Cheap credit that frontier economy sovereigns enjoyed ended abruptly in early 2015, rattling economies like Sri Lanka that had grown dependent on foreign currency commercial loans to finance infrastructure and government spending. Last year (2015), the island borrowed $2.15 billion to pay off some of the massive debt built up under the last regime. During the 12 months ending in April 2017, Sri Lanka must make a record debt settlement. For a small economy turning over a sovereign debt pile far greater than its meager official reserves – which were just $6.06 billion by April 2016 – is no mean consequence.
The sudden reversal of capital flows has put the rupee under pressure. The central bank has been selling dollars out of its foreign exchange reserves to prevent the rupee from weakening further against the dollar. In the four months to end-April 2016, the central bank had sold $1.2 billion out of its reserves in defense of the rupee.
Sri Lanka now faces a debt crisis and an external vulnerability crisis, because it has been borrowing too much and from the wrong people. Recently, the International Monetary Fund announced it has reached a staff level agreement for a three-year $1.5 billion Extended Fund Facility. This loan can potentially boost confidence in Sri Lanka’s economic management and the seriousness of its reform efforts.
[pullquote]Last year (2015), the island borrowed $2.15 billion to pay off some of the massive debt built up under the last regime. During the 12 months ending in April 2017, Sri Lanka must make a record debt settlement[/pullquote]
Despite the IMF’s facility and a further $650 million other multilateral donors have pledged, Sri Lanka’s external finances are in precarious shape. According to central bank data, the country has to repay $5.3 billion in debt over the next year, excluding $3.3 billion in currency swaps it also has to settle with friendly central banks. That’s a total debt repayment of $8.6 billion over the next 12 months. Of this, $1.2 billion is due by July 2016.
Even following IMF assistance, it still has to face up to the legacy of borrowing for infrastructure – which contributed to growth over a long term – with short-term finance.Credit propped Sri Lankan economic growth in the years since the war ended in 2008. Corporate and consumer credit has boomed. Average private credit growth has run at double-digit rates over the last five years. In addition, outstanding private sector foreign currency borrowing now at $17.5 billion (in 2015) has grown at an even faster clip, up from $3.2 billion in 2010.
Private firms that owe this growing chunk of Sri Lanka’s foreign debt are now feeling the strain of the rupee’s weakness. The central bank spending $1.2 billion of its reserves have staved off rupee depreciation so far. There is little else the central bank can do to shore up the currency, except hike interest rates. A rate hike would make weak business even more difficult for the private sector already reeling from the weak economy’s effects.
Economists and critics have been pointing out that the government is borrowing too much. It has also borrowed from the wrong people. It now faces elevated refinance risks and changes to borrowing costs, depending on who is holding the debt.
Lenders to the government – both local and foreign currency – fall in to one of four groups. In some of these four categories there are domestic as well as foreign sources. Some of them are the right people and others the wrong people from whom loans can be obtained. It’s simplistic to assume that Sri Lanka – especially when its budget runs a large deficit – can exclude people or fully control who holds its debt. But it could act far more opportunistically, wisely and responsibly to reduce risks of its debt being in the wrong hands.
The first type of lender is official ones like governments, the World Bank and the Asian Development Bank (ADB). These lenders have funded infrastructure like roads, schools and large hydro power plants over three decades. Their low-interest loans offer long repayment periods and have been hugely advantageous. Official lenders are all foreign.
In the last decade Sri Lanka veered away, relatively, from engaging its traditional official lenders Japan, the World Bank and the ADB, preferring instead Chinese loans at commercial rates. Traditional lenders’ infrastructure loans had interest rates lower than one percent, often a decade-long period before capital repayments started and up to 40 years for loan repayment. More importantly, their insistence on economical viable projects or ones that impact human development excluded vanity projects like airports in the jungle or ports that don’t generate much income.
In contrast, Chinese lenders haven’t focused as intently on the financial viability of some of the infrastructure they fund. During construction, Chinese projects also don’t benefit Sri Lanka, as do projects financed by traditional lenders, because material and labour are all sourced from overseas.
Chinese official lending here was aligned more to boost its influence in South Asian and secure supply chains, and less to do with helping a poor country build critical infrastructure. Because better options exist, China isn’t an ideal source for infrastructure finance.
Forty eight percent of Sri Lanka’s total Rs8,266 billion in loans by end-2015 are foreign currency debt and the first category of lenders – the official ones – hold most of it. The other three categories of lenders to the government are non-banks, banks including primary market participants and central banks.
The second group of lenders to the government is non-banks – including pension funds, insurance companies and other investors with pools of money. These pools of funds are invested in Sri Lankan rupee- and dollar-denominated debt.
