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Sri Lanka is defaulting on its debts. A guest commentary by Carlos de Sousa, Emerging Markets Strategist, Vontobel – what bond investors need to know now.
For more than a year we have been expecting Sri Lanka to default in July 2022 because we identified the ongoing balance of payments’ crisis and didn’t see how the government could get sufficient external financing to repay their $1bn bond maturing on July 25. The default is now materializing a couple of months ahead of our initial expectations, with the government suspending debt service. Yet, the promise to capitalize (pay interest on interest) payments at the original coupon rates signals the government’s willingness to eventually reach a consensual debt restructuring with creditors, which is positive.
The Sri Lanka debt crisis explained
Sri Lanka’s main sources of FX reserves are remittances and tourism. Tourism arrivals dropped to zero since the beginning of the pandemic and only started to recover more meaningfully in the last six month. It had recovered to ~44% of its pre-Covid level in March 2022 despite a significant decline in arrivals from Russia. Moreover, the ongoing protests are likely to discourage holidaymakers from visiting Sri Lanka.
Remittances performed well in 2020 but started to decline after the central bank pegged the currency at 200 rupees per dollar, which created a weaker parallel exchange rate and disincentivized formal remittances. Remittances were down by more than 60% y/y in the first two months of 2022. Losing its two main sources of FX revenues while simultaneously fixing the exchange rate and continued to service its external debt resulted in a predictable decline of the central bank international reserves from $7.9bn in February 2020 to just $2.3bn in February 2022, and that includes a $1.5bn FX swap from the central bank of China that is unlikely to be freely usable. Thus, one can conclude that FX reserves have been nearly depleted by now.
Sri Lanka default: government refused to accept reality
Instead, they responded to the worsening dollar scarcity (through 2021) by imposing increasingly tighter import restrictions that have now resulted in daily blackouts (due to lack of sufficient fuel for power plants), scarcity of goods, and double-digit inflation. Despite this, the government wanted to avoid getting an IMF program as they were hoping for an eventual recovery of tourism and remittances. In the last month, the government finally realized that it could no longer continue in this path and decide to pursue an IMF program and to liberalize the exchange rate. And it has now officially suspended external debt servicing. This is positive for the prospects of recovery value under restructuring.
Our restructuring scenarios (pre-political crisis) estimated a recovery of ~60 cents on the dollar with an IMF program, and ~50 without an IMF program. We expected the government to eventually lean towards the IMF, which ultimately happened. And therefore, held a small position of Sri Lankan sovereign bonds because market prices were below our estimated recovery value most of the time. Because the political crisis is likely to delay the process of obtaining an IMF program and agreeing on a restructuring and is resulting in a weaker exchange rate, we now think the recovery will be ~50 cents on the dollar.
Sri Lanka’s population had been very quiet given the extent of the economic crisis, but everything changed last weekend. Large protests gather in front of the president’s residence demanding his resignation. Next day, cabinet members resigned, and since then the government has lost its majority in parliament. It’s not clear whether the government of President Gotabaya Rajapaksa and PM Mahinda Rajapaksa will survive this crisis.
A government change could be positive in the medium term as the opposition had been urging the government to pursue an IMF program for a while and they’re likely to deliver better policymaking. However, the President is refusing to resign, and in the short-term, the political crisis has increased the probability of a disorderly default in the short-term. Belly and long-end Sri Lankan bonds were trading at ~50 in January and February this year and have now dropped to low 40s.
Carlos de Sousa
Emerging Markets Strategist und Portfolio Manager
Vontobel Asset Management
Carlos de Sousa joined Vontobel Asset Management in January 2021. Prior to this, he was working as Lead Emerging Markets Economist at Oxford Economics, a leading organization in global forecasting and quantitative analysis. Prior to that, he was a research fellow at Bruegel in Brussels; a think tank specialized in economics, where he authored policy-oriented research with a focus on European economics.
