Tried and trusted

Everywhere you turn in Sri Lanka, you see the mind and the money of the People’s Republic of China at work. Both are visible when you stand in Colombo, staring at the vast new offshore financial hub taking shape. Port City, funded by loans from China Development Bank (CDB) and built by another powerhouse state firm, China Communications Construction Company (CCCC), aims to attract US$13bn in investment over the next 20 years.

Venture south to the flattened base of this teardrop-shaped island, and you find Hambantota Port, once dilapidated but now revived thanks to billions of dollars of soft loans, courtesy of Export-Import Bank of China (Chexim). In 2017, Colombo sold an 80% stake in the port to Hong Kong-listed China Merchants Ports Holdings, a unit of Beijing-controlled China Merchants Group.

And that’s just the start. Under former president Mahinda Rajapksa, who ruled the country until 2015, Sri Lanka seriously cozied up to China. CDB and Chexim, Beijing’s twin development banks, poured nearly US$5bn into projects over a five-year period, building airports, highways, power plants and sports facilities.

When Rajapaksa was voted out of office, a new government pledged to get a grip on its finances. But it couldn’t quite shake its addiction to easy Chinese money. In May 2018, Chexim lent Sri Lanka US$1bn to fund a highway linking Colombo with Kandy, a city in the island’s temperate heart. And in March 2019, it signed a US$989m loan with the same development bank to extend the road south, to Hambantota.

In between, the sovereign accepted a US$1bn eight-year syndicated loan from CDB, which beat competition from four other bidders, including a consortium of 10 global lenders. Sri Lanka’s logic is simple but circular. It needs money, and China’s liquid lenders are only too happy to oblige. Yet much of that fresh funding was set aside to repay CDB and Chexim. At the end of 2018, according to data from the Central Bank of Sri Lanka (CBSL), the government owed US$12.7bn to foreign creditors, a quarter of which was payable to the People’s Republic. Nishan de Mel, head of research at Colombo-based Verite Research, puts the amount owed to China at US$5bn.

As the central bank’s governor Indrajit Coomaraswamy knows, the hard work starts now. His team has tied itself in knots in efforts to restructure or roll over debts, with some success. It now faces a punishing bunching of debt repayments, with US$5.9bn owed in 2019, and another US$11bn due over the next three years, US$3.36bn of which is in the form of interest payments. On January 14, the central bank repaid US$1bn by dipping into its foreign exchange reserves, which fell to US$6bn at the end of February 2019, scarcely enough to cover three months of imports.

The sovereign’s reputation suffered another bruising hit in December, when Fitch and S&P downgraded its credit rating by a notch. Both agencies pointed to trio of trials facing the island: large outflows from the bond market, a depreciating exchange rate, and political crisis stemming from a ham-fisted attempt to sack prime minister Ranil Wickremesinghe and replace him with Rajapaksa, the controversial former president. Moody’s downgraded the sovereign, also by a single notch, the previous month.

To the untrained eye, Sri Lanka might seem to be a de facto subsidiary of China Inc., floating in the Indian Ocean. Yet there is more to the story than meets the eye. Yes, Colombo is deeply indebted to China. But as Daniel Alphonsus, a financial analyst and one-time press secretary to former foreign minister Ravi Karunanayake, notes, 39% of Sri Lanka’s overseas debt is borrowed from international markets, largely US-based institutional investors, with significant amounts also owed to development banks located in Europe, New Delhi and Tokyo.

And Colombo, an expert in what Coomaraswamy describes as ‘asymmetric diplomacy’, has been careful to retain close relations with a host of international allies, including Japan, the US, Europe, and its giant neighbour India. Japan and India are widely tipped to get the nod to develop the Trincomalee Port, one of the world’s great natural deep-water harbours, located in the east of the island.

Sri Lanka is also keenly aware of its strategic value of its location at the heart of the Indian Ocean, equidistant between the Middle East and Asia. Most of the maritime trade flowing between Asia and Europe passes within a few miles of the island’s southern coast. Coomaraswamy & Co have also managed, so far at least, to resist heavy and persistent mainland pressure to print sovereign debt denominated in renminbi. ‘Beijing has been on the central bank’s back to do this since at least the start [of 2018],’ said one Colombo-based investment banker.

The widespread view here is that China sees the island as a key market in its attempt to transform the renminbi into a liquid and globally relevant reserve currency. Sri Lanka may be small in size and population, but its economy is increasingly hard-wired into China’s, the source of most of its foreign direct investment.

