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Sri Lanka’s international bondholders brace for a haircut

BANGKOK — Debt-ridden Sri Lanka has stepped into uncharted waters. Negotiations begin this week in Washington between government officials and the International Monetary Fund for a relief program, against the backdrop of protests at home and the decision to stop paying its overseas debts.

It is the 17th time the Indian Ocean nation has sought a financial lifeline from the fund, the second-highest frequency in Asia, after Pakistan. The planned default, however, is a first, leaving holders of its hard currency-denominated bonds expecting a debt restructuring in which they will take a haircut on what they are owed.

Nandalal Weerasinghe, a veteran central banker and economist brought out of retirement this month to be governor of the Central Bank of Sri Lanka, has his sights on calming creditors.

He told reporters after raising interest rates by a record 700 basis points in one of his first acts, “[This] will give a strong message to the international investors, to our creditors and to the markets that we are going to get out of this crisis as soon as possible.”

His stance has set him apart from his politically tainted predecessor, Nivard Cabraal, whose views mirrored the ultranationalist vision of President Gotabaya Rajapaksa and who eschewed engagement with the IMF in favor of homegrown solutions like cutting imports and making bilateral currency swap deals with the likes of China to build foreign exchange reserves.

For the markets, the lead-up to Sri Lanka’s historic failure to make an interest payment due April 18 is a chronicle of a default foretold.

An international sovereign bond (ISB) maturing in July had been trading at 54 cents to the dollar even before the default plan was announced, reflecting the risk of a significant haircut. A $1.25 billion bond maturing in 2023 was trading at 47 cents to the dollar.

“Existing market prices were significantly down, and bondholders knew a default was on the cards,” said Murtaza Jafferjee, managing director of JB Securities, a financial consultancy in Colombo.

Sri Lanka’s foray into the international capital markets began in 2007, while the country was at the end of a nearly three-decade civil war and under the presidency of Mahinda Rajapaksa, Gotabaya’s popular elder brother. International investors clamored for that first $500 million bond for its high yield, an 8.25% coupon rate.

“It was oversubscribed, a real success story, but it led to a borrowing binge,” said a veteran commercial banker in Colombo, recalling a wave of further issues with coupons averaging 6%. “We were partying without thinking when to repay.”

Sri Lanka has been grappling with its history of “twin deficits” — trade and budget deficits — and its cycle of borrowing to settle older loans was possible only as long as rating agencies gave the country a good grade for an emerging market. After all three main agencies had downgraded Sri Lanka’s sovereign ratings to junk by early 2020, the door to the capital markets slammed shut.

Nearly 70% of the government’s revenue was going toward debt interest payments by 2020 after it slashed taxes, worsening the budget deficit to over 10% of GDP for 2021 and 2022. COVID-19 caused receipts from tourism to plummet, robbing the country of a key source of foreign earnings to build currency reserves. Likewise, the pandemic disrupted the foreign exchange that came from remittances of migrant workers employed abroad.

By the end of last month, the $81 billion economy’s usable foreign reserves had slumped to just $200 million, from $7.6 billion in December 2019. Official reserves stood at $1.7 billion, but that included a $1.5 billion swap with the People’s Bank of China that has conditions attached, according to bankers in Colombo.

Food, fuel and pharmaceutical shortages in the import-dependent country and a spike in inflation — including food inflation at over 30% by March — turned public anger against the ruling Rajapaksas, the country’s most influential political clan. The idea of paying foreign debt while people went hungry became untenable.

Amid calls for the president to step down, Gotabaya’s entire cabinet resigned, and he has appointed a four-member rump to replace them, including a confidant, Ali Sabry, as finance minister. On April 12, a five-page document released by the Ministry of Finance said the Sri Lankan government will “suspend normal debt servicing of all affected debts for an interim period.”

The move has raised the stakes in the talks with the IMF, which will begin at the fund’s spring meeting on Monday.

The fund has already offered Sri Lanka economic benchmarks that need to be met to restore macroeconomic stability and debt sustainability. The country needs to raise income tax and value-added tax (VAT), fund staff members have said. It must implement a tighter monetary policy to contain rising headline inflation, now at 18.8 %, the highest in Asia. It must have a flexible exchange rate to rebuild international reserves and phase out the central bank’s direct financing of budget deficits, the IMF said in a report released in March.

But it will be bitter medicine for a Sri Lankan public already battered by economic hardship. “Raising interest rates will bankrupt small businesses, the backbone of the economy, and increasing VAT at a time of a crisis will affect more people,” said Ahilan Kadirgamar, a political economist at the University of Jaffna in northern Sri Lanka. “This is going to be a long, painful process.”

Bondholders will also be key stakeholders. By the end of 2020, a year into Gotabaya’s term, the country’s foreign debt was $38.6 billion, accounting for 47.6% of the central government’s total debt, according to the IMF. International sovereign bonds made up the largest share, at $14 billion, followed by $8.8 billion in loans from multilateral lenders and $6.2 billion in bilateral debts. The top 20 ISB holders included BlackRock, Allianz, UBS, HSBC, JPMorgan Chase and Prudential, according to Advocata Institute, a Colombo-based think tank.

Weerasinghe said he is seeking to appoint international legal and financial advisers as the country readies for intense negotiations. Bond market analysts are building models to judge how much investors will have to write off and what kind of payment schedule they can expect on the restructured bonds.

The political pressure building up against the government has not been lost on markets. “We believe investors are worried that the IMF talks and restructuring negotiations may be disrupted in the absence of a unified government that can ratify the economic adjustments and commit to the implementation of reforms,” Avanti Save, credit strategy research director at Barclays, wrote in a note to clients.

Investors reached by Nikkei Asia echoed those sentiments. “The bondholders will be looking to the IMF talks to assess the deal and whether the government is capable of implementing the reforms,” said one Hong Kong-based fund manager who has invested in Sri Lanka’s international bonds. “They will use that to figure out what kind of haircut lies ahead — a reasonable one, or something worse.”


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