WHAT NEXT? The Path Forward with an IMF Program Presented on 8 th April 2022 WHERE DO WE STAND? Meeting our financing needs is not just a problem that is resolved in 2022. We are required to finance between US$4 - 5bn annually in debt service payments for at least the next 4 years Source: CBSL, Ministry of Finance (Data as at end - 2020) 79% 80% 84% 87% 101% 107% 86% 85% 92% 94% 110% 119% 2016 2017 2018 2019 2020 2021 Central Government Debt to GDP Public Guaranteed Debt 6,904 4,248 4,414 5,075 3,734 2022E 2023E 2024E 2025E 2026E Total net drains on foreign currency assets (Foreign debt service payments + Project loan + SOE settlements) The budget deficit has ballooned in recent years, with a majority of it needing to be financed through domestic sources. As a result, CBSL asset purchases have increased to record highs (429) (382) (465) (543) (83) 48 (211) (352) (296) - 896 - 1,751 - 1874 - 5.3% - 5.5% - 5.3% - 9.6% - 11.1% - 11.1% 2016 2017 2018 2019 2020 2021E Domestic Financing of Budget Deficit (Rs. Bn) Foreign Financing of Budget Deficit (Rs. Bn) Budget Deficit as a % of GDP 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000 Jan-21 Mar-21 May-21 Jul-21 Sep-21 Nov-21 Jan-22 Mar-22 CBSL Holdings of G-Secs The growing budget deficit has been increasingly financed through domestic sources ... ... resulting in excessive money printing since the mid - 2020 s In 2021 , CBSL holdings increased by Rs 678 bn (c 1 / 3 rd of the domestic financing of the budget can be assumed to be through money printing) LKR bn We estimate a shortfall of US$600mn in dollar funding in the next 2 months (April & May), factoring in only the essential imports. Suspension of debt service payments (USD 1.9bn) would significantly ease this pressure. Source: CBSL, CAL Estimates 900 96 277.7 1,530 1,898 Outflows Fuel Pharma F&B Intermediate Goods (exc. Fuel) Principal & Interest Payments 1000 2200 500 400 Inflows Indian Credit Line Exports of Goods Remittances Net Services Exports USD 4.7bn USD 4.1bn USD 600mn gap Foreign inflows and outflows until May 2022 ( USDmn ) 0 2 4 6 8 10 12 14 16 18 Oct-21 Nov-21 Dec-21 Jan-22 Feb-22 Mar-22 Apr-22 12 month T Bill Auction Rate SDF SLF Controlling excess depreciation in the currency post the float will require sharp adjustments on monetary policy +730bps YTD 100 150 200 250 300 350 1/3/2022 2/3/2022 3/3/2022 4/3/2022 USD/LKR 35% depreciation YTD Source: CBSL, 0 2 4 6 8 10 12 14 16 18 0 5 10 15 20 25 30 1-Jan-18 1-Jun-18 1-Nov-18 1-Apr-19 1-Sep-19 1-Feb-20 1-Jul-20 1-Dec-20 1-May-21 1-Oct-21 1-Mar-22 Lending Rate USD/TRY TRY depreciates Rates increased by 1600bps in 3 months (8% to 24%) TRY appreciates 24% Rates increased by 1075ps in 8 months TRY depreciates 98% Rates cut by 1575bps within 14 months TRY depreciates 29% TRY appreciates 18% Rates cut by 500bps in 6 months Turkey is a prime example of using interest rates to defend currency movements Lending Rate USD/TRY Source: Investing.com, Central Bank of the republic of Turkey During the Asian Financial Crisis, S. Korea and Thailand also resorted to hike rates to stabilize the currency 0 500 1,000 1,500 2,000 2,500 0 5 10 15 20 25 30 1996/01/03 1997/01/07 1998/01/14 1999/04/01 Call Rate (Overnight-All Trades) Won per United States Dollar (Close) 0 10 20 30 40 50 60 0 5 10 15 20 25 30 Jan-96 Aug-96 Mar-97 Oct-97 May-98 Dec-98 Jul-99 Interbank overnight lending rates : Average USD/THB USD/THB USD/WON Source: Investing.com, Bank of Korea, Bank of Thailand WHAT DOES AN IMF PROGRAM MEAN RIGHT NOW? Source: CAL findings and IMF 10 Time taken to complete debt restructure mainly depends on how long it takes to negotiate – On average completion takes 9 - 13 months Sovereign Debt Restructuring process 1. The Players: (i) Sovereign Debtor (ii) State owed Entities (iii) The Creditors Multilateral official creditors Bilateral official Commercial private 2. The restructuring Envelope: ( i ) Hire financial and legal advisors to guide through the process (ii) Determine overall quantum debt relief • Trade creditors are excluded • Any senior or collateralized debt excluded • Excluded Claims of International financing institutions (IFI’s – IMF, World bank etc.) 3. Preparing restructuring proposals (Indicative Restructuring Scenarios): Laying out both overall quantum of debt and relief methods of each creditors. The release of IRS would help to reduce sticker shock. 