Beth Morrissey, recently received a phone call from a client who said they must be reading fake news about Bangladesh providing a $200m currency swap to the Central Bank of Sri Lanka.
“I put them straight and said it’s true. Bangladesh is bailing out Sri Lanka. ‘You did not read that wrong, and yes, it’s totally unbelievable’”, says Morrissey, managing partner at Washington DC-based emerging market analysts, Kleiman International.
Bangladesh, a country with a gross domestic product (GDP) per capita of $1,626, slightly more than Cambodia and Timor Leste, had not just provided its South Asian neighbour with a currency swap it had also highlighted the scale of the country’s economic problems.
On 16 November, thousands of Sri Lankans poured through the streets of the country’s capital protesting against President Gotabaya Nandasena Rajapaksa’s government over the issues of spiralling prices and import controls that have led to shortages of basic foodstuffs.
Sri Lanka's government faces tough decisions
But the economic situation in Sri Lanka could soon get much worse.
With a $500m sovereign bond repayment due in January, Rajapaksa’s government is facing a difficult decision.
“The January payment hangs in the balance, given the level of Sri Lanka’s foreign currency reserves. So the government faces a very tough decision - either it depletes what’s left of its foreign currency reserves further, or there is a default,” says Carmen Altenkirch, London-based emerging market analyst at Aviva Investors.
According to Altenkirch, Sri Lanka has one of the highest debt-to-GDP ratios of the emerging market economies that Aviva Investors cover, at about 100%. This figure is similar to the levels of Zambia and Mozambique, countries that have both experienced sovereign defaults in recent years.
But the emerging market analyst says that in one key area Sri Lanka’s financial position is worse than both African states.
“What is particularly concerning with Sri Lanka is it has an extremely high interest rate cost to revenue ratio of around 90%. In other words, 90% of Sri Lanka’s government revenue goes just to paying interest.”
Central bank takes unorthodox approach
By comparison, Altenkirch says the International Monetary Fund (IMF) puts 20% as the upper limit for an economically sustainable interest rate cost to revenue ratio.
According to the analyst, the next highest set of countries, in terms of interest rate cost to revenues, are Egypt and Ghana which spend roughly 45% of government revenues on servicing debt payments.
Aviva Investors considers both of those countries as vulnerable to a sovereign default.
The Sri Lankan central bank has attempted a number of unorthodox measures in recent months to shore-up the country’s foreign exchange reserves. These include offering future pension benefits to overseas workers to encourage an increase in remittances and launching broadsides at the country’s exporters for not repatriating enough of their hard currency earnings.
But for W A Wijewardena, deputy governor of the Central Bank of Sri Lanka between 2000 and 2009, the country’s only option is to call for outside help.
“Delaying IMF assistance is fatal to Sri Lanka in the coming periods,” he told Capital.com in an exchange over LinkedIn.
How did Sri Lanka’s problems start?
CEIC data show that Sri Lanka’s tourism earnings stood at $5.6bn in 2018, in 2020 this dropped to $956m. The obvious explanation for this is COVID and the travel restrictions that Sri Lanka put in place on 8 April 2020. But Morrissey, says that tourism revenues were dropping a year before the pandemic.
“The problems started in Easter 2019 with the bombings that targetted tourist hotels and killed 300 people. This is something we have seen before in several other countries like Egypt - after a terrorist attack tourism typically falls off a cliff but about a year. Well at the end of that year COVID came.”
In any case, according to one Sri Lanka-based financial analyst, the pandemic has simply highlighted existing problems in the country’s economy.
“Sri Lanka has structural problems in terms of high deficits, low tax receipts, and a depreciating currency, these are inherent issues. COVID just magnified these 50 fold because of foreign revenue from tourism was practically wiped out.
“Added to this was the significant increase by the government on COVID, related expenditure. If COVID was not here Sri Lanka would have been on a better footing. But the inherent issues would have still remained”.
Ratings agency actions
The ratings agencies have taken a mixed approach to Sri Lanka’s difficulties. On 27 August, Standard & Poor’s (S&P) downgraded the country’s sovereign debt to CCC and assigned it a negative outlook.
In a pithy comment accompanying the release its analysts simply stated: “the negative outlook reflects our expectation that Sri Lanka's financing environment may get more difficult over the next 12 months. This would affect Sri Lanka's ability to service its debt.”
