Sri Lanka May Need Bailout as War Debt, Currency Drain Reserves

Feb. 27 (Bloomberg) -- Sri Lanka may need a bailout from international donors to help pay its debts as the island’s 26- year civil war draws to a close.

Since August, the South Asian nation has spent half its foreign reserves, now $1.7 billion, on supporting its currency, paying debt and buying imports. That doesn’t leave much after the government shells out another $900 million due in 2009. The reserves aren’t getting replenished as the ailing world economy pummels exports and overseas investors flee emerging markets.

President Mahinda Rajapaksa’s government is unwilling to turn to the International Monetary Fund, which requires austerity measures in return for loans. Securing financing from other countries may be challenging for a nation whose credit rating from Standard & Poor’s is the lowest apart from those of Bolivia, Pakistan, Grenada, Argentina and Lebanon.

“Sri Lankan authorities have to act fast to beef up the country’s reserves,” said Ashok Parameswaran, senior emerging markets analyst at Invesco Inc. in New York. “Otherwise, they may have to devalue their currency significantly.”

Since December, countries including Russia, Vietnam and Kazakhstan have weakened their currencies rather than use reserves to prop them up. That has made imports costlier, reducing demand for goods from overseas.

Neighboring Currencies

Sri Lanka kept its exchange rate at about 108 rupees per dollar between January and October 2008 to slow inflation, even as the currencies of neighboring India and Pakistan weakened. The Sri Lankan rupee has since dropped to 114.95.

“Sri Lanka has relaxed the rupee in stops and starts, but they need a controlled devaluation,” said Agost Benard, a Singapore-based sovereign analyst at S&P. “The implicit currency peg will have to change and that’s one of the long-term solutions to the nation’s foreign-exchange problems.”

S&P cut Sri Lanka’s rating by one level in December to B, five steps below investment grade. Fitch Ratings has a B+ for the nation, which is four levels below investment grade and unchanged since April 2008.

Sri Lanka is banking on currency swaps with central banks, sales of treasury bills and bonds and offering higher interest rates on deposits to citizens living abroad to boost reserves.

Once the northern region of the country is recovered from the Liberation Tigers of Tamil Eelam, peace will lead to more remittances and aid for construction of houses, schools and hospitals, said P. Nandalal Weerasinghe, chief economist at the Central Bank of Sri Lanka. This will provide “some balance of payments support,” he said.

Tamil Tigers

The Tamil Tigers, who have been fighting for a separate homeland, have retreated from most of the northern part of the island nation. They now control a pocket of only 87 square kilometers (34 square miles) in the Mullaitivu region in the northeast, the Sri Lankan Defense Ministry said Feb. 22.

John Keells Holdings Plc, Sri Lanka’s biggest diversified company, last week doubled its stake in Union Assurance Plc, a local insurer, to 74 percent. The company said it’s anticipating that the liberation of Tamil Tigers-occupied territories will spur demand for finance and insurance.

To be sure, the dispute hasn’t ended yet.

“Although there is the possibility of outright military defeat of the Tamil Tigers, a potentially different style and lower-intensity conflict will continue to pose a risk to growth prospects and public finances,” S&P’s Benard said.

Still Raiding

Tamil Tigers launched an air raid in the Sri Lankan capital, Colombo, on Feb. 20. Their two aircraft were shot down, one crashing into a building housing the Inland Revenue Department and the second north of the city.

At the end of November, Sri Lanka had 1.4 trillion rupees ($12 billion) of foreign debt outstanding. Its total debt is 3.4 trillion rupees, or 75 percent of the nation’s gross domestic product, according to S&P.

Liabilities increased as Sri Lanka, which spends a fifth of its annual budget on defense, borrowed from local and foreign sources to build roads and ports, among other spending. The nation’s budget deficit has averaged 8.7 percent of GDP in the past decade.

Sri Lanka must reduce reliance on dollar-denominated short- term commercial borrowings to ease public debt “distress,” the IMF said in October. It called on the government to weaken the rupee as part of a “comprehensive policy package that would underpin confidence in the currency.”

The central bank said Jan. 19 that it will neither let the currency fall nor approach the IMF for a bailout to pay for imports and repay its debt.

On Feb. 19 Governor Nivard Cabraal said the central bank received $200 million from Malaysia, declining to reveal the terms of the deal or whether it was a swap or any other facility with Bank Negara Malaysia. Bank Negara didn’t respond to an e- mail sent by Bloomberg News for comment.

“It’s unlikely that Sri Lanka will go to the IMF for funds,” said Dushni Weerakoon, deputy director of the Institute of Policy Studies in Colombo. “At whatever cost, they will try to raise small sums from other countries.”