4. Negotiation Process: The complexity of the debt profile and widely diverse creditors will Engagement with creditors: Creditor Restructuring vehicle Commercial banks London Club Bond holders Exchange offers Bilateral (governments) Paris Club Multilateral (World bank, IMF) Preferential treatment; Debt relief only for poorest countries Suppliers, Trade creditors Ad hoc 5. Creditor objectives: (i) Accept some degree of debt relief in order to enhance the collectability of the balance of exposure. (ii) Creditors watch each other warily, No creditors wants to give more debt relief than the other. (iii) Ensuring no backsliding by the sovereign debtor. 6. Methods and Techniques: (i) Change maturity dates for amounts of principal or interest due and introduce grace periods.. (ii) Hair cut: Reduce the principal amount of debt (iii) Coupon adjustments: Reduce the interest rate on debt (iv) Mix and match these techniques Default or announcement T+1 T+2 T+n+1 Negotiations (and preparations) Exchange offer (or principal agreement ) Debt Exchange Result: Participation in % Haircut in % .... .... Stylized Timeline of a Sovereign Debt Restructuring The process is triggered by either • a default (missed payments), or • the announcement of restructuring • Negotiations on restructuring terms (formal or informal) • Exchange offer prepared by government and its legal and financial advisors. • Creditors accept or reject debt exchange offer The standard IMF prescriptions will apply... • Exchange rate – “Recommend a gradual return to a market - determined and flexible exchange rate to facilitate external adjustment and rebuild international reserves” • Import and Capital controls – o Import restrictions and capital flow management measures (CFMs) introduced during the pandemic should be temporary. o The authorities should develop a schedule for the import restrictions to be phased out. o Directors called on the authorities to gradually unwind capital flow management measures as conditions permit Source: IMF 0 2 4 6 8 10 12 14 16 18 20 Jan-20 Mar-20 May-20 Jul-20 Sep-20 Nov-20 Jan-21 Mar-21 May-21 Jul-21 Sep-21 Nov-21 Jan-22 Mar-22 Headline Inflation (YoY) 12 Month T Bill Auction rate In most cases, interest rates are required to match inflation in order to attain positive real interest rates Source: CBSL With inflation expected to rise further due to pass - through impacts of depreciation and impacts of future tax changes on prices of goods & services, interest rates are expected to continue its upward trend % A gradual l reduction in debt is expected within 5 years • A positive primary balance within a 2 year period has been previously outlined as a debt relief target by the IMF We expect Sri Lanka to have similar guidelines on the primary balance following an IMF program External debt is a key driver to the gradual reduction Source: IMF and CAL Research Estimates 13 The IMF has outlined a positive primary balance within a 2 year period following the commencement of the program while debt is expected to gradually reduce -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Primary Balance (as a % of GDP) Ecuador Barbados Greece Ukraine 0% 20% 40% 60% 80% 100% 120% 140% 160% 180% Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Debt to GDP (%) Ecuador Barbados Greece Ukraine 0% 50% 100% 150% 200% 250% Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 External debt to GDP (%) Ecuador Barbados Greece Ukraine Positive primary balance expected within 2 years • A gradual reduction in debt to GDP is to be expected over the next 5 years Historically, a 20 % reduction is outlined by the IMF with extreme cases ( eg : Greece) being an exception • The reduction in external debt has been the key driver towards supporting the reduction in total debt 14 Source: Ministry of Finance, CAL Estimates With the right fiscal measures, the Budget deficit can be reduced to c 4 1 % by 2028 E (538) (771) (533) 94 503 (1,439) (1,826) (1,648) (1,364) (1,534) -8,000 -6,000 -4,000 -2,000 0 2,000 4,000 6,000 2019 2021 (Budget Estimate) 2022E 2024E 2028E Revenue Expenditure Primary Deficit Budget Deficit Possible tax Increases: Rs. Bn Income Taxes (PIT + CIT + PAYE) 100 WHT (10% on Interest Income) 80 VAT reversal 200 NBT + SCT+ESC 150 A minimum of a reversal of tax measures taken in end - 2019 could raise c Rs 700 bn+ between 2022 - 24 E In addition, reducing Public investment for the next few years and minimal changes in public sector wages could raise the remaining balances to bring the primary balance