Sovereign Analysis /
Sri Lanka

Sri Lanka: Time to take profits as upside is priced in

  • Sri Lanka ‘21s and ‘24s have rallied 20.2% and 23.2%, respectively, since we upgraded to Buy on 2 November

  • Debt and liquidity risks have also risen, raising probability of default (unlikely this year, increasingly likely after)

  • We now think Sri Lanka ‘21s and ‘24s are trading in line with fair value, and downgrade from Buy to Hold

Sri Lanka: Time to take profits as upside is priced in
Tellimer Research
26 April 2021
Published byTellimer Research

After we upgraded Sri Lanka’s 6.25% ’21 and 6.85% ’24 eurobonds to Buy on 2 November, they rallied 28.2% and 23.8% on a mid-price basis, respectively, as of cob last Monday (19 April), outperforming all other EMBI constituents and surpassed only by the performance of the Sri Lanka ‘22s and ‘23s (up by 33.5% and 33.8%, respectively, over that same period).

Eurobonds

Investors appeared to have seized the opportunity to take profits, dampening the rally on the ‘24s to +20.2% by the end of the week (with the ‘21s dropping only slightly to +23.2%). The pullback also likely stems in part from the surge in Covid cases in India, raising concerns about the impact on Sri Lanka’s tourism recovery.

The main catalyst of the rally was the US$1.5bn swap line secured from the PBoC, helping to smooth over external financing constraints. However, reserves have continued to plummet, and are down to US$4.1bn (only c3 months of imports and c75% of short-term external debt obligations) at the end of March. The swap line only offers temporary relief, with underlying BOP weakness still unaddressed.

Reserves

Against the backdrop of deteriorating external and fiscal indicators, and with prices on the ‘24s now roughly in line with our target price of US$70 in November, we have taken another deep dive to see if the time has come to take profits.

We find that the rally has pushed bond prices back to fair value and downgrade our ratings from Buy to Hold on Sri Lanka ‘21s and ‘24s.

In this report we take a deep dive into Sri Lanka’s economic outlook and the rationale behind our rating change.

Import controls can only hold the line for so long

Subdued imports and robust remittances, alongside financing from key bilateral partners like China and India, have been the only thing preventing Sri Lanka’s BOP deterioration from becoming a proper BOP crisis in the past year.

In 2020, the 21.2% drop in imports more than offset the 16.6% drop in exports, causing the trade deficit to narrow by nearly US$2bn. This was accompanied by a 5.8% (US$400mn) rise in remittances, with travel restrictions pushing remittances to formal channels.

Imports and exports

Together, the narrowing trade deficit and strong remittances nearly offset the 73.5% (US$2.65bn) decline in tourism receipts and supported a narrowing of the current account deficit from 2.2% to 1.4% of GDP in 2020. However, the IMF projects a widening of the current account deficit to 2.3% of GDP in 2021, driven by recovering domestic demand and rising fuel prices.

And while Sri Lanka has opened back up to tourists in a limited fashion, the sector is unlikely to recover much before the year-end peak season (hampered by surging Covid cases in India, which made up c20% of arrivals pre-Covid).

Current account balance

The government hopes to keep a lid on BOP pressures by regulating imports, but there are limits to how far this strategy can go. As a small open economy that relies on intermediate imports to support domestic production, import controls will hold back Sri Lanka’s recovery and fails to address underlying BOP vulnerabilities. Import controls also weaken the investment climate, making it harder for the government to attract the FDI needed to fund its current account deficit.

Indeed, FDI inflows fell to just US$435m (0.5% of GDP) in 2020. The Cabinet has recently approved a draft law to set up a Special Economic Zone and lay the groundwork for the construction of Colombo Port City by China Harbor Engineering Corporation, which the government hopes will attract US$15bn of investment. However, the project is facing numerous court challenges so is not a foregone conclusion, and more work needs to be done to improve the business climate before FDI rebounds in earnest.