Since early 2015, they have sold off the equivalent of $2 billion in local currency securities investments after the US Federal Reserve announced an end to its bond-buying programme and subsequently raised interest rates. These non-bank funds are the flightiest bits of global capital and sought higher yields in junk bonds – the type issued by Sri Lanka – when investment-grade rich country securities were low yielding.
At its peak, in mid-2014, foreign investors owned around 14% of Sri Lankan rupee debt, which has since declined to around 8% of issues. Portfolio managers who didn’t immediately take fright of the impacts on foreigner market bond yields of the US Federal Reserve were spooked when they discovered the new Sri Lankan regime was not reform-minded and fiscally irresponsible. By March 2015, the trickle of an outflow had become a deluge that continues.
Sri Lanka’s fumbling central bank, and the government tweaking trade and tax rules to arrest the decline worsened the rate of the sell-off. Limits have been imposed on exporters holding their proceeds overseas and import levies raised on the most popular goods.
Sri Lanka’s sovereign bonds also attract non-bank funds managed by global fund managers. In these too, yields have risen. The yield on Sri Lanka’s 10-year bond issued in October 2015 was 561 basis points above the benchmark US 10- year treasury yield in mid-May 2016. That bond’s yield at its issue of 6.85% rose to 7.99% by end-February 2016 before reaching 7.35% in May 2016.
Higher premiums are a reflection of investors looking away from sub-prime sovereigns and the lack of confidence in Sri Lanka’s economy.
[pullquote]Sri Lanka’s position will likely get worse in 2016. Inflation will rise, interest rates may also have to rise to keep inflation in check and economic growth will be lower[/pullquote]
Banks – local and foreign – and local primary bond market participants are the third type of lender. These are a separate category, as shareholders funds are a significant portion of their investible assets. They are also tightly regulated all over the world and subject to risk-based capital rules.
Foreign banks are investors in Sri Lanka’s sovereign bonds and syndicated loans. Banks – even the foreign ones – generally aren’t as fickle as portfolio managers and can afford to take a longer-term view.
Local banks and primary dealers are also important investors in government securities here. In their role as market makers, they bring breadth and depth to trading and improve pricing efficiency. Local banks and primary dealers also tend not to knee-jerk react like portfolio managers.
Central banks themselves are the fourth category of bondholders. Most central banks buy bonds of states with strong reserve currencies. Sri Lanka’s central bank holds US government bonds as part of its reserves. However, only a handful of countries have currencies with enough credibility to be widely considered as reserve worthy.
Currency swaps have emerged as a stopgap for Sri Lanka to shore up reserves. A swap – an exchange – is when two central banks exchange one currency for another. These are done with agreements on when and at what exchange rate these will be unwound. Swaps are a pseudo sort of borrowing used when countries have friendly foreign central banks that are willing to assist to overcome balance of payments trouble.
The central bank lending to the government, except when it’s for smoothening out cash flow, is deeply undesirable. In the 12 months to February 2015, reserve money expanded by Rs139 billion to Rs385 billion. Reserve money – or printed money – is created by the central bank buying government debt. The central bank – when it fuels inflation by becoming a lender to the government – causes terrible consequences.
[pullquote]Economists and critics have been pointing out that the government is borrowing too much. It has also borrowed from the wrong people. It now faces elevated refinance risks and changes to borrowing costs, depending on who is holding the debt[/pullquote]
Sri Lanka’s economy, more vulnerable than most due to actions of the former regime, has been further compromised by the current rulers. Economic growth has been disappointed, averaging just 4.3% in the last three years, which is close to half the rate seen in the years following the end of the conflict. Not surprisingly, inflation is now picking up. In April 2016, prices rose 4.3% compared to a year ago, accelerating from 2.2% in March. Despite talk, no important reforms that will help Sri Lanka become more globally competitive have been pushed though.
Total foreign currency financing needs in the next 12 months – or the debt that needs rolling over – is at least $8.6 billion. This does not include any amount of the current account deficit in the budget that may be financed with new foreign currency loans. At least part of the current account deficit – more than $20 billion – and all interest payments on foreign currency debt will have to be financed from borrowings from overseas.
The finance minister says Sri Lanka will borrow $3.5 billion in a syndicated loan, sovereign bonds and a Sukuk (a Sharia compliant bond), during 2016. These loans – now desperately needed – will help postpone the problem. Sri Lanka’s position – because its been borrowing too much and from the wrong sources – will likely get worse in 2016. Inflation will rise, interest rates may also have to rise to keep inflation in check and economic growth will be lower. Perhaps the only important outcome will be it’s prompting of a more serious debate that Sri Lanka needs to be less vulnerable to unforgiving borrowers. Less debt is one such policy and immediately being choosy about who is holding that debt.