The Democratic Socialist Republic of Sri Lanka is expected to return to the international bond markets after Easter in what is shaping up to be a busy year for the sovereign.
Its first deal will be of benchmark size and as such will provide a key test of global investor appetite for emerging market debt amid sharper increases in US rates. But it is unlikely to be the country’s last foray into the market during 2018.
As central bank governor Dr Indrajit Coomaraswamy explains in an interview with FinanceAsia, Sri Lanka is also drawing up plans to launch a liability management exercise for its shorter-term maturities following the enactment of a Liability Management Act last week.
Dr Coomaraswamy is one of those rare government officials who attracts very little criticism and is widely liked and respected, at home and abroad, for his ability to clearly articulate problems and formulate solutions.
In the following interview, he explains why investors should dive below the surface of recent negative headlines. These have concentrated on local election results, which showed a resurgence of support for Sri Lanka’s former strongman president Mahinda Rajapaksa, and violent clashes in Kandy between the city’s Muslim and Buddhist communities.
Instead, the central bank has been laying the groundwork for a stronger economy that can withstand any renewed bout of emerging markets volatility caused by rising US rates.
If the bank can put that message across, the B+/B1/B1 rated credit may also be able to reverse recent momentum, which has seen its five-year bonds fall to just a few basis points tighter than two-notch lower-rated Mongolia on a like-for-like basis.
There have been a number of unsettling events in recent months such as local elections when the coalition government lost heavily and then religious violence. How will these impact your macroeconomic policy?
We’ve definitely had some issues. But my consistent message is to look beyond the noise.
For example, the violence in Ampara and Kandy was shocking, but not entirely surprising. Whenever we have elections, there’s always a small minority of candidates who try to whip people up.
This time, the new dimension was social media. The most rabid nationalists used it to spread inflammatory rhetoric and mislead people.
That’s why the government closed down sites such as Facebook and WhatsApp until things settled down, which they now have.
One should recognize that local government elections have no direct impact at the national level. In addition, the local authorities were, to a significant extent, under the control of politicians sympathetic to the opposition even prior to the election.
Hence, there hasn’t been a dramatic change to the overall political configuration. But clearly the governmental coalition parties would like to have done significantly better than they did.
But don’t peoples’ fears run deeper than that? One taxi driver told me he was too upset to work the day after the results came through. He felt Sri Lanka only narrowly swerved a dictatorship when Mahinda Rajapaksa lost power in 2015 and could be heading back in that direction again.
I think it’s good to give these concerns a longer-term perspective because there have been a number of times when Sri Lanka has been in similar situations in the past. But what cuts through them all is our 70-year history since independence as a politically pluralist society.
We should never ever take that for granted, but it’s also as well to remember that our political system really is quite resilient.
It rebalances itself. In the 1970s there was a period of emergency rule. In the 1980s, the government of the day held a questionable referendum to prolong its power when it held a two-thirds majority.
In the 1990s there was another authoritarian period when there was concern about democracy being eroded. Then we had another one again after the war ended because people were so grateful it had ended. That period is also now over.
However, the local election results will focus minds. The government has 18 to 20 months to demonstrate results before there are presidential elections.
One could argue that they haven’t moved as quickly as they should have done on a number of issues. But on the plus side, progress has been made in stabilising the economy.
We have just had an IMF team in town. We’ve satisfied all the quantitative performance indicators and outperformed in certain areas as well.
Such as?
Well gross reserves are now about $7.95 billion, up from $6 billion at the end of 2016. That’s about 4.5 months of import coverage.
We’ve also improved the reserves’ quality. We were able to bring short-term swaps down from $2.5 billion to $1.5 billion during 2017. We’d like to reduce swaps by about a further $1 billion this year as well.
Is that going to be the high water mark for reserves?
No. We think we could end up around the $9.5 billion mark by the end of the year.
One reason is because of a government policy decision to earmark all divestment proceeds for liability management. That money is being placed in a separate account managed by the central bank.
