For the past two years, COVID-related restrictions have prevented physical travel, and while virtual roadshows are invaluable for analysis and engagement purposes, the return of in-person trips and the additional perspectives they bring is a very welcome step. First to get back on a plane was our Asia specialist, Mark Evans, who headed to Colombo last week.
A key question on Mark’s mind was whether recent – albeit very belated – policy moves heralded a shift in the right direction for the country. Instead, the trip confirmed fears and concerns shaped by several years of economic decline. Here, Mark explains how Sri Lanka’s current economic crisis came about, what he learned on the trip, and what he’s watching for when assessing the investment case for Sri Lankan debt.
An economic crisis in the making
It has been our view for some time that Sri Lanka’s macroeconomic policy is far too loose and not sustainable, weighing on the governance rating in our ESG framework to give the country a low overall score. The promise of “Vistas of Prosperity & Splendour” – which helped the current government claim victory in the 2019 election – featured generous tax cuts, which the country simply could not afford, even before the COVID-19 pandemic hit. Fast forward two years, with today’s reality of high inflation and soaring commodity prices, and the situation has come to a head.
As the price of oil rose above US$130 a barrel last month, the oil-importing economy’s bond price fell to distressed levels. Then came tentative positive signs as the Sri Lankan authorities approached the IMF and the central bank ended its currency peg, allowing the rupee to depreciate; the bond market reacted positively, with bond prices staging a recovery.
However, the FX policy shift failed in its execution: the central bank had no reserves to defend the currency and was unwilling to hike rates given the resultant impact on debt servicing costs (‘fiscal dominance’) for the highly indebted economy. The resultant currency weakness and shortage of US dollars has seen inflation soaring and made imports unaffordable – cutting off supplies of medicine, gas and food, and sparking recent protests.
The charts below illustrate how Sri Lanka’s economic crisis has unfolded.
- Significant tax cuts, introduced in late 2019, significantly impacted fiscal revenues while expenditure stayed relatively constant:
12-month rolling fiscal revenue and expenditure, % GDP
- These policies shut Sri Lanka out of the international capital markets from 2020, meaning the increased deficit had to be financed by local financing sources:
Net borrowing via international sovereign bonds, US$ millions
- With a lack of alternative financing sources, the fiscal deficit became increasingly financed by the central bank monetising debt (printing money):
12-month rolling fiscal deficit and monetary financing, % GDP
- This put significant pressure on the balance of payments, leading to FX reserves dropping to critical levels:
Gross FX Reserves, US$ millions
- The currency was being pegged at unrealistic levels at around 200 to the US dollar. With reserves dwindling, the central bank no longer had the capacity to defend the currency, leading to a significant fall in the currency in March 2022:
USD/LKR exchange rate
Source: Haver Analytics, Bloomberg. As at March 2022.
A lack of urgency
In various meetings with Sri Lanka’s policymakers during Mark’s trip, it became clear that the current economic woes are viewed more as temporary issues that will disappear once remittances begin to flow back into the country and tourism returns to pre-COVID levels. The reality – as noted by the IMF – is that this is a structural wound needing immediate and serious attention. With debt/GDP now likely closing in on 150% post the currency ‘float’, interest/revenue likely to reach around 100% and usable gross FX reserves dwindling, time is of the essence.
In short, any hopes of a positive shift in policymaking direction for the country proved unfounded. A combination of a failure to grasp the gravity of the situation and an unwillingness to fix the cause of the problem via fiscal austerity measures, or seriously tackle the resultant issue of debt sustainability through a restructuring (which would be the country’s first) were all in evidence, despite the worsening humanitarian crisis.
There are now myriad potential scenarios for investors to analyse when assessing the investment case for Sri Lankan debt. There are undoubtedly more questions than answers at this stage, but these are the key points investors will be watching over the coming days and weeks:
- Since Mark returned from Colombo, the entire cabinet and the central bank governor have resigned, leaving only the prime minister and president in their original posts. One thing seems clear at this stage: civil unrest is unlikely to be resolved until there is complete regime change.
- It will also be important to see who becomes the governor of the central bank following Governor Cabraal’s resignation, along with the central bank policy response at its next meeting. Cabraal was a key architect of the macroeconomic framework implemented over the last couple of years and had been dismissive about potentially going to the IMF. A more orthodox central bank governor will be a critically positive development.
- Having approached the IMF for assistance in March and given a significant deterioration in circumstances since then, the upcoming meeting with the IMF scheduled for early April will be closely followed to see what progress has been made towards a potential program.
There are a number of other considerations for investors to analyse, particularly in the context of a debt restructuring, but for now we believe the issues above are the most pressing.
A country with significant potential
A debt restructuring that works for the country and investors is entirely feasible, with plenty of low-hanging fruit to be picked, if the political willingness is there. However, the path to that is uncertain and unlikely to be quick.
Longer term, underpinned by solid institutional foundations such as an independent judiciary, a young and well-educated population with budding entrepreneurial spirit, Sri Lanka has significant potential once the macroeconomic foundations of the economy are properly dealt with.
Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
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