Amid the ongoing market rout and a worsening economic crisis at home, Sri Lanka’s eurobonds have continued to plummet to below 33 cents on the dollar, excluding the 22s, 25s, 26s (more on this later).
This is well below our base-case recovery value calculated in April of US$45-49 at 12-14% exit yields for the 24s, US$37-42 for the 27s and US$33-40 for the 30s, and broadly in line with our worst-case recovery value of US$32-35 at 12-14% exit yields for the 24s, US$26-30 for the 27s and US$24-29 for the 30s.
However, external and domestic conditions have worsened significantly since then, raising exit yields (we now use 12-14% rather than 10-12%) and making the worst-case restructuring much more likely than the base case (we previously assigned a 40% probability to our worst case, but the probabilities have flip-flopped and the worst case is now a more reasonable base case). As such, it is not clear whether bonds are approaching the bottom or if more weakness is in store.
In the following report, we unpack the status of Sri Lanka’s restructuring and economic and political developments since our last update in May and analyse what these developments mean for bond prices. Although bonds are now trading at the lower end of the recovery-value range we estimated in April, the restructuring is likely to be a long and messy process and the ongoing economic and political crisis means bonds could still fall further before they find a floor.
We maintain our Hold recommendation for Sri Lanka’s eurobond curve (excluding the 22s) at US$32.8 for the SRILAN 6.85 03/14/2024s at cob on 30 June on Bloomberg, and also maintain our Sell recommendation on the SRILAN 5 ⅞ 07/25/2022s at US$41.1 based on the wide (albeit narrowing) premium to the rest of the eurobond curve (notwithstanding the pending lawsuit).
Economic crisis spiralling out of control
Unable to draw upon the US$1.5bn People's Bank of China swap due to a breach of covenants on minimum reserve coverage, 'usable' FX reserves have fallen to less than US$50mn and Sri Lanka has no money to pay for necessary imports of food, medicine and fuel, with US$5bn required over the next six months to meet domestic needs and another US$1bn to support LKR, per government estimates. Prime Minister Wickremesinghe said recently that the economy has “completely collapsed”, projecting a 4-5% contraction this year.
The government has imposed a two-week moratorium on “non-essential” fuel imports and imposed a four-day work week and two-week work-from-home policy for public sector workers in an effort to reduce monthly fuel consumption. It is hoping to secure further credit lines from India to import fuel after receiving US$700mn earlier this month, but suppliers are reportedly refusing to accept cash for fuel shipments due to the accumulation of unpaid bills.
Meanwhile, inflation has ballooned, with the Colombo CPI rising from 39% to 55% yoy in June (well above the 44% Bloomberg consensus). While food (80% yoy) and transport (128% yoy) inflation were key drivers, high core inflation (40% yoy) shows that the trend is broad-based. Further, without market access, the government has turned to rampant money printing to fund their spending needs, with Central Bank of Sri Lanka (CBSL) T-bill/bond holdings rising by LKR670bn (4.1% of last year’s GDP) in H1.
This will make it difficult to defend LKR, which has been effectively re-pegged at LKR360/US$ since mid-May, after initially depreciating by 44% following the early-March devaluation. This compares with a parallel market rate of cLKR388/US% (c8% premium). And despite the implementation of policies to limit FX demand (with a recent circular reducing the limit on FX a resident can hold from US$15,000 to US$10,000), pressure will remain given widespread FX shortages and rapid money printing.
The LKR depreciation has also substantially increased the debt stock. While public debt reached 107% of GDP at the end of 2021 (or 119% of GDP including contingent liabilities), this rises to 142% of GDP (154% of GDP including contingent liabilities) when revalued at the new exchange rate. That said, this will be offset in part by rapid inflation, which will inflate away the value of domestic debt. But, overall, the starting point for the restructuring has worsened significantly.
IMF talks kick off but restructuring talks will be painful
IMF negotiations are now underway, with the Fund releasing a statement yesterday after concluding its visit to Colombo from 20-30 June. The statement cites “productive discussions with the authorities on economic policies and reforms” with discussions to “continue virtually towards reaching a staff-level agreement on the EFF arrangement in the near term".
Tax hikes will be a key pillar of any reform programme, with Wickremesinghe proposing to raise the VAT to 12% from 8%, telecom levy to 15% from 11.25%, and corporate tax to 30% from 24% “over the immediate and near term” and to remove electricity subsidies through a c55%-85% tariff hike, with an eye to reaching a primary surplus of 1% of GDP over the medium term (versus the IMF’s original suggestion of 2%, which Wickremesinghe says is politically unfeasible).