It will include about $700 million more from the Chinese for the port at Hambantota. Then a further $300 million to $500 million will come from the government’s divestment of a couple of hotels, plus it hopes to find a strategic partner for Sri Lankan Airlines before the end of the year.
That’s moving ahead. The airline has a restructuring plan and a new board is about to be appointed.
Secondly, we’ve been making direct purchases from the market. In 2017, we purchased $1.7 billion, or $200 million net. This year it could be another $150 million net.
How much do you plan to borrow from the international bond markets during 2018?
We’ve got approval for $2.5 billion. About $2 billion will be to fund the budget deficit and that will be our first issuance of the year.
Then the remaining $500 million will go towards the liability management exercise we want to conduct. We’ve got maturities every year from 2019 to 2022 and we’d like to push those international sovereign bond maturities out and reduce the debt stock.
We’re currently working out the modalities with assistance from the World Bank, US Treasury and our investment bankers. Back in January, there was appetite for 30-year paper at the current rate for 10-year paper in the international bond markets.
That window has gone because of what’s happened in the US Treasuries market, but we’d still like to push out to 10 years, or more.
What’s the status with Liability Management Act, which will allow you to be more flexible with your debt management strategy?
The act has just been enacted by parliament.
It’s one of the four policy frameworks we’re putting in place. The current Appropriation Act limits government borrowing to a specific year’s requirement. So we haven’t been able to create buffers and engage in liability management by borrowing more in any particular year.
The new act creates that headroom, but it limits how much we can borrow and it also specifies what purposes that extra money can be used for. The limit has been set at 10% of the total debt outstanding at the end of the previous year and the additional borrowing can only be used for liability management.
We’re talking to our bankers right now and there’s clearly a case for going to the market sooner rather than later so we hope to come in the next month or so. US Treasuries are unlikely to come down again this year.
Yes, your longer-term bonds dropped five points during the first two weeks of February.
That’s mainly because 10-year US Treasuries jumped from 2.3% to 2.9%. Our $1.5 billion 6.2% May 2027 bond has widened about 100bp, but about 60bp of that was down to Treasuries.
There’s also been an increase in the risk premium attached to emerging markets in general.
Do you think your spreads overshot because of concerns about the government’s competence?
Sri Lankan politics are always untidy, but we do get things done.
Look at the passage of all the most recent pieces of big legislation - the VAT Act, the Inland Revenue Act, the Hambantota Port deal. They all follow a similar pattern.
People go to court; they come out on the streets; politicians start arguing amongst themselves. But they get done. That’s just the way things are in this country.
The government has laid a lot of the necessary groundwork to achieve more robust macroeconomic fundamentals and a stronger growth framework. But too many Sri Lankans just think in terms of kilometres of tarmac, or bricks and mortar.
One needs both: the capacity to lay down a sound and predictable policy framework, as well as the ability to deliver projects and programmes effectively.
Yet even critics within the government’s own ranks say it has not been good at communicating that message to the wider population.
It’s not an easy one to communicate, but what we’ve got to do is convince people we’ll remain on track.
There’s been genuine progress in stabilising the economy, which the IMF has recognised. For instance, on the inflation front we’ve created a policy framework that seems to be working.
Headline inflation was 4.5% in February. Both the Central Bank and the IMF forecast that it should remain within a 4% to 6% target band this year.
It did go up to 8% in the last quarter of 2017, but core inflation remained well within the band. The issue was weather-related supply disruption.
Three cultivation seasons were affected by drought, although the government was criticized for not moving faster to get import supplies.
I believe there was an issue with high fertiliser prices.
That was a problem. The government didn’t get supplies out in time.
But they were a bit unlucky. They put in an order to Pakistan, which then imposed an export ban so one big consignment didn’t arrive and that exacerbated the situation.
Are you confident about meeting the IMF’s targets this year?
Yes, because we’re trying to institutionalise our policy frameworks. The most important one is revenue enhanced-based fiscal consolidation.
