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Sri Lanka: Talks for IMF support confirmed; debt restructuring likely

  • What would a debt restructuring look like?

  • IMF instrumental to Sri Lanka’s exit deal and recovery value of bonds

  • SL economic reform plan will play a key role; we factor in a higher dep’n in 2H

Lakshini Fernando
Asia Securities
18 March 2022
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Following President Rajapaksa’s talks with the IMF’s Asia Pacific director led delegation earlier this week, the government announced its stance of seeking IMF support for managing its upcoming debt obligations. The decision to commence discussions for a possible debt restructuring comes as foreign reserves declined to USD 2.3bn in February (which includes a USD 1.5bn Yuan swap). Talks of re-structuring also follow the heightened external pressure arising from the Russia-Ukraine tensions, with tourism inflows negatively impacted. This, combined with elevated commodity prices add further pressure on the external balance. This also comes amidst a repayment extension of ~USD 900mn due to India in March.

Meanwhile inflation measured by the Colombo Consumer Price Index reached 15.1% YoY in February, with food inflation soaring to 25.7% YoY ahead of the sharp increases in fuel prices and ~15.0% depreciation of the currency recorded in March.

We note that an IMF program generally includes an agreed economic reform program. As such, the finance minister is expected to present the policy proposals to the IMF in April. In our view, an alignment between the Monetary and Fiscal authorities is key to successfully implementing the expected proposals in the coming months.

What would a debt restructuring look like?

With little or no access to international markets, high fiscal deficit (we forecast 11.5% of GDP in 2022, revenue collections at 9.0% of GDP in 2022) and increasing debt/GDP (110% in 2021) and 70.0% of government revenue used for interest payments (compared with 45.0% prior to COVID-19), we see the news of a potential debt restructuring as a key positive to bring about a stronger economic setting.

Its noteworthy that the government has already initiated some debt restructuring related to bilateral debt (payment extension to India, SWAP extension with Bangladesh, etc.). However, restructuring of the International Sovereign Bonds (ISB) – which is the most visible external foreign-currency denominated debt – remains a complicated process. At this point, we factor in a restructuring only external debt, and not domestic debt. However, we note that the need for domestic debt restructuring is also a need given the current fiscal backdrop and also considering the recent loading of short-term debt (3M bills taking a higher share in issuances since 2021).

An official debt restructuring with IMF involvement indicates that the government will look to restructure the upcoming 1) ISB payments, 2) commercial loans and 3) multilateral and bi-lateral loans. However, many scenarios are possible under debt restructuring, and IMF’s assessment of SL’s debt sustainability and debt serviceability would determine the ultimate outcome.

In terms of the ISB’s, the outstanding amount is currently USD 12.6bn, with the most recent payment of USD 1.0bn due in July. The largest payments of USD 2.15bn is due in 2025. As of end June 2021, bilateral lending accounted for 24.0% of total stock of foreign debt while multilateral lenders account for 23.0%. Commercial lenders stood at 45.6% of total debt stock as at this period. We note that following the depreciation, the external debt numbers would have increased.

IMF instrumental to Sri Lanka’s exit deal and recovery value of bonds

In terms of the exit deal (i.e. the rate at which the future cash flow is discounted which will essentially be the yield at which the new bonds will trade in the first days of trading), the assumption of longer maturity extensions is a key factor. This is mainly because cash flows (which will be longer) are discounted more to the present value.

The IMF will play a key role in the exit deal given that investors will be more confident of a sustainable medium-term scenario, compared with the expectation of the government independently implementing corrective policy measures to turn towards a more sustainable economic environment. Analysts familiar with distressed bond trading expect Sri Lanka’s exit yield to be 10.0% or lower with the IMF compared with an exit yield of 12.0% or higher without the IMF.

As such, the recovery value would depend on the exit deal finalised by the government and the IMF’s involvement. Our discussions with experts indicate that a restructuring with the IMF has a high probability of a recovery value in the range of 60 or higher. this has been reflected in the recent rally seen in Sri Lanka’s bonds, with the 2030 bond reaching 49 cents to the Dollar, compared with the record low of 38.9 cents to the Dollar recorded on the 9th of March. Media reports also indicate that Bloomberg data shows that the one-year default probability declined to 18.2% from 31.0% recorded in late December 2021.

SL economic reform plan will play a key role; we factor in a higher dep’n in 2H

However, we note that Sri Lanka’s economy reform agenda which is expected to be announced to the IMF in April is key to the recovery value as this would indicate the government’s ability to repay any upcoming debt in the medium term. We also expect improved financing assistance following an IMF agreement given that institutions like the ADB and World Bank and further lending facilities from bilateral partners will be in a position to support Sri Lanka’s financing needs. This will be a key positive of an IMF agreement, in our view.

With an IMF agreement in place, we factor in higher pressure on the currency towards 2H 2022. As such, we see a scenario where the USD/LKR could settle at 280.00 – 290.00 by year end, provided Dollar inflows materialise following the depreciation. For this, we note that export conversion regulations currently in place combined with outward remittance controls would need to be relaxed. We note that a further depreciation of the currency would have a negative impact on inflation, which already remains elevated. This combined with continued money printing by the Central Bank will lead to higher-than-expected inflationary pressure, in our view. As such, we revise our inflation forecast to 15.0% - 18.0% by year end, with the 12-month average reaching 12.0% in 2022.

We also expect some of the reforms implemented by the Government to concentrate on strengthening Sri Lanka’s fiscal balance, potentially through higher government revenue. We note that similar measures were a part of the 2016 IMF Extended Fund Facility program, with fiscal consolidation, public financial management and state enterprise reform taking center stage. As such, the 2016 reform program was outlined under the following key pillars;

  • Fiscal consolidation – to achieve 3.5% of GDP by 2020

  • Revenue mobilisation – higher government revenue and reforms toward efficient, risk-based tax administration

  • Public financial management reform – to improve expenditure management and fiscal risk monitoring

  • State enterprise reform – in terms of creating public-private partnerships with non-strategic enterprises

  • Transition to flexible inflation targeting under a flexible exchange rate regime – to maintain inflation at low-single digit levels in the medium term

  • Reforms in the trade and investment regime – through higher FDI, private sector investments, and greater integration into regional and global supply chains