Sri Lanka Default Hints at Trouble for Developing Nations

Sri Lanka’s impending default on $12.6 billion of overseas bonds is flashing a warning sign to investors in other developing nations that surging inflation is set to take a painful toll.

This South Asian country will end Wednesday’s grace period for $78 million in payments. It is the first default on its sovereign debt since 1948 when it was granted independence from Britain. Holders of its bonds are already in troubled territory and they could suffer losses as high as 60 cents per dollar. Last month, the government declared that payments for foreign debt would be stopped.

Sri Lanka’s situation is unique in the way all debt crises are—the particulars here involve an unpopular government run by an all-powerful family, the unresolved aftermath of a 30-year civil war and violent street protests. But the island’s saga is starting to be seen as a bellwether for emerging markets where shortages exacerbated by inflation, including record-high food costs globally, have the potential to roil national economies.

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

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

Widespread arson, clashes, and homes and property of many government legislators were all reported in various parts of the country. Nine people were among the dead, one of them a member of Parliament.

Sri Lanka currently does not have a Finance Minister. This could make it more difficult for the government to resolve the crisis. The government must also negotiate with its creditors, including BlackRock Inc. or Ashmore Group, a restructuring.

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

Negotiations with creditors will begin after Wednesday’s end of the grace period for those payments. This is a crucial step in obtaining IMF aid. According to previous statements, the country needs $3 billion to $4Billion this year in order for it not be in crisis again.

The nation’s $1 billion dollar debt due this July was indicated 0.24 cents higher at 42.73 cents on Wednesday, near the record low of 42.5 cents reached last week, according to data compiled by Bloomberg.

But getting such a deal done quickly won’t be easy. Although President Gotabaya Rajapaksa already asked one of his political rivals to become the prime minister following Mahinda Rajapaksa’s resignation, there is still instability. Divides remain deep after a 30-year civil war that ended in 2009, and the central bank governor has threatened to quit if political stability doesn’t return soon.

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

Risque of replication

Sri Lanka is in turmoil and its troubles are a warning to other emerging markets with high levels of debt that is converging together with social problems. This is because the Federal Reserve and major central banks have raised interest rates to combat inflation. Higher borrowing costs are a result.

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

Bloomberg has identified at least 14 countries with debt yields that exceed 1000 basis points of US Treasuries. That is the threshold required for bonds to be considered distressing.

Already, other countries such as Peru, Tunisia, Egypt and Tunisia are experiencing the added pressure of high food and energy prices. It risks turning into a broader debt debacle and yet another threat to the world economy’s fragile recovery from the pandemic. Bloomberg Economics last month stated that Ghana, Ethiopia, and Pakistan are all at risk of doing the same.

“Sri Lanka could be the start of a trend across the frontier and emerging markets where governments experience debt crises — and possibly default on their obligations,” said Brendan McKenna, a strategist at Wells Fargo in New York who says Pakistan and Egypt look particularly vulnerable. “As rates move higher, a lot of the fundamentally weaker countries with dollar-denominated debt may struggle to repay bonds.”

— With assistance from Ronojoy Mazumdar, Lilian Karunungan and Liau Y-Sing.

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