This aims to bring the fiscal deficit down to 3.5% of GDP by 2020. This year it should be about 4.6% or 4.7%.
If there is any slippage, there will have to be some adjustments.
What kind of adjustments?
The government will need to cut expenditure, increase revenue, or a mixture of both.
So there won’t be any fiscal slippage then? Economists are worried the government will need to buy votes ahead of the presidential elections.
The government will clearly have to think about some expenditure switching after re-prioritising certain sectors.
They’ll need to respond to some of the messages from the local elections particularly from the rural sector, where three consecutive seasons have been affected by drought. This is where a large percentage of the population lives.
So the switching will be net neutral?
Yes. It would be disastrous if there were any significant fiscal slippage. I hope that is well understood.
What about fuel subsidies? Many economists are worried they won’t be scrapped as promised to the IMF.
The timing may be slightly affected, but I still see it getting it done. There may be some drama similar to the VAT and Inland Revenue Acts as well as the long lease of the Hambantota Port. But it needs to be done.
I think we’re broadly on track and more importantly, I believe there’s an understanding that we need to remain that way given our deficit and debt dynamics. We have no choice.
We’ll continue putting our four key policy frameworks in place. Strengthening the Fiscal Responsibility (Management) Act by giving it teeth through fiscal rules is the first one.
Has it moved forwards yet?
There’s a continuing commitment to it from the Hon. Prime Minister. We’ve asked the IMF to give us some material on how other countries have tackled it.
We already have an act but it doesn’t have any teeth. What we want to do is set our clear pathways when the government is allowed to deviate from the prescribed targets and ensure it has to spell out how it will get back again.
Inflation targeting is our second policy framework. We’ve already strengthened our forecasting and modeling capacity. The legal and accountability framework should be ready by the end of the year, with full implementation in the first quarter of 2019.
The third framework concerns the exchange rate. We want to set certain, clear and transparent parameters for government intervention.
We’ll finalise that in the coming month. We’re working with the IMF, which are giving us some technical assistance.
What impact will the new Inland Revenue Act have?
It kicks in on April 1 so the full effect will only be felt next year. It should net about Rs30 billion ($192.3 million) and will bring tax collection up to about 15% of GDP.
We’re also forecasting 5% to 5.5% GDP growth for 2018, whereas the IMF thinks it will be more like 4.4%.
What are your foreign direct investment (FDI) forecasts?
I feel almost shy about saying this given how low our overall levels still are, but we had record FDI and exports last year. FDI reached $1.7 billion according to Board of Investment (BOI) figures.
On top of that, there’s some additional money, which the BOI doesn’t count and that probably added another couple of hundred million dollars.
Aside from the $300 million we booked from the Hambantota port sale, the rest mainly went to the leisure and real estate sectors. Manufacturing hasn’t really kicked in yet.
But that will change once the Chinese investment gets going. There is also interest from India, Japan, Singapore and other regional countries.
The land reclamation continues apace at the Colombo Port City and is about 65% done now. The Kandy/Colombo Highway is also being built.
Then there is the port in Hambantota. The Chinese are initially targeting an LNG plant, a refinery, a steel plant, a cement factory and a ship repair facility.
A master plan for Trincomalee has also been developed. The idea here is for India and Japan to work together along with Singapore.
Back in December, we also run a business outlook survey for the first quarter. It turned positive, which was very encouraging.
Are these flows at risk now? Investors don’t like instability.
Obviously in an ideal world we wouldn’t have wanted this instability. But the violence has been contained and the political configuration hasn’t changed either.
However, the political momentum has changed and that will create uncertainty. So the government needs to give a clear signal that it will stay on track in terms of economic strategy. There are no signs of any significant changes.
What message would you like to leave investors with?
I’d ask them to look at the fundamentals, which are getting better. In addition, the investment and trade climate is improving.
We’re beginning to gain some momentum. I’m cautiously optimistic, not euphoric and certainly not complacent. The most import thing is for the government to stay on track.
