Sri Lanka is already in economic crisis and the consensus of investors reflects this. But President Gotabaya Rajapaksa's declaration of a state of emergency on 2 April could start the country down a path of political division. And that could make taking the economic reform decisions to get out of the ongoing crisis even more difficult. The crisis can get significantly worse from here.
The declaration of a state of emergency to ward off the spread of domestic mass protests has the potential to trigger greater authoritarianism. Emergency powers include rule by decree, arrest without warrant and confiscation of property.
The more the Rajapaksas are associated with the current economic distress and the more heavy-handed their response is to any potential or actual discontent, the more their ability to marshal enough of the Sinhalese-Buddhist majority – over 70% of the population – comes into question.
The ruling SLPFA bloc (over 10 parties) controls 64% of seats in parliament, where the Rajapaksas' SLPP alone controls 51%. The SLPP was founded merely in 2016 and became the Rajapaksa vehicle for electoral politics before the local elections in 2018 (which the SLPP swept).
However, the Rajapaksas have lost seemingly impregnable control of party discipline before. Concerns over authoritarianism proved highly distracting and ultimately terminal for the government led by Mahinda Rajapaksa in the phase between reaping the peace dividend from the end of the civil war in 2009 and his defeat in the 2015 presidential election at the hands of a breakaway faction from his own party, led by Maithripala Sirisena.
Similar to that era there are divisions over economic policy (eg state-owned enterprise reform, fiscal prudence, currency flexibility), foreign policy (closer alignment to China or India) and minorities policy (devolution or stronger federal government) that can be exploited by rivals to the Rajapaksas.
Sri Lanka's biggest short-term risks obviously surround its economic crisis, which results from:
Fiscal populism under the Rajapaksa-led government (10% of GDP deficit in 2022, according to IMF forecasts);
An interest rate policy hopelessly behind the inflation curve (real rate is negative 11%); and
The spike in net fuel import costs (equivalent to 6% of GDP at US$100 Brent, on our estimate), which exacerbated the prior balance of payments stress wrought by security and Covid hits to tourism.
This crisis is arguably very well understood by investors and reflected in the performance of Sri Lanka assets. However, the political train set in motion by the declaration of a state of emergency could make things worse in the short term and make for a more challenging recovery (in terms of building a consensus behind unpopular austerity or state-owned enterprise reform).
The FX rate is down 32% ytd after the belated 7 March devaluation of the soft peg.
The equities CSE All Share index is down 53% ytd in US$ total return terms – but it is still valued at 1.0x trailing PB, which is almost on par with the five-year median.
The z-spread on the SRILAN 7.55 03/28/2030s is almost 100bps wider than at the start of the year – but it is still 450bps narrower than prior to the March devaluation and the announcement of an approach to the IMF.
Sri Lanka: IMF confirms our view on restructuring (Curran), 29 March 2022