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SRI LANKA: No Default This Year

In a series of two reports, we initiate our coverage of Sri Lanka as a high-yield sovereign credit. In this report, we review a number of factors on macroeconomic, political, and institutional fronts against the country’s Asian closest peers (Mongolia, Papua New Guinea, Tajikistan, Pakistan, and Iraq), in our judgment. We pointed out problems the country is facing, assessed the likelihood of the government defaulting on its external debt obligations, and gauged the possibility of the major rating agencies downgrading the country’s ratings. We will follow up with a subsequent report on the country’s USD bond relative value comparison and recommendation in due course.

We find that it is unlikely for Sri Lanka to default on its debt obligations this year given several options available to the country, although the cost to financing and to the wider economy is rising. Sri Lanka’s debt is undoubtedly unsustainable, in our view, if necessary reforms are not in place to cure all the severe imbalances in its economy. Beginning in March, the COVID-19 pandemic jitters hit Sri Lanka’s SRILAN bonds hard, with prices falling by 30%-40%. On 1-April, Sri Lanka’s Treasury Secretary Sajith Attygalle said the country would honor all debt commitments. 

Moody’s, on 17-April, placed Sri Lanka's B2 sovereign ratings under a downgrade review. On 24-April, Fitch downgraded Sri Lanka to 'B-' with Negative outlook. We believe it will take some more time, at least until October this year, for the agencies s to decide whether or not to downgrade Sri Lanka’s ratings. We expect a downgrade if some or more of the factors are in play, including whether the pandemic will prolong, the difficulty for the government to secure funding especially for the October USD1bn debt instalment, whether the government succeeds in appealing for debt moratorium, and whether the government carries out ill-designed policy reform measures.

 Most of Sri Lanka’s major macroeconomic indicators show signs of severe deterioration in economic performance and sustainability even before the COVID-19 pandemic. The pandemic has exacerbated the country’s default risk  on external debt due to continued falling revenue, rising debt, constrained foreign reserves, and increasing cost of external financing. This happens at the time that both fiscal and monetary policies are of little help in reviving the economy while maintaining macroeconomic stability. At the same time, we believe political uncertainty makes it more difficult for Sri Lanka to access funding from multilateral organizations such as IMF though any news of securing the debt package from IMF will be spread positive for the country’s USD bonds.