Note: See here for a more detailed report on the state of Sri Lanka's debt restructuring published on 1 July.
Today, the Central Bank of Sri Lanka (CBSL) hiked its standing lending rate by 100bps to 15.5%, in line with the median forecast of seven analysts surveyed by Bloomberg (forecasts ranged from no hike to +300bps). The move comes alongside a sharp rise in inflation, with the Colombo CPI index rising nearly 55% yoy and 13% mom in June (with food rising 80% yoy and core rising 40% yoy).

With the three-month T-bill yield rising above 28% at yesterday’s auction, the hike is largely symbolic, and further monetary tightening is necessary to tame inflation. The CBSL projects a further increase to c70% in the coming months before it begins to moderate later in the year, and Sri Lanka’s -39% real policy rate is surpassed only by Turkey’s -65% as the most steeply negative among the set of 66 emerging and frontier markets that Tellimer tracks.
Further, while Prime Minister Wickremesinghe says that the government plans to limit money printing in 2023 and end the practice completely by the end of 2024, it has reached alarming levels this year. Through 5 July, the book value of the CBSL’s T-bill holdings has risen by LKR940bn (4.75% of projected full-year GDP), on pace to outstrip the LKR1,223bn (7.5% of GDP) rise in 2021 and LKR640bn (4% of GDP) rise in 2020.

With limited access to external financing and limited capacity by domestic banks and investors to absorb further issuance, the CBSL will be forced to keep printing money to meet the government’s spending needs. This will continue to place upward pressure on inflation and the LKR, which has been effectively repegged (using "market guidance", in CBSL parlance) at 360/US$ after depreciating by 44% since the March devaluation. If the peg is maintained, this could exacerbate FX shortages even further, with Sri Lanka having already completely run out of FX to pay for fuel and food imports and LKR now trading at a c7.5% premium on the parallel market.
In comments this week, Wickremesinghe said that IMF discussions have been made more complicated because the economy is completely bankrupt, but said he expects to reach a staff-level agreement in August. CBSL Governor Weerasinghe echoed that sentiment in an interview today, saying that he expects to reach an agreement soon, and adding that the IMF has already submitted its debt sustainability analysis (DSA) to Sri Lanka’s financial and legal advisors to serve as the basis for the IMF programme and debt restructuring. In the meantime, Wickremesinghe says that discussions are underway with India, Japan and China to form an aid consortium once a staff-level agreement with the IMF is reached.
However, in a detailed report on Friday, we outlined why Sri Lanka’s restructuring is likely to be a protracted process. As a result, despite Sri Lanka’s eurobonds now trading towards the lower end of our estimated recovery value range, we think things will get worse before they get better and that a more attractive entry point may emerge in the future. Today’s rate decision does nothing to change that thesis, and we maintain our Hold recommendation on Sri Lanka’s eurobond curve (excluding the 22s) at US$30.6 (31.3% YTM) for the SRILAN 7.55 03/28/2030s on a mid-basis as of cob on 6 July on Bloomberg.
Related reading
Sri Lanka’s restructuring is off to a rocky start, July 2022
Sri Lanka: Worsening political crisis will delay restructuring, May 2022
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Sri Lanka: IMF talks mark beginning of long road, April 2022
Sri Lanka announced external debt restructuring, April 2022
Sri Lanka: New central bank chief hikes rates and confirms plans to restructure, April 2022
Sri Lanka: Market implications of political crisis, April 2022
Sri Lanka’s state of emergency could make things worse, April 2022
Sri Lanka: IMF confirms our view on restructuring, March 2022
Sri Lanka finally turns to the IMF, March 2022
Sri Lanka: Recovery analysis puts bonds at fair value, March 2022
Sri Lanka: Devaluation is step in right direction but not enough, March 2022
Sri Lanka: Russia-Ukraine conflict raises risk of default, March 2022
Sri Lanka: Reserves plummet amid unsustainable debt payment Ponzi, February 2022
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