S&P declined to comment for this article saying that their analysts had nothing to add to their August statement.
Fitch’s current rating of Sri Lanka at CCC that has been in place since November 2020 and was last affirmed in June 2021, which the firm says in an email exchange, indicates substantial credit risk, with default a real possibility.
“In a six-monthly roadmap published in October by the Central Bank of Sri Lanka, authorities outlined plans to secure funds through bilateral, multilateral and other syndicated loans for the first quarter of 2022,” says Sagarika Chandra director in Fitch’s APAC Sovereigns group.
“However, these plans contain limited details, including the sources and timelines of financing arrangements and fall short of alleviating the external pressures in our view,” Chandra adds.
In late October, Moody’s downgraded Sri Lanka’s sovereign rating to Caa2, but mysteriously kept the country's “stable” outlook. Morrisey says that may reflect Moody’s take on the country’s upcoming debt repayments rather than a reflection of its economic outlook.
“Well, I actually interpreted Moody’s stable rating to reflect that the agency thinks Sri Lanka is going to muddle through and make the January debt repayment.”
Van Eck increases Sri Lanka government debt exposure
Whatever the answer is Moody’s are not saying, they declined repeated requests to explain the stable outlook in their October release.
Another company keeping quiet is US fund manager Van Eck which recently put out a statement on investor site Seekingalpha.com where it said the firm had increased its exposure to Sri Lankan sovereign debt in its emerging markets bond fund.
Van Eck did not reply to an interview request from Capital.com and the webpage referring to the Sri Lanka sovereign debt investment has since disappeared. Capital.com has yet to receive a response to its subsequent email asking if this meant Van Eck was declining to comment.
Moody’s October stable outlook report cited foreign direct investment and in particular tourism-related receipts as having, “the potential to accelerate in an upside scenario and supplement the authorities' ability to keep default at bay”.
Others are less convinced.
“Relying on an increase in tourism revenues or an increase in foreign direct investment, for Sri Lanka to make its January payments of $500m is extremely optimistic,” says Aviva’s Altenkirch.
Will Sri Lanka default in January?
Sri Lanka’s looming challenge is meeting a $500m sovereign debt repayment in January, followed by another $1.5bn due in July next year. Currently its forex reserves stand at about $1.6bn, according to local media report, which is down from $2.1bn in September.
If this rate of attrition continues the Sri Lankan central bank should have enough money to meet the January payment.
Indeed, former central bank deputy governor Wijewardena expects the government to use what is left of Sri Lanka’s forex reserves to avoid being branded a defaulter, but he is less optimistic about further payments in 2022 and beyond.
“Sri Lanka’s estimated debt servicing commitments within next 12 months amount to about $7.3bn and available reserves and planned inflows fall short of that requirement; the country needs to generate a minimum of net inflow of $8bn over that period to avoid default.
“On average, government debt alone during 2022-25 needs $4.5bn annually; restructuring of a debt commitment of that magnitude is not easy; the only way is to get IMF support and work to improve the country’s stand in raising funds from markets.”
So far the government has refused to request help from the IMF. In an emailed response, the IMF told Capital.com that a team from the multilateral lender will be in Sri Lanka for two weeks starting from 7 December to conduct a consultation.
“The IMF has not received a request for financial support from Sri Lanka recently, but the staff stands ready to discuss options if requested,” says the organisation's Sri Lanka mission chief Masahiro Nozaki.
Argentina soverign debt default
The IMF may be Sri Lanka’s only option to avoid a disorderly default but Morrissey is pessimistic about the chance of the government asking for one.
Instead she likens the country’s current situation to Argentina three decades ago, when systematic economic mismanagement led to the Latin American country defaulting on $80bn of sovereign debt in 2001, and being locked out of the global capital markets until 2016.
And even if it does opt to use the IMF there is a high chance it will not complete a programme which will almost certainly require a currency devaluation that would increase food prices in a country already experiencing shortages of basic commodities.
“Sri Lanka has requested 16 bailouts since independence 73 years ago. But they've only completed nine of them. And the stance of the current government is ‘we're going to do swap lines, we're going to borrow from all our friends and neighbours, we're going to do anything but go to the IMF’.
“The situation in Sri Lanka looks like Argentina's train wreck in the early 90s. You know, what's going to happen, it's just a matter of what sets it off. And exactly what the timing is going to be,” says Morrissey.
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