Further, import compression could begin to reverse as the economy recovers. Growth contracted by -3.6% in 2020, up from the -4.6% projection in the October WEO, driven by stronger than expected growth of +1.3% in H2. It is projected to rebound to 4% in 2020 and 4.2% over the medium-term, lower than the 5.3% and 4.8% estimates from the October WEO, reflecting weaker base effects in 2021 and a worse medium-term growth outlook thereafter.

That said, as the cyclical drop in imports reverses, Sri Lanka’s government will struggle to stabilise the BOP via import controls and direct/bilateral investment flows. Import compression is already slowing, falling just 5.5% yoy over the first two months of the year versus a 5.3% decline in exports. Meanwhile, oil prices, which contributed nearly US$1bn to the drop in imports in 2020, are up nearly 30% ytd, and it is unclear how sticky remittances (up 13.2% ytd through February) will be moving forward.

A natural response to BOP pressures would be to seek IMF funding, but the government has continued to express strong resistance to a program. And while Sri Lanka requested emergency RFI funding last April, the IMF says that “we have sought, but not reached understanding, on how to fulfill the key requirements…which would include policies to continue ensuring debt sustainability.” While discussions are ongoing and an updated Article IV can be expected at some point this year, it appears a program is off the table for the time being.

Revenue-based fiscal consolidation increasingly urgent

The key sticking point is Sri Lanka’s lax fiscal policy. While the November budget outlined plans to reduce the deficit and debt stock to 4.0% and 75.5% of GDP, respectively, by 2025, we have previously highlighted how these projections were unrealistic and not backed by concrete policy measures. Indeed, updated IMF projections show debt stabilising above 105% of GDP from this year onward, with the budget deficit consolidating slowly from 9.7% of GDP this year to 7.7% by 2026. This is a materially worse outlook than projected in the October WEO and November budget.

Budget forecasts

Debt forecasts

The worse medium-term outlook stems in part from slippage towards the end of last year, with the IMF’s estimated 11.9% of GDP deficit for 2020 far exceeding the government’s November projection of 7.9%. The slippage appears to be driven by a pickup in capex towards year-end, with a Jan-Nov revenue run rate (the latest available data) unchanged from the Jan-Aug run rate (as of the November budget) of -28% yoy, the recurrent spending run rate falling from +12% to +11% yoy, and the capex run rate rising from -48% to -16% yoy over the same period.

With revenue falling to just 9.6% of GDP in 2020 and little room for further spending cuts, an ambitious revenue-based consolidation is necessary to rein in Sri Lanka’s budget deficit and set debt on a sustainable path. While weak private sector demand has allowed the government to finance its deficit domestically, without access to international markets this will begin to crowd out the private sector as demand picks up in 2021.

The government has increasingly resorted to monetisation of the deficit, with the CBSL financing 28% of the budget deficit through November (the remainder from domestic sources, with negative net foreign financing) and helping to fuel rapid growth in monetary aggregates. While inflation remains subdued (rising from 3.3% to 4.1% yoy in March) amid weak demand, the accommodative monetary and fiscal policy could begin to push up inflation this year as the recovery unfolds and demand pressures build.

Monetization

Monetary aggregates

After a prolonged period of currency stability throughout 2020, rapid money supply growth finally caused the LKR to capitulate in recent months before appreciating sharply last week on apparent CBSL intervention. If the CBSL continues to monetise the deficit, LKR depreciation will either accelerate or force a quicker reserve drawdown if the CBSL opts to defend the currency. Indeed, with recent interventions, it is difficult to say what fair value is for the LKR, and there could be a sharp adjustment if markets overwhelm the CBSL’s limited currency defence ammunition.  

LKR/USD

Currency depreciation would exacerbate Sri Lanka’s external debt problem, with 43% of public debt denominated in FX. For illustrative purposes, a one-time 30% currency adjustment would increase the public debt stock relative to the IMF’s baseline forecast by 13.5% of GDP this year and 12.5% of GDP over the medium-term, greatly increasing the risk of default. 

