Sri Lankan Default Points to Future Problems for Developing Countries

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Bloomberg News

Sydney Maki and Amelia Pollard

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(Bloomberg) – Sri Lanka’s impending default on $12.6 billion in foreign bonds is a warning sign to investors in other developing countries that rising inflation will take a painful toll.

The South Asian nation will blow through the grace period on Wednesday on $78 million in payments, marking the first debt default since it gained independence from Britain in 1948. The bonds are already trading deep in distressed territory, with holders bracing for losses approaching 60. cents on the dollar. The government said last month it would halt payments on foreign debt.

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Sri Lanka’s situation is unique in the way all debt crises are – the specifics here include an unpopular government led by an all-powerful family, the unresolved aftermath of a 30-year civil war and violent street protests. But the island’s saga is beginning to be seen as a bell tower for emerging markets where shortages exacerbated by inflation, including record high food costs worldwide, have the potential to storm national economies.

“The default in Sri Lanka is an ominous sign for emerging markets,” said Guido Chamorro, co-head of emerging markets hard currency debt at Pictet Asset Management, which owns Sri Lankan bonds. “We expect the good times to end. Slowing growth and more difficult financing conditions will increase the default risk, especially for border countries.”

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Read the QuickTake on how Sri Lanka ended up in crisis and what this means for investors

Sri Lanka, an $81 billion economy on India’s southern coast, has been in turmoil for weeks amid an annual inflation rate of 30%, a plummeting currency and an economic crisis that leaves the country with insufficient hard currency to import food and fuel. . Anger at the situation — sparked by years of excessive borrowing to fund bloated state-owned enterprises and generous social benefits — has boiled over into violent protests.

Widespread arson and clashes were reported from various parts of the country, while houses and properties belonging to various government legislators were set on fire. At least nine people, including a member of parliament, were killed in the violence.

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Sri Lanka currently has no finance minister, which could complicate efforts to get through the crisis as the government struggles to restore security and get a rescue package from the International Monetary Fund. At the same time, it must negotiate restructuring with creditors, including BlackRock Inc. and Ashmore Group.

The country’s dollar-denominated bonds are among the worst-performing in the world this year, with only Ukraine, Belarus and El Salvador’s Bitcoin-broken notes doing worse. The government failed to transfer approximately $78 million in coupons to holders of debt maturing in 2023 and 2028 on April 18, prompting S&P Global Ratings to declare a selective default. Fitch Ratings and Moody’s Investors Service have yet to announce any official defaults, despite issuing their own warnings.

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After the grace period on those payments ends Wednesday, negotiations with creditors could begin in earnest, a process that will be essential to win help from the IMF. The country has previously said it will need between $3 billion and $4 billion this year to get out of the crisis.

But closing such a deal quickly will not be easy. While President Gotabaya Rajapaksa has already called on one of his political opponents to take over as prime minister after the resignation of his brother, Mahinda Rajapaksa, instability lingers. The division remains strong after a 30-year civil war that ended in 2009 and the central bank governor has threatened to resign if political stability does not return soon.

“We are in a volatile situation that is very dangerous for Sri Lanka,” said Matthew Vogel, London portfolio manager and head of sovereign research at FIM Partners.

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Read more:​​A powerful dynasty has bankrupted Sri Lanka in just 30 months

Risk of replication

As Sri Lanka grapples with the turmoil, the troubles are a warning to other emerging markets where heavy debt has coincided with economic hardship and social unrest. The challenge becomes even more difficult as the Federal Reserve and other major central banks raise interest rates in an effort to suppress inflation, leading to higher borrowing costs.

“They are now forced to face their debt burden amid tightening financial conditions,” said Trang Nguyen, executive director of emerging markets strategy at JPMorgan Chase & Co.

At least 14 emerging economies, tracked in a Bloomberg gauge, have debt yields above 1,000 basis points against US Treasuries, a threshold for bonds to be considered distressed.

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Additional pressures from rising food and energy prices have already begun to bubble up in other countries, including Egypt, Tunisia and Peru. It threatens to turn into a broader debt debacle and a new threat to the fragile recovery of the global economy from the pandemic. Pakistan, Ethiopia and Ghana also threaten to follow suit, Bloomberg Economics said last month.

“Sri Lanka could be the start of a trend across borders and emerging markets where governments are experiencing debt crises — and potentially failing to meet their obligations,” said Brendan McKenna, a strategist at Wells Fargo in New York, who says Pakistan and Egypt are there. look particularly vulnerable. “As interest rates rise, many of the fundamentally weaker countries with dollar-denominated debt may struggle to repay bonds.”

©2022 Bloomberg LP

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