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Letter from Sri Lanka: a bond market opportunity?

Letter from Sri Lanka

Mention Sri Lanka and tea, cricket, sea and safari typically come to mind. These are the more positive perceptions of the country. But political turmoil, policy confusion, currency depreciation and a bond scandal remain some of the negatives that the nation has yet to shake off.

A national unity government that took power in 2015 – with President Maithripala Sirisena hailing from the Sri Lankan Freedom Party and Prime Minister Ranil Wickremesinghe from the United National Party - remains in place but appears to be very unpopular.

In its early days, the coalition government pushed through substantial civil servant wage hikes that strained an already difficult fiscal position. Coinciding with a disastrous budget and at a time when the government was supposed to be addressing corruption, irregularities around a bond auction cost both the former central bank Governor Arjuna Mahendran and former Finance Minister Ravi Karunanayake their jobs.

Key infrastructure projects were stalled causing growth to slow, including the $15 billion Port City project, which will encompass a financial district and residential property. Progress on other crucial development, such as the airport expansion, has been slow.

Businesses were hurt by the imposition of a one-off super gains tax, banking and telco levies, sugar taxes and other ad-hoc revenue raising measures. In addition, investigations by the newly-established Financial Crimes Investigation Division have also weighed on sentiment.

Sri Lanka remains vulnerable to shocks with its high public debt, large financing needs and weak external position.

Sri Lanka remains vulnerable to shocks with its high public debt, large financing needs and weak external position. These weaknesses are reflected in a sovereign credit rating of B+ by S&P and Fitch. There appears to be a strong sense onshore that neither the coalition government nor its leaders individually will survive the next general elections due in 2020.

Understandably, global investors are wary of investing in a market marred by scandal, political uncertainty and a slowdown in growth. But Sri Lanka has made progress on important reforms and regardless of how the political leadership transitions there will remain a focus on infrastructure development.

The International Monetary Fund (IMF) program has been successful with notable improvements made on tax and fuel price reforms and a rebuilding in forex reserves. Road connectivity is improving. Some of the significant real estate development around Colombo is nearing completion. So is the land reclamation required for the Port City project. Real gross domestic product (GDP) growth may rebound to 4.6% this year from 3.1% in 2017 with inflation around 5% through 2018.1

Politics, politics and politics

Politics weighed heavily on our minds during a recent visit to Colombo. In meetings with current and former government officials and business executives, our conversations never strayed far from prospects of political change at the next general elections.

A transition in leadership could result in adverse policy changes or even derail progress on reforms. It can be argued that a political change could be positive for growth by removing some of the uncertainty around policy that has partly been weighing on business sentiment. But it could also negatively impact expectations, particularly on the part of the rating agencies if it involves the unwinding of important tax reforms.

Former President Mahinda Rajapaksa’s party has made a significant come back by performing well in recent local elections with the coalition government suffering from notable defections. With changes made to the constitution, neither himself nor his brothers can run for President and the sequencing of Presidential, General and Parliamentary elections. These are all due around the same time and will have important implications for political outcomes.

Uncertainty is likely to crescendo through 2019. We are bracing ourselves for a potentially complicated election cycle ahead. Investors should be mindful of appropriately managing risk during this period but also be aware of opportunities that elevated uncertainty will likely create.

Bridging infrastructure gaps

In any 2020 election outcome, the focus will likely continue to be on infrastructure development. There is a much-needed expansion of transportation and logistics infrastructure.

Tourism numbers have quadrupled over the past decade to 2.1 million in 2017,2 but this has put pressure on the transportation infrastructure with the airport running at double its capacity. The Port of Colombo will hit full capacity in the next few years.

There hasn’t been any development of specialised industrial zones since 2002. Progress will have to be made on the plans to develop five locations that have been identified. Parts of the Port City project (mainly the planned International Financial Center) could be up and running by 2023.

Free trade agreements with China, India and Singapore are already in place or will be concluded relatively soon. The government is working with the World Bank to develop the infrastructure that will provide a single portal detailing all procedures relevant to import/export; and a National Single Window to provide a single transaction point between the trade community, private sector and government.

With good execution, Sri Lanka could see itself playing a greater role in areas such as tourism, logistics and services, and as a financial center in the years ahead. Even taking into account the political backdrop and election risks in 2020, we remain positive on the longer term outlook for Sri Lanka, supported by improvements in policy coordination, infrastructure development and strategic geographic advantages.

Risk versus reward

Why do we look at a bond market like Sri Lanka given the risks? Compared with some of the other frontier and core bond markets in Asia, Sri Lanka has a relatively liquid market. Foreign ownership is low, having been around only 5%. It is an off-benchmark trade for most investors and one that requires a significant amount of due diligence.

The local currency market is primarily domestically driven, which gives it a lower correlation and some resilience in the face of some of the external shocks that have hit broader emerging markets.

At the levels the market has traded at in recent years, an investor has more than adequately been paid to take risk. After taking into account some anticipated currency depreciation, Sri Lanka has delivered some of the stronger returns in the region.

1The World Bank in Sri Lanka, April 12, 2018.

2Tourism growth trends, 1970-2017, Sri Lanka Tourism Development Authority.

 

Important Information

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

Fitch is an international credit rating agency. Fitch ratings range from AAA (reliable and stable) to D (high risk).

Standard & Poor’s credit ratings are expressed as letter grades that range from “AAA” to “D” to communicate the agency’s opinion of relative level of credit risk. Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. The investment grade category is a rating from AAA to BBB-.

ID: US-230718-69127-1