China Tears for Teardrop Island Sri Lanka

Worry about debt sustainability in Sri Lanka has surged in recent weeks as a region first default candidate post-Covid.   News from the Central Bank that gross official reserves continued to slide in January to USD 4.8 billion from USD 5.2 billion a month earlier further pressured bond prices and the rupee. After losing 7% against the USD the past twelve months – and 17% vs. EUR – the LKR is coming under increasing pressure. Foreign currency repayments for 2021 total USD 5.7 billion.  The fall in reserves came as the CBSL settled a USD 400 million currency swap facility from the Reserve Bank of India. Originally granted at end-July for 3-months for pandemic-related spending, it was rolled over until February. Further extension by the RBI was contingent on Sri Lanka reaching at least a staff level agreement for an IMF program. The current government insists an IMF deal is not necessary and is holding out for further assistance from China, focused on a USD 1.5 billion swap facility.  

With some of its external sovereign bonds trading 40% below face value, the debt office has also had massively undersubscribed Treasury Bill sales. At its most recent auction it failed to sell two-thirds on offer, accepting average yields only 2 basis points higher for 3- and 12-month paper and 7 bps. for the 6-month bill.  The most recent auction for longer-term Sri Lanka Development Bonds was also a dud, with less than one-quarter of the USD 200 million on offer raised even as yields surged more than 100 basis points.

Portfolio investment is not expected to return in 2021. Foreign investors sold net USD 25 million of shares in January after dumping USD 273 million in 2020, according to Bloomberg data. The Colombo Stock Exchange is flat in USD terms year-to-date on the MSCI Index although local investors have in recent months poured into the market in part due to fixed-income flight, with stock trading volumes in the first 22 trading days of the year exceeding annual volumes from 2016-2019.  The local index advanced 30% in January, but this week trading was halted after a fall of more than 7.5% which triggered the circuit breaker.  The downturn, expected to be short-lived, was attributed to a “misunderstanding” between regulators and brokers over new margin credit reporting but was also seen as a needed correction.

Pre-pandemic the banking sector showed weakness, with non-performing loans at 4.7% at end-2019, with the level recently estimated to be near 6%.  Many loans are still on deferral and pressure on balance sheets will continue to rise at the same time banks will likely face challenges in accessing foreign currency funding as sovereign pressures mount. In addition, commercial banks are now required to sell 10% of foreign worker remittances that are converted each day to the central bank, and can no longer hedge exposure in the suspended forward market.

More broadly, analysts expect economic growth to rebound to the anemic average 3% recorded in recent years after an estimated 4% contraction in 2020. The current account gap should remain in the 3% range as remittances grew 5.8% in 2020 to top USD 7 billion. The perennial trade deficit did narrow in December as imports remained low on continued government controls on non-essential goods and a pick-up in exports on the cheaper currency. Tourism revenues, which accounted for about 5% of GDP pre-pandemic, are expected to rebound marginally as borders were recently re-opened with strict Covid precautions. Budget plans to attract USD 2.5 billion in foreign direct investment are again ambitious after not being met in recent years, and the official 2021 budget projects a deficit of 8.9% of GDP, up from 7.9% in 2020.

While the Sri Lanka government awaits a decision on further funding from China, it may also be the recipient of larger allocation of the IMF’s Special Drawing Rights. If new issuance of USD 500 billion in SDRs is approved, analysts estimate that it would increase Sri Lanka’s reserves by 10%.  The China rescue appears doubtful. In recent months China has not come to rescue of state-owned enterprises defaulting on dollar bonds. By end-2019 it was already Sri Lanka’s largest bilateral creditor, holding over 9.5% of total outstanding foreign debt, and in 2020 provided an additional USD 500 million loan. Public debt is nearing 100% of GDP, with more than half in foreign currency. With reserves continuing to drop, investors will maintain growing skepticism of Sri Lanka’s creditworthiness. The Rajapaska government’s harder political and economic line against India, the West and the IMF is a recipe for self-isolation. Beijing will not repeat the equity conversion/concession controversy the last time the leadership was in trouble five years ago, as the private and official payment squeeze unlike other countries in the default shadow elicits scant sympathy. 

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