Macro Analysis /

Sri Lanka: Refinancing risk and BoP concerns emerge amidst Covid-19 impact

  • Sovereign risk priced in by the market; CDB loan a positive

  • Widening fiscal slippage pointing to a looming BoP deficit

  • Trade worst hit; China re-start and low oil prices a positive

Asia Securities
19 March 2020
Published byAsia Securities

Impact of Covid-19 paints a bleak macro picture

Amidst the current backdrop, quantifying the economic impact of Covid-19 looks to be complex, giving significant rise to several assumptions and uncertainties on the outlook and downside risk. Globally, fears of a US recession and a global slowdown have been factored in with markets tumbling across the board. Two rate cuts by the Federal Reserve within the past two weeks combined with a significant stimulus package which included a USD 700mn asset purchase measure have not calmed markets and is unlikely to do so until a clearer picture of the global impact of Covid-19 materialises.

In our view, there will be a significant impact on 1) the fiscal deficit, from low revenue collections and higher expenditure, 2) trade deficit, despite low global oil prices, 3) tourist arrivals and remittances, leading to a weakening current account, 4) currency, on the back of heightened net outflows and 5) international debt refinancing, owing to a significantly higher risk premium for sub-investment grade frontier credits.

At this point of time, we place our macroeconomic forecasts under review with a relatively strong negative bias for 2020. While at the beginning of the outbreak we forecast GDP growth to come in at 3.5% YoY, the outbreak both locally and globally which unfolded during the past few weeks indicates growth stagnating significantly, even closing in at near recession levels. We acknowledge that the current economic dynamics of low consumer and investor sentiment amidst the Government’s position of having little room to offer a further fiscal stimulus does not bode well in the current backdrop.

Our initial analysis at this point of time indicates that overall growth looks to come in between 0.9% - 1.2% YoY for 2020 in our base case scenario where the spread of the virus within Sri Lanka is contained by end May (i.e. major impact lasting three months), and the country doesn’t go into a full-scale lockdown.

As Covid-19 ravages globally, we see tourist arrivals dropping to zero in the next few weeks, with the Bandaranaike International Airport closing for arrivals. In our view, this will also negatively impact logistics in the short run, as our channel checks indicate that certain cargo like apparel is exported through passenger flights.

Sovereign risk priced in by the market; CDB loan a positive

At this point of time, a key concern for investors is the heightened risk of a Sovereign default amidst this crisis. The current 10-year Sovereign yield (ISB maturing in 2030) passed 14.00% (as of 18th March), up ~653bps for the year so far as foreign investors priced in higher risk. As expected, the higher risk in the short term has been factored in, with the short end of the curve picking up ~647bps during the past 10-day period.

This has resulted in the spread widening to ~1,300bps, compared to ~900bps for a set of B-rated peers (as of 18th March) reflecting outflows to safer asset classes. In addition, the 10-year CDS spreads have widened by over 540bps since early February, more than the B-rated peer group, indicating that a higher level of risk is being factored in.

While the USD 1.0bn Sovereign bond maturity falls in October, in our view, the government has a tight window to roll over the maturity with a new sovereign bond issuance in the coming months, amidst the current global context.

Earlier this month, our channel checks indicated of the Government’s plans of seeking a USD 1.0bn loan from China, while media reports state that the government has finalised a USD 500mn funding line from China Development Bank during the month (in addition to the USD 1.0bn 8-year loan extended in 2018). This can be further extended to an additional USD 500mn or more in the medium term. We perceive inflow to be crucial for ensuring continued debt refinancing for 2020 where repayments amount to USD 4.8bn.

Widening fiscal slippage pointing to a looming BoP deficit

Given that the current slowdown comes on the back of lower demand due to social distancing, we believe the fiscal measures already announced will support the businesses to some extent.

At a macro level, Sri Lanka is likely to see the fiscal budget squeezed amidst emergency expenditure to curb the virus. However, in our view, the country cannot afford this at this point of time given the fiscal deficit and slow revenue collections owing to the tax breaks imposed in November. The government will see a drop in revenue from slow economic activity combined with low indirect taxes mainly stemming from slow imports. We note that for the 3M from March 2020, government expenditure was approved by the President, including election expenditure.

However, in the current context, our view is that the government would need to depend on further loans to bridge the fiscal deficit which is likely to have widened in 1Q CY20.

In terms of foreign exchange, 2Q CY20 will see slow remittances, tourism revenue and slow FDI. With significant bond outflows since end January, the BoP looks to be stressed given the need to bridge the gap between foreign exchange inflows and outflows.

This raises a high probability that Sri Lanka will most likely go for another IMF program this year in the absence of inflows through avenues like bilateral loans amidst the globally low interest rate environment.

Trade worst hit; China re-start and low oil prices a positive

According to Bloomberg, China’s industrial output fell 13.5% YoY; the worst factory output since 1990, while retail sales across China have dropped 20.0% YoY for 2M 2020. With Sri Lanka’s dependence on imports (China is the second largest, behind India), we expect intermediate goods like chemical products, plastic products and textile articles and investment goods like building material and machinery equipment to face a slowdown. On the positive, China looks to be recovering, with most of Sri Lanka’s import partners (except China) avoiding an epidemic stage of Covid-19 as of now. With Sri Lanka being a net importer of oil (accounting for ~20.0% of total import bill) we expect the current low oil prices to help mitigate some of the negative impact from low export revenue.

Looking at the export front, with fears of a US recession in the cards, we expect a significant slowdown in export demand in 2Q CY20, possibly spilling into 3Q in the event of a prolonged epidemic. The recent lockdowns in Italy, France and Spain look to push the EU into a recession this year, with Germany also slowing down in terms of close to halting industrial production. Overall, looking at the top 5 key export destinations, current trends indicate that 4 out of the 5 countries will be going into a recession in 2020. In our view, this leads us to conclude that the slow demand for Sri Lanka’s exports would continue till at least 3Q 2020.