The Democratic Socialist Republic of Sri Lanka returned to the international bond markets on March 7. It picked what may turn out to have been the optimum issuance window to lock in its dollar-denominated bond funding for 2019.
The B2/B/B rated sovereign took full advantage of a strong rally in emerging market bonds and a hiatus in the ongoing domestic tug of war between former president Mahinda Rajapakse and current prime minister Ranil Wickremesinghe.
This positive momentum enabled the country to achieve its lowest cost of funding since a constitutional crisis erupted last October. It raised 1 billion in five-year money at 6.85% and $1.4 billion in 10-year money at 7.85%.
However, both bonds closed the Asian trading day down half a point on Friday. This suggests that the sovereign had pushed pricing too far since neither tranche offered much in the way of a new issue premium despite the transaction’s large size.
Both the five- and 10-year tranches offered a very slim 5bp concession over the sovereign’s existing debt after adjusting for the maturity extension (worth about 20bp).
Sri Lanka may have been emboldened by its $7.5 billion final order book ($2.7 billion for the five-year and $4.8 billion for the 10-year). Yet, while this was strong in relation to its own recent outings, it was far smaller than the $19.5 billion that B3/B/B rated Egypt attracted for a $4 billion deal in late February.
Over the past week or so, market participants have started to query whether the emerging market bond rally has run ahead of itself, notwithstanding inflows of $18.5 billion into emerging market bond funds during the first two months of the year.
For example, spreads on Sri Lanka’s existing 5.75% April 2023 paper tightened 228bp between late November and early March. The country’s 6.75% April 2028s also tightened 155bp over the same period.
Other Asian frontier market credits have performed as impressively. Pakistan’s 8.25% 2024 bond has come in about 140bp since late November, while Mongolia’s 8.75% March 2024 bond has tightened about 134bp.
Sri Lanka’s spread levels relative to its Asian frontier market peers suggest that its constitutional crisis has added an 80bp to 100bp political risk premium. Last year's six-week-long political confrontation saw Rajapakse try to regain power after the current president, Maithripala Sirisena, installed him as prime minister despite the fact that Wickremesinghe still commanded a majority in parliament. It took a Supreme Court ruling to remove him from office.
Sirisena and Wickremesinghe’s difficulties working with each other are one of the reasons why Sri Lanka has underperformed both Pakistan and Mongolia since the coalition came to power in early 2015. The other is because the country has had to impose IMF-led austerity and structural reforms thanks to over-borrowing by the previous Rajapakse regime, largely from China.
Back in 2015, for example, Sri Lanka traded 200bp inside of Pakistan. Today it is at the same level as its one notch lower rated B3/B-/B- rated peer.
Likewise in 2015, it traded 450bp inside of Mongolia, which was feeling the full force of a global commodities bust. Today, Sri Lanka is trading 80bp wide of B3/B/B rated Mongolia.
The key question for investors now is whether Sri Lankan spreads are likely to come under renewed pressure, or whether the country will regain the B2/B/B rating it held before the constitutional crisis. Domestic economists agree that the economy is now recovering, but believe that politics will soon rear its head again as Sri Lanka moves towards presidential elections at the end of the year and general elections next year.
Having served two terms already, Rajapakse cannot re-stand as president. Local observers expect one of his three brothers (mostly likely Gotabaya if he can renounce his US citizenship) to contest against a candidate from the ruling United National Party (UNP).
The family, which dominates the Sri Lankan Podujana Peramuna Party (SLPP), remains extremely popular among the rural population, but historically less so in urban areas where there are more concerns about authoritarianism.
Many UNP rank-and-file members are pinning their hopes on MP, Sajith Premadasa, the son of former president Ranasinghe Premadasa, who is also popular in the rural hinterlands. One of the main accusations commonly levelled at his current boss, Wickremesinghe, is that he is an elitist who is far more comfortable speaking English than Sinhala.
Kavinda Perera, head of research at Asia Securities in Colombo, told FinanceAsia that investors should remain conscious of the forthcoming elections. “We’re in an election year, so politics will increasingly dominate the headlines and political risk will remain elevated, albeit at a lower level than seen in October to December last year,” he said.
CT CLSA strategist Sanjeewa Fernando agrees that politics will dominate. “The populace is very focused on how to get out of the coalition mess and improve governance,” he said. “There’s a real understanding that what this country needs is proper and fast execution of projects."
Fernando also thinks the government picked a good issuance window for its overseas bond, “because domestic interest rates are likely to rise this year and the sovereign risk premium will go up with them”.
On the plus side, Sri Lanka has also just reached a staff-level agreement with the IMF following its fifth review and has asked for a one-year extension to the current programme.
In 2019, the country is forecasting growth of 3.5%. That is up from 3% last year, although well below both its potential and historical growth rate.
Asia Securities’ Perera thinks that disposable incomes could surprise on the upside. “The agricultural sector hasn't been affected by any weather-related issues and none are forecast,” he said. “While agriculture only accounts for 8% of GDP, the sector employs 25% of the labour force."
He also says that the central bank has done a good job locking in foreign exchange reserves in a timely manner. This includes a $400 million swap facility with the Reserve Bank of India that may be increased to $1 billion, and a $300 million bilateral loan through Bank of China, which may also be lifted to $1 billion.
The country hopes to raise reserves from $6.9 billion at the end of 2018 (3.7 months of import coverage) to $8.6 billion by the end of the year.
Perera also notes that the recent budget and its predecessor have “put a greater emphasis on enabling the private sector to facilitate growth. That’s a big change from the previous administration, which relied on government investment that crowded out the private sector,” he said.
He is, however, more cautious about the government’s revenue targets. This year it hopes to hit a ratio of 14.8% to GDP, of which 13.3% will come from taxes and 1.7% from non-taxes.
But that is a big jump from 2018 when provisional government estimates suggest that the country managed 13.4% of which 11.9% came from taxes and 1.4% from non-taxes.
“This is one area we’re cautious on,” Perera concluded. “We think that some of the government’s capex spending on infrastructure and housing could be slowed down because of revenue collection shortfalls.”
Joint bookrunners for the bond deal were BOCI, Citi, Deutsche Bank, HSBC, JP Morgan, SMBC Nikko and Standard Chartered.
