Sri Lanka default portends trouble for developing nations

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(Bloomberg) – Sri Lanka’s impending default on $12.6 billion in foreign bonds is a warning signal to investors in other developing countries that soaring inflation is set to have painful consequences.

The South Asian nation is set to go through the grace period on $78 million in payments on Wednesday, marking its first default on its sovereign debt since gaining independence from Britain in 1948. Its bonds are already trading deep in territory in difficulty, with holders bracing for losses approaching 60 cents on the dollar. The government said last month it would stop payments on the foreign debt.

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Sri Lanka’s situation is unique in that all debt crises are – the details here involve an unpopular government led by an all-powerful family, the unresolved legacy of a 30-year civil war and violent street protests. But the island saga is beginning to be seen as a bellwether for emerging markets where shortages exacerbated by inflation, including record high food prices globally, have the potential to upend national economies.

“Sri Lanka’s default is a bad sign for emerging markets,” said Guido Chamorro, co-head of emerging markets hard currency debt at Pictet Asset Management, which holds Sri Lankan bonds. “We expect the good times to end. Slower growth and tougher financing conditions will increase the risk of default, especially for neighboring countries.

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Read the QuickTake on how Sri Lanka landed in a crisis and what it means for investors

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

Widespread arson and clashes were reported in several parts of the country, while the homes and properties of several government lawmakers were torched. At least nine people, including a deputy, were killed in the violence.

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Sri Lanka is currently without a finance minister, which could complicate efforts to weather the crisis as the government scrambles to restore security and secure a bailout from the International Monetary Fund. At the same time, it must negotiate a restructuring with creditors such as BlackRock Inc. and Ashmore Group.

The country’s dollar bonds are among the worst performers in the world this year, with only Ukraine, Belarus and El Salvador’s broken bitcoin notes faring worse. On April 18, the government failed to transfer about $78 million in coupons to holders of debt maturing in 2023 and 2028, leading S&P Global Ratings to declare selective default. Fitch Ratings and Moody’s Investors Service have yet to declare official defaults, despite issuing their own warnings.

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After the grace period on those payments ends on Wednesday, negotiations with creditors can begin in earnest, a process that will be key to securing IMF assistance. The country has previously said it needs $3 billion to $4 billion this year to pull itself 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 following the resignation of his brother Mahinda Rajapaksa, instability persists. Divisions remain deep 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 fluid situation which is very perilous for Sri Lanka,” said Matthew Vogel, London-based portfolio manager and head of sovereign research at FIM Partners.

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

Replication risk

As Sri Lanka grapples with turmoil, its troubles are a warning sign for other emerging markets where heavy debt is converging with economic problems and social unrest. The challenge is made more difficult by the fact that the Federal Reserve and other major central banks are raising interest rates in an effort to contain inflation, which is driving up borrowing costs.

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

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

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Additional pressures from rising food and energy prices have already started to manifest themselves in other countries, including Egypt, Tunisia and Peru. This risks turning into a broader debt debacle and a new threat to the global economy’s fragile post-pandemic recovery. Pakistan, Ethiopia and Ghana are also likely to follow suit, Bloomberg Economics said last month.

“Sri Lanka could be the start of a trend across frontier and emerging markets where governments are experiencing debt crises — and possibly defaulting on their obligations,” said Brendan McKenna, strategist at Wells Fargo in New York. , which says Pakistan and Egypt look particularly vulnerable. . “As rates rise, many fundamentally weaker countries with dollar-denominated debt may struggle to service their obligations.”

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