Sri Lanka Default Seen ‘Inevitable’ as Bond Losses Deepen

(Bloomberg) -- Sri Lankan bonds slumped after protests against soaring inflation and lengthy power cuts led to a cabinet reshuffle, adding to concern political turmoil will hamper the government's ability to repay its debts in the face of a deepening economic crisis.

The nation's $1 billion bond due in July was quoted at 59 cents on the dollar on Monday, down 7 cents and indicated at its lowest price since May 2020. The latest leg down, the biggest among developing countries, suggests that investors are getting more and more convinced Sri Lanka will have trouble honoring its debt when it comes due in less than four months.

The political upheaval comes as Sri Lanka struggles with a cash crunch that's caused the government to implement capital controls and import curbs. On late Friday, the nation declared a public emergency after protests flared in the wake of the deepening crisis. Running short of dollars to buy necessities, Sri Lanka is looking to renegotiate the terms of its obligations to avoid a default, while contending with Asia's fastest inflation and a collapsing currency. Last month, Sri Lanka sought out support from the International Monetary Fund.

“Default was inevitable before the political turmoil, but it reduces the likelihood that the government will be able to secure an IMF program and engage with bondholders in the near-term,” said Patrick Curran, an economist at Tellimer, a research firm specializing in emerging markets. “The prospect of broader political and social unrest also increases downside risks and could lead to higher exit yields and lower recovery values.”

‘Debt Overhang' 

Sri Lanka's trade deficit doubled to $1.1 billion in December and the country had about $2.3 billion of foreign-exchange reserves in February. The nation has external obligations of close to $7 billion this year, according to Fitch Ratings. That figure includes the $500 million bonds that Sri Lanka repaid in January, as well as the notes due in July.

“The reckoning time has come,” said Carlos de Sousa, an investor at Vontobel Asset Management in Zurich. “The government and the central bank have ignored it. What's not clear is whether the current president will survive this episode of protests.” 

The country's “debt overhang,” along with persistent fiscal and balance-of-payments shortfalls, “will constrain growth and jeopardize macroeconomic stability in both the near and medium term,” the IMF said in its Article IV consultation report, released late last month.

“Rollover risk is very high,” the IMF said. The country's debt service needs each year “will require access to very large amounts of external financing at concessional rates and long maturities, sustained over many years.”

The extra yield that investors demand to hold Sri Lankan government bonds over U.S. Treasuries widened to 28.36 percentage points on Monday, according to data compiled by JPMorgan Chase & Co., well above the 10 percentage-point threshold for debt to be considered distressed.  Meantime, the cost of insuring the nation's debt against default in the next five years has nearly doubled in the past year.

“The government will likely need to secure private creditor participation in debt reduction,” Johanna Chua, chief economist for Asia Pacific at Citigroup, wrote in a report to clients.

New Finance Chief 

Central bank governor Ajith Nivard Cabraal, who had opposed IMF aid, offered to quit separately following a decision by members of the previous cabinet to resign en masse. The monetary authority postponed a policy decision originally scheduled for Tuesday after Cabraal's resignation. 

President Gotabaya Rajapaksa swore in a new finance minister on Monday. Ali Sabry, who replaces the youngest Rajapaksa brother Basil and is among the key decision makers as the country starts bailout talks with the IMF. G.L. Pieris will continue as the foreign minister. Both are part of a team that will oversee its debt restructuring, key to obtaining IMF support. 

“Sabry defended the president against corruption charges in the past, and was most recently justice minister, so his appointment doesn't appear to be based on his technical expertise,” Charles Robertson, global chief economist at Renaissance Capital in London wrote in a note Monday. That is “unfortunate as the previous finance minister was supposed to be seeing the IMF for talks in Washington next week -- all very messy.” 

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