While these reforms represent “important first steps,” according to the IMF statement, the tax hikes are projected to raise just LKR195bn annually versus estimated annual revenue losses of LKR800bn from the 2019 tax cuts, indicating that more heavy lifting will be needed on the fiscal front. Other priorities will include “containing rising levels of inflation, addressing the severe balance of payments pressures, reducing corruption vulnerabilities and embarking on growth-enhancing reforms".
The key hang-up for programme approval, however, is likely to be the need for “financing assurances” from creditors. Since debt is assessed by the IMF as unsustainable, the Fund will require “assurances” that creditors are willing to provide enough debt relief to bring debt within the relevant sustainability thresholds, per the debt sustainability analysis (DSA) to be conducted as part of programme formulation.
In practice, the IMF could announce a staff-level agreement before the assurances are secured (this is what we have seen in Zambia), but an agreement on the terms of the restructuring with official sector creditors is likely to be a "prior action" (in IMF parlance) for Board approval. An agreement with private sector creditors may not be necessary for Board approval, as long as “good faith discussions” are underway, but the finalisation of relief on terms at least as good as those offered by the official sector would likely then be a prior action for completion of the first programme review.
China, which holds c10% of Sri Lanka’s external debt stock, has already expressed its dissatisfaction with Sri Lanka’s decision to default, meaning there will almost certainly be delays to the formation of an official sector creditor committee and commencement of restructuring talks. This is exactly what we have seen in Zambia, where the official sector creditor committee met two weeks ago for the first time 17 months after Zambia first defaulted, 10 months after the new administration took office, and six months after a staff-level agreement was reached with the IMF.
In the meantime, one commercial creditor, Hamilton Reserve Bank (from St Kitts & Nevis) has filed a suit against Sri Lanka in the Federal Court of New York. According to the filing, Hamilton holds just over US$250mn (25%) of the SRILAN 5 ⅞ 07/25/2022s, which allows them to unilaterally accelerate in an Event of Default, which they say has occurred due to the moratorium announced on 12 April and the expiration of the 30-day grace period on the missed interest payments on 23s and 28s on 18 May, which exceeds the US$25mn cross-default clause on the 22s.
On this basis, Hamilton has accelerated the bonds in a New York court filing on 21 June, demanding the full payment of the outstanding US$250mn of principal plus US$7mn of interest. Hamilton also argues that Sri Lanka has violated the Equal Treatment Provision (pari passu) by planning to exclude the US$-denominated Sri Lanka Development Bonds (SLDBs), which were issued to local buyers under Sri Lanka law, from the restructuring. Of the US$1.79bn of SLDBs outstanding, US$1.59bn is held by domestic banks and most of the rest is held by domestic non-banks and individuals (foreign holdings are negligible).
While we had previously said that the decision to exclude SLDBs from the restructuring could be problematic, we had not predicted that their exclusion would be the basis for legal action against the government. The move represents a tough opening position by Hamilton, and could complicate the restructuring process. That said, in a recent note on the suit, law firm Cleary Gottlieb says that “the plaintiff recycles arguments that have been rejected by New York courts in many of those past cases”, casting doubt on the likely success of the case, for which an initial conference date of 26 August has been scheduled.
Beyond the 22s, several of Sri Lanka’s eurobonds reportedly have differing terms pertaining to collective action clauses (CACs) and aggregation clauses, which may allow holders of certain bonds to hold out if there is insufficient support for Sri Lanka's restructuring approach. This is an area for further research, as we need to see the relevant documentation to determine which bonds this applies to.
Currently, the 25s and 26s are also trading at around a 2pt (6%) premium over the rest of the eurobond curve, which compares with a c8.5pt (26%) premium for the 22s. For context, the Venezuela 27s, which do not have CACs, traded at a c5% premium to the Venezuela 28s in the year after it defaulted, though this has since collapsed to effectively zero. Even taking an agnostic stance on the likely success of the court case on the 22s, an 8.5pt premium looks to be on the high side (but further analysis is required).