In the long term, mainland officials want Chinese firms operating onshore to conduct their business in renminbi rather than US dollars. That massively important switch has to happen somewhere, and Beijing sees a key first step being an inaugural yuan-denominated Panda bond: printed, bound and sold by the Sri Lankan central bank.

After that, local bankers expect Panda bonds to become a regular occurrence, and for the renminbi to develop into an integral part of local funding and financing, serving the needs of big mainland firms such as CCCC and China Harbour Engineering. Bank of China, the mainland’s most international commercial lender, opened its first full-service branch in Colombo in September 2018, with the aim of becoming the largest onshore foreign bank by 2025. To meet its objectives, it needs to start processing a significant amount of Sino-Sri Lankan trade in the Chinese currency.

Dollar surprise

So the decision by the Democratic Socialist Republic of Sri Lanka to tap the overseas bond market for US$2.4bn in March 2019 came as something of a surprise.

The deal did not come out of the blue. It was flagged well in advance by the central bank, and carried out with the professionalism investors expect from the country’s most respected institution. Colombo rationalised the print, pointing to the need to cover its debt obligations for the year, and to lift its level of foreign reserves.

The sovereign priced US$1bn in five-year bonds and another US$1.4bn of 10-year 144A/Reg S bonds at par, to yield 6.85% and 7.85%, respectively. Total orders exceeded US$7.5bn, with a bias toward the 10-year notes, benefiting from the return of positive sentiment since the start of the year toward emerging market fixed income securities.

That strong support underscored a widespread belief among investors that despite struggling with debt and being low on growth, Sri Lanka has a bright future. It is an open, safe, friendly and naturally mercantile sovereign state that has signed new or augmented free-trade deals with the likes of China, Singapore, India and the EU since emerging from a long and painful civil war in 2009.

Moreover, its debt burden, while painfully real, is also only part of the picture. The country’s finances are steadily improving, its fiscal deficit on track to narrow to 4.4% this year, from 5.3% in 2018. The sovereign promised, when securing a US$1.5bn IMF bailout in 2016, to broaden and deepen its tax base, and has remained true to its word. Tax revenues hit US$10.96bn in 2017, up 11% year-on-year.

Rather, what surprised many about the central bank’s latest sovereign bond sale was its relative lack of adventure. The print was well timed and well received, but it was also, local bankers said, an ideal time to test the waters with a more complex, multi-currency print. When cabinet approved the sale of US$2bn of sovereign bonds in January, Coomaraswamy was asked about the central bank’s plans. His response was typical of the man: direct and detail-packed, but stopping short of any cast-iron commitment. He noted that Sri Lanka was in good shape as it prepared for years of painful repayments, which spike in 2019-2022 and again in 2025-2027.

A US$300m loan from Bank of China, tipped for completion in January, remained pending, sources said, delayed in part by the Lunar New Year, but also by the challenge of getting both sides to agree over terms. Another US$700m loan from the same creditor, contingent on the first, has also been delayed. But ready sources of liquidity exist elsewhere. In January, the CBSL signed a US$400m currency swap with the Reserve Bank of India, and is in talks with India, Qatar and China to ink another three currency swaps, potentially for a combined US$2bn.

What remains unanswered is why Coomaraswamy opted to issue a straight-and-simple US dollar bond in March. He has equivocated over the past year about the prospect of issuing a US$500m sovereign bond, split evenly between Japanese yen and Chinese renminbi, in an attempt to tap into Asia’s vast investor base.

At various points, the governor has mooted selling so-called Samurai and Panda bonds together, in a standalone bond either preceding or following the sale of US dollar notes – or in combination with an enlarged dollar print. In the end, it opted for the safer second of those three options. Deshan Pushparajah, head of global markets and investment banking at local investment bank, Capital Alliance, now tips a dual-currency sale of yen- and yuan-denominated debt to take place ‘in the second half’ of 2019, adding that the central bank was still ‘actively exploring [a sale] this year’.

To some, the central bank’s moment of caution makes sense. This is after all a country deep in debt, struggling for growth, and keen to temper and unwind at least some of its Chinese obligations. It also faces, over the next two years, parliamentary and presidential elections that will test its political stability.

Yet to others, the decision to disburse a chunky parcel of fixed income securities priced exclusively in US dollars, eschewing the opportunity to test the waters with debt printed in renminbi, a currency that is set to dominate Sri Lanka, as well as other South Asian nation states, for decades to come, seems like an opportunity missed.