to 0 4 % by 2024 E We have factored in a 20 % haircut on debt restructuring This means the budget deficit would reduce by Rs 291 bn between 2021 to 2028 E How much can we raise between 2022 - 2024 E? 65% 60% 62% 60% 59% 58% 56% 55% 39% 44% 33% 25% 23% 22% 21% 20% 12% 9% 8% 8% 7% 6% 6% 5% 0% 20% 40% 60% 80% 100% 120% 140% 2021 2022E 2023E 2024E 2025E 2026E 2027E 2028E Domestic Debt to GDP Foreign Debt to GDP Other debt commitments Source: CBSL, Company Data and CAL Research Estimates 15 We believe a max 20 % haircut on foreign denominated securities (principal and coupon payments) with a postponement of payments for 4 - 5 years is sufficient if the restructuring is combined with a fiscal consolidation plan (LKR 291 bn reduction in deficit by 2028 E) and monetization of non - strategic SOE (USD 2 5 bn) by 2028 E to bring down the Public Debt/ GDP to 80 3 % by 2028 E (vs 119 % at present) If the fiscal consolidation path is put in place, FX debt repayments can be managed via regaining access to bilateral and international funding whilst the current account deficit could be bridged by higher tourism receipts, resumption of worker remittance flows and reduction in imports owing to the LKR depreciation LKR Bn Public debt as at 2022E 24.3 Increase in Domestic Debt 7.3 Reduction in Foreign Debt (1.2) Monetization of non - strategic SOEs (0.8) Public debt as at 2028E 29.7 Public debt to GDP (2028E) 80.3% Fiscal deficit to GDP 2028E 4.1% 119% 80% 20% haircut on foreign debt USD 2.5bn SOE monetization We can get our debt/GDP to c.80% by 2028 with fiscal deficit of 4 - 4.5% which is acceptable without a domestic debt restructure 7.41% 5.33% 3.82% 2.57% 2.43% 1.62% 1.35% 1.24% - 0.23% - 1.03% - 1.10% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% UBC NTB PB HNB SAMP PABC SEYB DFCC NDB BOC COMB Adjusted 4Q2021 tier - 1 capital buffer following haircut on ISBs and SLDBs, surcharge tax expense and cash dividend payout 16 We believe an external haircut on external debt (ISBs and SLDBs) will be the most likely scenario... A 20 % haircut on external debt (ISBs and SLDBs) will likely erode tier - 1 capital for commercial banks In our analysis, we have taken into account a 20 % haircut on foreign denominated securities taking into consideration the impairment provisioning undertaken in 2021 following the reversion to a 30 % probability of default and a 20 % loss given default under a 12 month ECL model The reduction in the haircut on foreign denominated securities is then applied on the current tier - 1 capital and RWA after factoring in the one - off surcharge tax burden coupled with the cash dividend payout announced in 1 Q 2022 Our analysis indicates that NDB, BOC and COMB will face immediate capital constraints following the haircut on foreign denominated securities An external debt restructuring, according to our estimates NDB, BOC and COMB will collectively require LKR 27 5 bn to revert to the minimum threshold in capital adequacy COMB will be able to obtain the required infusion in capital via a rights issue or private placement The extended infusion in capital required by PB and BOC will likely be sourced through printing NDB, BOC & COMB will require a infusion of capital following an external debt restructure Source: Company Data and CAL Research Estimates Source: IMF and CAL Research Estimates 17 “Domestic debt is like surgery: You only do it if you must, and you avoid it if you might do more harm than good” : IMF As at 30 th June 2021 , the banking sector held 30 % of total G - Sec 58% 30% 12% Composition of T - Bills and Bonds Held (%) June 2021 Non-Bank sector Commercial Banks CB A domestic restructure can be considered if the following measures have been undertaken The key is to consider the net benefit of a domestic debt restructuring : To avoid compromising the viability of the domestic financial system, the government may be required to recapitalize some banks or replenish pension savings The net benefit calculation will determine whether or not the domestic debt should be part of a restructuring, together with external debt, or on a standalone basis The domestic debt restructuring should be designed to anticipate, minimize and manage its impact on the domestic financial system : The authorities need to put in place measures that mitigate losses for banks, non - bank institutional investors, and households and that minimize spillovers The impact on banks can be limited by extending