IMF bailout inevitable for Sri Lanka, says Citibank

• Says no credible strategy available for achieving debt sustainability and boosting external repayment capacity
• Expects foreign reserves to fall US $ 3.7bn by end-2021, from US $ 5.8bn at end-October 
• SL has US $ 1bn ISB maturing in July, 2021 and another two ISBs maturing in January (US $ 500mn) and July (US $ 1bn) in 2022
• Says govt.’s “piecemeal approach” in settling maturing ISBs is unlikely to restore investor confidence
• Says 40% chance of govt. going ahead with IMF but such programme unlikely to be welcomed by foreign investors 

By Nishel Fernando
An International Monetary Fund (IMF)-backed deal is inevitable for Sri Lanka’s government that is in denial of the looming debt crisis, the research arm of Citibank, Citi Research said.

“While officials continue to mention their willingness to pay, we cannot see a credible strategy for achieving debt sustainability and (external) repayment capacity beyond talking up their growth prospects and expecting this to attract FDI and other portfolio equity inflows. The ability of financial repression to contain domestic borrowing costs is limited by rising debt ratios, still expected to grow amid a pro-growth 2021 Budget,” Citi Research cautioned its clients in a recent report titled ‘Sri Lanka Economics and Strategy: Denial is not a Strategy-Assessing Debt Restructuring Scenarios’.

In the most optimistic scenario, Citi Research expects the country’s foreign reserves to fall to US $ 3.7 billion, at the end of next year, from US $ 5.86 billion at end-October, this year, assuming short-term debt and official loans are rolled over, China lends an additional US $ 800 million and FDIs would finance 40 percent of the current account deficit.

Sri Lanka has a US $ 1 billion international sovereign bond (ISB) maturing in July, next year and another two ISBs maturing in January (US $ 500 million) and July (US $ 1 billion) in 2022. 

In addition, the government also faces over US $ 1 billion maturities in US dollar-denominated and domestically issued Sri Lanka Development Bonds, including US $ 693.9 million maturity in May. 

“We expect the government will pay the July 21st and possibly the January 22nd (though the latter is less certain),” Citi Research noted.

It pointed out that the government’s “very piecemeal approach” in settling maturing ISBs is unlikely to restore investor confidence.

Further, they noted that the time delay in obtaining the US $ 700 million much-talked financing facility from the China Development Bank (SDB) remains a concern.  

If new official and Chinese commercial lending to be delayed or fall short amid debt sustainability concerns, Citi Research estimates that Sri Lanka’s foreign reserves could fall to US $ 3 billion by July next year.

“We remain cautious on Sri Lanka bonds as the road to restructuring is long. We do not recommend getting involved in Sri Lanka bonds, given the government’s lack of a debt repayment strategy and the uncertainties around the government’s willingness to engage with the IMF. Our NPV analysis suggests further downside,” the report cautioned. 

However, Citi Research widely expects the government to come into grasp with the reality by beginning of 2022 and to enter into a fresh IMF programme, as the country would require a debt restructuring programme to come out of the current debt crisis. 

“In our base case we assume Sri Lanka’s government will be compelled to engage with the IMF to execute the restructuring. We expect a coupon haircut of around 52 percent to stabilise the debt at current levels, with maturity extensions three to five years across the curve,” Citi Research noted.

It expects private sector creditors, both domestic and international and official bilateral creditors, representing 73.9 percent of GDP in public debt (excluding debt stocks held by state banks and the Central Bank) to face haircuts in debt structuring.

“While there is political aversion to imposing large losses on foreign investors given worries about impairment of capital market access, imposing losses on domestic investors, especially the Employees’ Provident and Employees’ Trust Fund, for example, who own 39 percent of Treasury securities, won’t be politically easy either. However, the prevalence of capital controls and easier legal means to rewrite terms of local securities make us believe they will not go unscathed,” the report stated.

Thus, Citi Research expects private sector creditors, both domestic and international and official bilateral creditors, will face the burden of haircuts of the remaining 73.9 percent of GDP in public debt (the report hasn’t factored in guaranteed debt for this exercise).

However, in the absence of an IMF-backed credible debt reduction plan in place, Citi Research doubts whether the foreign investors would agree to such a deal.

Having said that, Citi expects the government to continue to explore alternative sources of funding and kick the can down the road, hoping for a vaccine-led recovery, while acknowledging that there is 40 percent probability of the government pursuing a debt restructuring programme without an IMF deal. 

However, it noted that such a deal would not only be unfavourable for the country, considering the high exit yields but also unlikely to be welcomed by the foreign investors.

Meanwhile, the report also differed from the government’s optimistic economic growth targets of 5-6 percent, while noting that the country’s long-term growth is likely to be close to 4-4.5 percent. In 2021, Citi Research forecasts Sri Lanka’s economic growth to rebound to 3 percent, from the estimated 4 percent contraction this year.

On the deficit side, it expects the IMF would likely push for a one percent primary surplus, which may not be realistic, given the government’s pro-growth policy agenda.

“However, given the government’s inclination to postpone fiscal consolidation, we assume reaching a primary surplus in the near term is not possible. We prefer to account for some fiscal slippage and therefore target -0.5 percent primary deficit as more realistic,” the report added.