Choosing the right time to visit

One of the many challenges for emerging market (EM) investors is deciding the timing of country research visits, particularly around pivotal events which can significantly influence asset prices. This decision becomes even more complex in countries experiencing severe economic crises, undergoing external debt restructuring, and holding elections following significant unrest, as these factors add layers of uncertainty to the investment landscape. One example of such an event is a close-fought election that features candidates with divergent market views. Visiting before the election offers insight into each candidate’s policy agenda, their feasibility, and potential market reactions to the election outcomes. However, pre-election discussions may lean heavily towards speculative, short-term electoral consequences, which quickly become outdated post-election as markets adjust to the new reality.

On the other hand, scheduling a visit after the election uncertainty dissipates allows for more forward-looking discussions about concrete policies and macroeconomic outcomes, albeit at a time when bond prices might have already adjusted to reflect the perceived market friendliness of the elected candidate. In the end, there is no right or wrong answer, and the decision has to be taken on a case-by-case basis depending on the investment thesis that is being pursued.

The journey from revolution and default to economic rebound

Sri Lanka was slowly emerging from a devastating economic crisis that had led to President Gotabaya Rajapaksa fleeing to the Maldives in 2022 amid nationwide protests and the country defaulting on its debts during a harsh recession, characterised by high inflation and drained foreign exchange (currency) reserves. By early 2023, under the new leadership of President Ranil Wickremesinghe, Sri Lanka embarked on a four-year IMF-supported recovery programme that allowed the economy to stabilise and foster a gradual macroeconomic stabilisation. This included revenue-based fiscal consolidation that, together with envisaged progress on debt restructuring, was meant to bring down Sri Lanka’s eye-watering interest burden from a record level of almost 80% of government revenues in 2022 to more sustainable levels (Figure 1).

Landing in Colombo in early September 2024, we found a nation gearing up for a close election that for the first time in the country’s history was likely to go into a second round of counting where voters’ second and third preferences could play a decisive role¹.  The two frontrunners were Sajith Premadasa, the opposition leader who secured 42% of the vote in 2019, and Anura Kumara Dissanayake, also known as AKD, a lesser-known figure with a Marxist ideology leading a radical left-wing party. Through our conversations, it emerged that AKD’s chances of winning might be higher than the market consensus suggested, but at the same time his policies would likely not be as extreme or investor unfriendly as anticipated. Despite his manifesto calling for a “renegotiation” of the IMF programme and an “alternative debt sustainability analysis”—factors that could disrupt or compromise the IMF programme reviews and Eurobond restructuring—his emphasis on the rule of law² and combatting corruption could, if effectively implemented, foster positive outcomes for the country.

Defying predictions, a final hour agreement emerges…

The streets of Colombo

Source: Janus Henderson Investors.

The events of the following weeks broadly confirmed our findings. Battered by years of austerity measures and soaring poverty levels, Sri Lankan citizens clamoured for change. AKD won a plurality of votes in the first round (over 42%), which was enough to propel him to first place during the second counting round – given the relatively wide gap to Premadasa (who received less than 33% of votes) and the relatively low number of voters who chose to express second preferences³. As expected, the new president immediately dissolved parliament and called for early parliamentary elections to be held on 14 November. The effectiveness of his reform agenda hinges on:

• The ability of the socialist NPP alliance – where AKD is the leader of JVP, a member of this alliance – to garner enough seats in parliament for a majority;
• or alternatively, whether it will have to ally with one of the two established parties – and potentially govern in a fractious coalition – or try to establish a minority government.

However, the biggest surprise for markets came only 48 hours before polls opened, when against all local expectations, the outgoing government announced an Agreement in Principle (AIP) on the restructuring of approximately US$14 billion⁴ of international sovereign bonds. This followed intense negotiations with a representative group of foreign Eurobond investors, as well as domestic financial institutions, and featured a novel state-contingent debt instrument. This macro-linked bond (or MLB) offers various levels of debt relief depending on the future economic performance of the country.

As mentioned earlier, concerns loomed that an AKD presidency might disrupt or delay the IMF programme and the planned bond restructuring. However, the new president swiftly met with an IMF delegation in Colombo, affirming his commitment to the programme’s goals and the necessary actions for completing the third review and securing the next instalment of approximately US$337 million.

Further, on 4 October, Sri Lanka received formal acknowledgment from the Official Creditor Committee (OCC) and the IMF that the terms of the AIP align with the Comparability of Treatment (CoT) principle and the Debt Sustainability Analysis (DSA) parameters. This marks the final step before initiating the bond exchange⁵ and formally exiting default, anticipated to be resolved before the end of 2024.