the maturities and/or lowering the interest rate rather than reducing the nominal amount of the outstanding claims Losses should be recognized early and may need to be paired with a strategy to restore banks’ capital buffers System - wide emergency support that allows institutions to convert illiquid assets into cash may be needed to ensure the functioning of the banking system and shore up confidence In some cases, temporary measures to slow panic - driven deposit withdrawals and capital outflows might have to be considered The authorities should carefully evaluate the potentially adverse consequences of unilaterally amending domestic law 4.34% 1.96% 0.29% - 0.14% - 0.33% - 0.37% - 0.72% - 2.07% - 5.82% - 6.59% - 13.16% -16.0% -14.0% -12.0% -10.0% -8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% UBC NTB HNB PABC DFCC SEYB SAMP NDB COMB BOC PB Adjusted 4Q2021 tier - 1 capital buffer following haircut on ISBs and SLDBs, G - sec, surcharge tax expense and cash dividend payout A 10 % haircut on government securities (T - Bill and T - Bonds) and a 20 % haircut on foreign denominated securities will significantly erode tier - 1 capital for commercial banks In our analysis, we have taken into account a 10 % haircut on government securities and due to no impairments being undertaken due to the asset being categorized as 0 risk The reduction in the haircut on government securities is then applied on the current tier - 1 capital and RWA after factoring in the one - off surcharge tax burden coupled with the cash dividend payout announced in 1 Q 2022 The subsequent erosion in capital will cause significant pressure on the banking sector Source: Company Data and CAL Research Estimates 18 The banking sector will come under severe pressure if there is an imposition of an external and domestic restructure An external and domestic debt restructuring , according to our estimates will collectively require an LKR 313 bn to revert to the minimum threshold in capital adequacy Source: IMF and CAL Research Estimates 19 ...However, there have been exclusions on sector exposure even in countries that have undergone a domestic debt restructure Financial institutions hold a significant component of T - bills and T - bonds and a domestic restructure will likely cause undue stress on the financial sector Barbados (2018) The Financial services Commission (FSC) conducted extensive stress tests over a 3 month period to ensure the proposed debt restructure would not jeopardize financial stability On the eve of the debt restructure (in December 2017 ), banks held 53 % of total financial sector was highly solvent with capital buffers well over the minimum threshold However, Commercial banks and insurers were not subject to face - value haircuts, the NPV losses incurred by maturity extensions and interest rate reductions resulted in capital losses, under IFRS - 9 applied on financial institutions However, stress tests ensured that the proposed terms would not result in financial entities did not fall below the minimum capital threshold Adjustments in energy prices and pricing mechanisms are expected 0 100 200 300 400 500 600 2020 2022 CEB costs and revenue ( LKRbn ) IPP cost CEB fuel cost CEB coal cost Other expenditure LKR 240bn Revenue at an average tariff rate of LKR 16.81/kWh, with total cost per kWh at LKR 21.2 LKR 36/kWh Recommended tariff rate for CEB to break even In order for CEB to breakeven, the tariff rate needs to be c.LKR36/kWh as per our estimates. Prior to depreciation, the CEB generated electricity sales at an average tariff rate of c LKR 18 57 while incurring a cost of c LKR 28 91 per unit As per CEBs initial estimates they may make a loss of c LKR 145 bn due to the higher cost of importing fuel and oil for the year 2021 176 254 270 322 Lanka auto diesel Lanka petrol 92 octane Current Vs recommended fuel prices for CPC to breakeven (LKR/liter) Current price Recommended price to breakeven An upward revision in CPC petrol and diesel prices may be required in order to absorb CPC’s long standing losses Accordingly, the Lanka auto diesel prices may have to be revised upwards to c LKR 270 /liter from the current rate of LKR 214 /liter and Lanka petrol 92 octane to be revised to LKR 322 /liter from the current rate of LKR 303 /liter An upward revision in CPC fuel prices may also take place for the entity to breakeven and match the current LIOC prices. Source: Ministry of Finance, LIOC, CAL estimates