs warned.
“Since 2010, we find that, excluding Sri Lanka, the bond spreads of 13 sovereigns have traded at stressed levels (that is, above 900 basis points) for several months, of which only three have avoided default (Pakistan and Belarus in 2010-2012 and Tajikistan in 2020-2021) and two of these (Pakistan and Belarus) ended up in IMF programmes. Of the countries that have defaulted, the average time spent with spreads at distressed levels before default was 15 months. Sri Lanka’s spreads have been at distressed levels since March 2020, or 16 months,” said Sachs.
Sri Lanka has turned to the IMF for emergency support 16 times since 1950 and has no history of defaulting on its external commercial debt over this period. The most recent IMF package was extended in 2016 as falling exports, slowing remittances and capital outflow pressures engendered a balance of payments (BoP crisis) with FX reserves falling to US$ 5 billion (or around three months of exports) by mid-2016. The conditionality attached to this IMF programme was received positively by credit investors, with credit spreads narrowing from a peak of 600 basis points in early 2016 to 300 basis points by early 2018. The programme expired in June 2020 and uncertainty over whether it will seek a further IMF package has had a negative effect on the country’s dollar bond performance, said Sachs.
Significantly wider spreads
Sri Lankan dollar bonds trade at significantly wider spreads compared with similarly rated peers. In part, this reflects the sovereign’s challenging fundamentals. But a larger part of the spread premium appears to reflect the fact that Sri Lanka is currently not in an IMF programme, said Sachs.
The median spread (based on Bloomberg Barclays Indices) for CCC rated sovereigns under an IMF programme is 660 basis points compared with 1,270 basis points for CCC rated sovereigns that are not in an IMF programme and 1,950 basis points for Sri Lanka. “Looking at previous episodes of countries entering into an IMF programme, this has typically been associated with a significant outperformance of the sovereign’s dollar bond spreads relative to the Emerging Market Bond Index (EMBI) Global Diversified Index and we would expect the same for Sri Lanka if the GoSL were to announce its intentions to engage with the IMF.
We do not have a view on the likelihood of Sri Lanka entering into a new IMF programme, and much will depend on whether the conditionality attached to any programme is politically acceptable, and whether external financing conditions ease. That said, as noted by Moody’s in its assessment in February this year, the country’s previously volatile domestic political environment can slow reform momentum and heighten refinancing risk. This sentiment is echoed by S&P, which noted in its update in May this year that Sri Lanka’s institutional setting has been a persistent credit weakness over the past few years,” said Sachs.
The conditionality attached to the IMF programme in 2016 – fiscal consolidation, revenue mobilisation, monetary policy reform with a transition to a more flexible exchange rate and inflation targeting framework, alongside structural reforms to reduce protectionism and other trade barriers – give some insight into the structural constraints that have plagued Sri Lanka over the past few decades, it said.
“We think achieving a significant reduction in public debt-to-GDP over the next several years is going to be a challenging task. The fiscal and current account adjustments required to accomplish that in isolation – that is, without a significant increase in export revenues and/or funding from stable new external sources—would likely necessitate painful domestic adjustments that may be politically challenging. However, in an environment where there is a sustained boost from external growth drivers, an improvement in external competitiveness driven by structural reforms and increased funding from non-debt creating sources (FDI and equity inflows), a gradual reduction in public debt-to-GDP to more sustainable levels could be achievable over a longer time horizon,” Sachs in conclusion said.