Debt sustainability analysis points to greater likelihood of haircuts

The IMF last conducted a DSA in November 2019, at which point debt was deemed sustainable but with a high risk of distress. An updated DSA will be conducted alongside Article IV consultations this year, but Sri Lanka’s failure to secure RFI financing indicates to us that it is no longer viewed as sustainable.

We update our own DSA to see what degree of haircuts could be required in the event of a restructuring to reduce the debt stock to a sustainable level. We use the IMF’s indicative threshold of 70% of GDP for public debt in PV terms by 2026 for illustrative purposes, and include guaranteed debt (which is not included in WEO estimates, and totalled 6.3% of GDP in September from 5.2% at the end of 2019).

If the targets from the November 2020 budget are met, it would still require haircuts of c35% to bring public debt down to 70% of GDP in PV terms (using a 5% discount rate) by 2026 (with interest payments still taking up c40% of revenue, from nearly 70% in 2020). Using assumptions from the April 2021 WEO, haircuts would rise to c40%, and applying a one standard deviation shock to growth and the primary balance (1.1% and 1.3%, respectively, based on 2015-19 data), the required haircut would rise to c50%.

Debt projections

Thus, we derive a 35-50% range for potential haircuts using a DSA-based approach to debt sustainability. This is materially higher than the range of 25-40% we calculated in November.

External imbalances may require cashflow relief in absence of policy tightening

However, as we have long argued, liquidity, not solvency, is the binding constraint for Sri Lanka. Reserves are just 3 months of imports and 75% of short-term external financing needs, and given large gross external financing requirements, will only continue to drop until market access is restored.

We have previously argued that Sri Lanka could stabilise reserves with a 3-year maturity extension, 3-year interest grace period, and 50% coupon cuts. But with the significant drop in reserves, further cashflow relief could be required absent fiscal consolidation to reduce external pressures and restore market access.

In the short term, Sri Lanka has US$4.2bn of principal payments due over the last nine months of the year. However, some of this relates to the private sector, which we assume will be rolled over. We prorate the US$3.7bn of public amortizations due in 2020 to estimate that only US$2.8bn remains between now and year-end. This includes the US$1bn eurobond in July, with a eurobond maturity of US$500m following in January 2022 and another US$1bn in July 2022. It does not include the US$36-98mn of coupon payments due each month, except August, over the rest of the year.

Maturity profile

Adding in a projected current account deficit of US$1.95bn in 2021 from the April WEO, and prorating to US$500mn per quarter, that leaves Sri Lanka with gross external financing needs of US$4.3bn over the last nine months of the year. And with annual public sector amortisations of US$3.5bn on average from 2022-27 (or US$4.2bn including private amortisations) and a current account deficit averaging US$1.8bn from 2022-26, external financing requirements will be elevated for the foreseeable future.

External financing needs

In terms of financing sources, FDI is unlikely to rebound materially from its 2020 trough in the current policy environment, so we pencil in a mere US$300mn for the remainder of the year. We add the US$500mn CDB loan (which will be factored into reserves in April), the US$1.5bn Chinese swap line (which will likely need to be drawn upon this year), and the SDR allocation recently approved by the IMF (which will provide another US$787mn and will likely be disbursed in August), leaving a US$1.2bn financing gap. This could be met via more financing or reserve drawdown, which would push reserves below US$3bn and is likely pushing the limit to which Sri Lanka can draw down reserves to retire external debt. Beyond 2021, Sri Lanka will need to find further financing and/or rein in the current account deficit to avoid a BOP crisis.