The decision to exclude LKR-denominated domestic debt from the restructuring, on the other hand, has become less problematic. While we had previously said domestic debt would need to be included in a restructuring to achieve a sustainable debt trajectory, there is now a stronger argument for excluding it since it has essentially received a large inflation-induced haircut (see above) and will have significant financial stability implications (with around one-third of banking sector assets comprising government debt).
That said, even pencilling in an ambitious reform programme that achieves growth of 4% and a primary surplus of 1% over the medium term, debt falls only marginally to 101.5% of GDP by 2030, per our projections. Excluding super-senior multilateral debt and SLDBs from the restructuring, which collectively comprise around one-third of external debt, a 50% nominal haircut would be required just to bring public debt below 85% of GDP by 2030, in line with our worst-case scenario in April.
As such, it is still not clear that Sri Lanka will be able to achieve a sustainable debt burden without including domestic debt as currently planned, so this could be a further point of contention down the line.
All that said, the restructuring process is likely to be messy given the diverse creditor base and seemingly different terms and creditor protections across the existing bond stock. Even if the government is able to quickly reach a staff-level agreement with the IMF, legal action by bondholders and potential resistance to restructuring from official creditors like China could complicate the process and cause delays.
From a game theory perspective, Sri Lanka, which has hitherto had an unblemished payment track record since independence in 1948 and a history of macro orthodoxy until recent times (despite bouts of fiscal weakness) has an incentive to reach a quick deal, especially given the severity of the economic crisis.
Bondholders, on the other hand, may have an incentive to wait and push for a better deal, especially if they can organise into a single strong and cohesive group, and will want to ensure that the dire economic situation now should not be used to force low recoveries, which should instead be based on medium-term prospects that would look rosier under an IMF-backed reform programme. Further, the accrual of past-due interest at annual rates of 5.75-7.85% annually may reduce urgency.
Unfortunately, unlike Zambia, whose delayed restructuring has taken place against the backdrop of a functioning domestic economy, Sri Lanka does not have the luxury of time and its economic crisis will only continue to deepen as the process unfolds, exacerbating the hardships for Sri Lankans who are already buckling under a cratering currency, massive price increases and a shortage of critical goods like food and fuel, with increasingly dire humanitarian consequences.
In this environment, the risk of social and political unrest will remain elevated. President Rajapaksa has remained steadfast in his refusal to step down, saying that he will see out the remaining two years of his term and step aside after the presential election due by September 2024 at the latest. The cabinet has instead approved constitutional reforms to scale back the power of the president in a bid to placate protestors, which now needs the votes of two-thirds of the members of parliament to become law.
However, this is unlikely to satisfy the many Sri Lankans who are calling for Rajapaksa’s immediate resignation, and the nation will remain a powder keg with a high potential for destabilising conflict as the economic and humanitarian crisis continues to worsen. This will make it difficult for the government to credibly commit to and implement the reforms required to obtain an IMF programme and negotiate with bondholders, who may worry about how long their Sri Lankan interlocutors will be able to stay in office.
Even with bonds now trading at the lower end of our recovery value range, it is too early to say with any confidence that they have found a floor. Indeed, with the ongoing EM credit rout pushing up yields across EM, and numerous performing bonds now trading in distressed territory in the 50s, 60s and 70s (including the ARGENT 0 ½ 07/09/2030s trading at cUS$24), the floor has fallen substantially for Sri Lanka’s bonds relative to our earlier analyses (see related reading, below).
Even if bonds are below recovery value, investors would have to be comfortable holding on for a long and bumpy ride and will likely need to see bonds get even cheaper to compensate them for the risks of political unrest and/or an even more intractable economic implosion. As such, even though bonds are starting to look cheap, we think things will have to get worse before they get better and prefer to wait for a more attractive entry point down the line.
We maintain our Hold recommendation for Sri Lanka’s eurobond curve (excluding the 22s) at US$32.8 for the SRILAN 6.85 03/14/2024s at cob on 30 June on Bloomberg. We also maintain our Sell recommendation on the SRILAN 5 ⅞ 07/25/2022s at US$41.1. While we are agnostic on the outcome of the pending lawsuit and the premium over the rest of the curve has nearly halved to c8.5pts from c15pts in April, it still looks to be on the high side and further compression may be required.
Sri Lanka: IMF talks mark beginning of long road, April 2022
Sri Lanka announced external debt restructuring, April 2022
Sri Lanka finally turns to the IMF, March 2022
Sri Lankan Eurobonds nearing fair value; retain Sell, December 2021