Sri Lankan government moves to service its debts to increase investment attractiveness

Sri Lanka’s debt picture is decidedly mixed. In some ways, the country has been greatly successful in managing its international exposures. Government obligations have fallen significantly, from over 100% of GDP in 2004 to about 74% in 2015.

As the civil war ended, defence spending decreased, and this opened up previously committed resources for covering the budget and paying down debt. Yet at the same time, Sri Lanka’s debt burden remains high – particularly in comparison to its peers – and may remain at current levels for some time. Expensive Chinese money, problems with tax collection (see analysis) and slowing economic growth suggest that the fall in the debt-to-GDP ratio may be a one-off as a result of the end of the war and that underlying problems remain.

Chinese Loans

At present, nearly 70% of infrastructure projects – roads, energy programmes, airports, seaports – have been funded by China in a near-tripling of Sri Lanka’s debt over the last five years. By early 2015 the government estimated it owed $3.8bn to Chinese state banks; Chinese and Indian media place the figure closer to $5bn and reports in early 2016 suggested it is closer to $8bn. While these loans provided quick solutions in a post-war economy, bypassing much of the red tape involved in financing through multilateral institutions, analysts say high interest rates are a key drawback to this development model. Some estimates place rates at 3% or higher, substantially affecting Sri Lanka’s debt-servicing bill, which equals around 40% of state revenues. At the start of 2015, Sri Lanka owed nearly $25bn to external creditors. In the first nine months of 2015, its outstanding debt rose by 12% to LKR8.27trn ($59.5bn).

To help resolve the poor management practices of the past, the new government put many Chinese projects on hold following its inauguration in early 2015 – part of its “realignment” of foreign policy aimed at reducing dependence on a single entity to finance development. The move inevitably complicated relations between the two nations. In October 2015, when Sri Lanka appealed for relief on loan terms, it was made clear no negotiations were possible until the delays on current projects were resolved. Many of these deals, worth billions of US dollars, represent foreign direct investment (FDI) Sri Lanka needs to help spur growth. By early 2016 the government had indicated a more relaxed stance on Chinese projects. In April, it asked China for a debt-equity swap on some of the $8bn it owes Chinese firms for such projects, offering to sell them stakes in local firms. Progress on this remained unclear as of early April 2016.

Other Sources

The country has since availed itself of a wider range of funding sources. In March 2015, India agreed to extend a $400m swap line to Sri Lanka, and an additional $1.1bn in July of the same year. In February 2016, the Asian Development Bank decided to scale up support as well, providing $2bn through loans and equity for 2016-18. The money will be directed towards highways, railways, power generation and education, and follows on from a previous $1.5bn allocation.

Sri Lanka has also been tapping the international capital markets for some time. Under the previous administration of President Mahindra Rajapaksa, a total of $5.5bn in bonds were sold at an average yield of 6.5%. In January 2014, the country sold $1bn in 5-year bonds at 6%, and a further $500m in 5-year bonds in April at 5.125%. In October 2015, it raised $1.5bn of 10-year money at 6.85% in a sale that was oversubscribed 2.2 times.

Some economists worry that the overall debt picture is distressing. Due to the high servicing costs, the country may be unable to invest enough to achieve the growth it needs. One answer is to improve the quality of investment by shifting away from borrowing and more toward FDI. Yet the World Bank sees the overall debt ratio increasing in 2016, as the government has had difficulty keeping the deficit within the budget as well as increasing tax revenues as a percentage of GDP.

Time Factor

The finance ministry has consistently said in comments to the local press that Sri Lanka is in a challenging position and has few avenues to pursue in dealing with the legacy of the former administration. The country cannot reduce the debt; all it can do is restructure existing debt by either lengthening the tenor of bonds or lowering interest rates. Time is another issue: once per capita income breaks the upper-middle-income threshold, Sri Lanka will no longer be able to access the development funding market.

Local observers note that should international assistance be forthcoming, the country needs to use this opportunity to undertake meaningful and lasting economic reforms. It must make the transition from a country eligible for development assistance to one that is attractive for FDI. Short of concessionary financing, the government believes that it can do better in commercial markets and reduce its overall debt payment burden.

IMF Role

Sri Lanka has had a mixed relationship with the IMF in recent years. In 2012 the IMF completed a $2.6bn finance programme for Sri Lanka to avoid a balance of payments crisis following the culmination of the civil war, and subsequently rejected a request for further assistance in 2013 aimed at bridging that year’s budget deficit.

Since early 2015, the government has argued that further assistance will be needed. Shortly after the victory of President Maithripala Sirisena, it went to the IMF to lobby for more support to reduce the nation’s debt burden taken on under the Rajapaksa administration. In March 2015, the IMF rejected the government’s request for a $4bn loan to be used to retire the higher-priced Chinese debt. The government had also been asking for a deferral of payments on existing IMF obligations. The IMF says that the country was not in need of a bailout, given its “comfortable” reserve position and relatively strong economic growth. It cited the situation as being far different from 2009.

IMF press briefings on the matter suggest that it objects to aspects of the new government’s budget proposals, which provided significant salary increases for civil servants. The IMF has also objected to import tax cuts and various one-off taxes that are seen to be unsustainable. Further relief will likely be linked to structural reforms that will keep the deficit within a reasonable range.

Meanwhile, concerns about the economy are shared by many analysts. Dependence on foreign borrowing, infrastructure, tourism and remittances leaves Sri Lanka especially vulnerable to exogenous shocks. The country has indicated that rejection by the IMF will push it towards the international markets, where rates are much higher than those provided by multilateral institutions.

In early 2016, and after losing $1bn in foreign reserves in January alone, Sri Lanka returned to the IMF formally requesting an aid package that took into account slowing growth and a rising budget deficit. On a mission in February 2016, the IMF delegation again expressed the need to put public finances onto a sustainable path. Then in March 2016, the IMF confirmed a $1.5bn loan package to avoid further balance of payment issues.

The current round of talks commenced in March 2016, and the eventual terms are yet to be finalised, although the expected thrust will be for further austerity, cutting the deficit and boosting government revenues through taxation. According to Central Bank Governor Arjuna Mahendran, an IMF package could help drive down the cost of borrowing to between 6-7% from the current 8.5%.