With domestic interest rates below eurobond yields, there will be no foreign inflows to domestic government debt (though with only US$30mn held by foreigners there is no risk of capital flight either). With eurobond yields in the high teens and low twenties, Sri Lanka is also likely cut off from international markets. The government could try to issue in the Thai market, as it has in the past, though it is unclear if they retain access there either. Eurobond market access will not be restored without evidence of fiscal consolidation, and an IMF program will likely be required to lend credibility. And while Sri Lanka has continued to rely on bilateral partners like China, it is unclear how long they will be willing to write blank cheques to stave off a BOP crisis (indeed, India has already made further funding contingent on an IMF program).

Bond prices have reached fair value; Downgrade to Hold

Against this backdrop, it is clear that the risk of default has risen materially in recent months as the government postpones fiscal consolidation and tries instead to push the burden of adjustment on the private sector via “import austerity”. The likely loss given default has also risen, with a higher starting point for debt/GDP and lower reserve buffers.

That said, default is not a foregone conclusion. With some low-hanging fruit to consolidate the budget on the revenue side (including administrative measures and reversal of the November 2019 tax cuts, which cost an estimated c1.5% of GDP), Sri Lanka can still set debt on a sustainable path without restructuring. However, with interest payments absorbing nearly 70% of revenue in 2020 and market access restricted, there is limited fiscal space and it will be difficult to avoid default without IMF backing.

We estimate a debt-stabilising primary deficit of around 0.7% of GDP, which is materially below the estimated 5.3% outturn in 2020 but only 1.5% of GDP narrower than the outturn in 2019 (which could be made up by reversing the 2019 tax cuts), indicating the need for heavy fiscal lifting to set debt on a sustainable downward trajectory. If the government remains resistant to an IMF program, it may ultimately have no choice but to default. But if push comes to shove, it may soften its stance to preserve its untainted debt servicing reputation. Ultimately, Sri Lanka’s debt puzzle is solvable with some will from the government, but recent evidence suggests that it may take a crisis for that will to materialise.

We run a scenario analysis to update our fair value for Sri Lanka’s eurobonds (with a separate probability distribution for the ‘21s, given lower risk of default).

In scenario 1, Sri Lanka continues to muddle through and avoid restructuring either through more concerted efforts at fiscal consolidation and an eventual turn to the IMF to set debt on a sustainable path and unlock market financing, or by sourcing more financing from bilateral partners like China to buy a bit more time for policymakers to tame the budget gradually (though this will just delay the inevitable if it is not followed by concrete consolidation measures). We assign a 40% probability to this scenario beyond 2021.

The other 4 scenarios draw on our DSA and external analysis to show potential restructuring paths, ranging from light cashflow relief (3-year maturity extension and grace period and 50% coupon cut) to heavy cashflow relief (5-year maturity extension and grace period and 50% coupon cut) to light cashflow relief with a 30% nominal haircut, and finally heavy cashflow relief with a 50% nominal haircut. We assign a 40% probability to cashflow relief, and 20% probability to cashflow relief with nominal haircuts.

Restructuring scenarios

There is still material upside to bond prices if a restructuring is avoided, but bond prices are now roughly in line with fair value for the ‘21s and ‘24s and above fair value for the ‘27s and ‘30s. As such, we downgrade the ‘21s and ‘24s from Buy to Hold at a mid-price of US$97.38 (mid-YTM of 16.89%) and US$69.41 (21.66%), respectively as of cob on 23 April on Bloomberg. Investors could also consider taking profits after the respective 20.2% and 23.2% rally that followed our Buy recommendation on 2 November.

Related reading

Chinese swap provides breathing room, 11 March

External pressure increases risk of debt default, 11 February

Fixed Income Strategy: Our Top 5 Picks, 23 December

Sri Lankan budget aims for ambitious consolidation, 17 November

Back to Buy as the pessimism is excessive, 2 November

Attractive again, but risks remain; Retain hold, 9 October

Eurobonds collapse on lack of IMF urgency, 17 September

Rajapaksas prioritize political over economic reform, 9 September

Bonds fairly valued after Rajapaksa landslide, 7 August