… but emerging from default is merely the first step of a tortuous journey

What does the future potentially hold for Sri Lanka? The country’s comparative advantages position it as a key player on the global stage, leveraging its strategic location that attracts interest from major powers like China, India, and the US. This interest has enhanced its port transshipment – the transfer of cargo between ships at an intermediary port – activities, particularly amid global geopolitical tensions in the Red Sea. A reminder of the capital’s history as a port is the decommissioned Old Colombo Lighthouse from the 1800s, which today stands right next to the Central Bank building. Sri Lanka’s burgeoning clothing sector stands to benefit from the turmoil in Bangladesh, especially those companies that invested in research and development (R&D) and climbed up the value chain. Additionally, its Business Process Outsourcing (BPO) industry, supported by a robust IT infrastructure and skilled workforce, enhances its competitive edge.

Old Colombo Lighthouse

Source: Janus Henderson Investors.

Finally, tourism continues to be a pivotal sector for the economy, bringing in US$2.17 billion in the first eight months of the year⁶ and playing a significant role in strengthening foreign exchange reserves. Several of our interlocutors have expressed optimism that a government with a renewed mandate could instil the confidence and stability needed to attract foreign investment to a new city development, Port City Colombo (PCC) and its Special Economic Zone⁷. Seen by many critics as a white elephant, PCC is set to transform 269 hectares of reclaimed land (from the sea) in the heart of the capital. Even though the project is not expected to be fully completed until 2041, we could already see from our hotel room its base structures beginning to take shape, emerging from the waters of the Indian Ocean.

Port City Colombo set to be completed by 2041

Going forward, the challenges Sri Lanka faces are not to be underestimated. Although some key reforms have been implemented and economic stability achieved, it remains to be seen whether the new authorities will be able to secure the necessary political and societal consensus for other essential structural reforms. These are critical to enhance the country’s growth trajectory, diversify its export base⁸, promote foreign direct investment, and manage its high debt load and interest obligations, which continue to attract concern even after the conclusion of debt restructuring⁹. Active EM investors, like us, will be closely following the country’s progress on these metrics, which will ultimately shape both the trajectory of its credit rating as well as the risk premium the market will attach to new Sri Lankan sovereign bonds.

Footnotes

¹ In Sri Lanka, the voting system for presidential elections employs a preferential voting method where voters rank their candidates in order of preference. If no candidate secures more than 50% of the first-preference votes, then the candidates ranked third  and lower get eliminated and their votes are redistributed to the first two candidates according to the second-preference votes.
² Rule of law captures perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence (World Bank).
³ According to official results from the 3.2 million votes cast for candidates who did not make it to the second round, only 273,000 of them (around 2% of the over 13 million total votes) were ‘reallocated’ to the first two candidates based on second preference votes: 105,000 to AKD and 168,000 to Premadasa. Even if Premadasa got 63,000 more votes than AKD in the second round, this was not nearly enough for him to recover the 1.27 million vote deficit from the first round.
⁴ As at the end of 2023.
⁵ A bond exchange in the context of sovereign debt restructuring involves the replacement of existing debt securities with new ones, often with different terms such as longer maturities, lower interest rates, or a combination of both. This process aims to alleviate the debt burden on a country by making its debt obligations more manageable and sustainable over time.
⁶ Source: Sri Lanka Central Bank, 30 September 2024.
7 A special economic zone (SEZ) is a region within a country that has different business and trade laws than the rest of the country.
⁸ Export base is used in the context of development economics to describe the kind of activities (goods or services) that a country can export abroad and thus generate foreign currency. Relevant export sectors could be tourism, agriculture, manufacturing etc – wherever a country has an advantage that can be used to boost trade with other nations.
⁹ After completion of the second Extended Fund Facility review in June 2024, the IMF estimates central government debt to remain slightly above 100% of GDP by 2028, even after incorporating the estimated local and foreign currency debt restructuring effects.  However, should the IMF’s growth forecasts prove unduly conservative— a concern that initially prompted bondholders to suggest the issuance of macro-linked bonds with payouts tied to the country’s economic growth—and Sri Lanka remains committed to its primary surplus targets, then debt reduction could occur at a more accelerated pace.

IMPORTANT INFORMATION

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.

There is no guarantee that past trends will continue, or forecasts will be realised.
Past performance does not predict future returns.

The information in this article does not qualify as an investment recommendation.

Marketing Communication.