Asia Credit-Sri Lanka:time to rethink bond positioning -Sell 22s &26s

YTD Sri Lanka’s bonds have been at the forefront of investors’ hunt for yield. Long-end of SRILAN curve has materially outperformed EM peers and those in Asia, even higher rated ones. The notes in the belly of SRILAN curve feature in the top-3 best performing bonds in Asia YTD. Overall, in the past two-three months the demand for SRILAN bonds in Asia has been second only to Mongolia (see our separate note). We have already been highlighting the richness of Sri Lanka’s bond valuations in the recent past and continue to believe that the yield tightening has priced the bonds out not only the relative value in EM, but also out of its own fundamental story.

    Despite the country entering the second year of its 3Y EFF arrangement with IMF and a stable inflow of international project financing, Sri Lanka is still facing the challenges in improving its fiscal position, contain inflation and reduce the cost of debt servicing. We would highlight five main difficulties that Sri Lanka has been facing lately that are likely to negatively affect its fundamentals in 2017 and are not currently reflected in bond valuations:

    A 4.6%/GDP fiscal deficit target set by the government for 2017 (vs. 5.6% in 2016 and 7% in 2015) would be quite difficult to achieve given the hike in the total government spending by 17% vs. a decline of 0.7% in 2016. The spending is likely to overshoot driven by the ongoing drought in the country and a recent decision by the government to provide compensation to the affected farmers that, according to Moody’s, could cost Sri Lanka 0.2% of GDP. An expected decline in agricultural output would increase an import bill for the country, reduce economic activity (the sector accounts for 9% of GDP) and have negative impact on income tax collection (28% of the workforce).

    Ongoing drought is beginning to affect FDI-related decisions in the country. The drought is reportedly the worst in the past four decades and as of Dec-16 Sri Lanka’s water reservoirs had already been at 29% of capacity, which likely is by now at much lower rate. The recent decision by Coca Cola to relocate one of its largest bottling plants from India, where the company has already been banned to draw water from Thamirabaran River, to Sri Lanka is now facing strong political opposition in the latter.

    In Asia, Sri Lanka remains most exposed to the risk of capital outflows. Portfolio investments, especially equities, had negative trend for the good part of 2016 and still continue in 2017, which has been the main reason for a decline in FX reserves. By Dec-2016 FX reserves dropped 17% since Jan-16 to USD6bn and then declined even further to USD5.4bn as of Jan-17. Sri Lanka is falling behind IMF’s requirements on FX reserves.

    Inflation has been rising at a fast pace, and this trend is likely to be exacerbated by the ongoing drought and Central Bank printing money to repay maturing government debt. Feb-17 annualised inflation rate came at 6.8% - a 120bp jump from Jan-17 and is the highest print for the past 12 months. Although IMF’s current ceiling for inflation stands at 8.1%, Sri Lanka is facing tougher conditions for its future monetary policy moves.