SRI LANKA: GOVERNMENT SEEKS LOWER BORROWING COSTS BY

UNCLAS SECTION 01 OF 02 COLOMBO 000450 SENSITIVE SIPDIS STATE FOR SCA/INS AND EEB/IFD/ODF E.O 12958: N/A TAGS: EFIN ECON EINV KMCA CE SUBJECT: SRI LANKA: GOVERNMENT SEEKS LOWER BORROWING COSTS BY ALLOWING FOREIGN INVESTORS TO BUY TREASURY BILLS REF: COLOMBO 366 ¶1. (SBU) Summary and comment: Seeking to reduce government borrowing costs, Sri Lanka opened ten percent of its short-term local currency Treasury bill market to foreign investors. The Central Bank calculates, accurately it appears after the first day of trading, that offering the 3-12 month debt instruments to foreign buyers will bring down the interest rates it pays -- currently around 19% -- by increasing the number of potential buyers of the debt. The move comes a year and a half after Sri Lanka first allowed foreign buyers to buy Rupee-denominated Treasury bonds, which have maturities of over a year. The Treasury bills may prove easier to sell than the longer term bonds, as foreign buyers will be more comfortable with the shorter-term exposure. By limiting foreign purchases to ten percent of both the overall bill and the bond stock, Sri Lanka is protecting itself against sudden large cash outflows -- the hot money problem that drove the 1997 Asian financial crisis. Nevertheless, with the government unable to rein in its persistent budget deficits, the move also reflects a continuing effort to find new buyers for government debt. This is exactly why credit rating agencies have recently expressed concerns about Sri Lanka's sovereign creditworthiness. End Summary and comment. ¶2. (U) Sri Lanka on May 6 began allowing foreign investors to buy up to ten percent of the total stock of its Rupee-denominated Treasury bills. The move paralleled Sri Lanka's opening a year ago of ten percent of its Treasury bond market to foreign buyers. Treasury bills have maturities extending up to one year, while Treasury bonds have maturities of one to five years. The move will allow the Central Bank to sell up to about Rupees 300 billion ($2.8 billion) of Treasury bills to foreign investors; about Rupees 1.1 trillion ($10.5 billion) in bonds are open to foreigners. Yields currently range from 18.5% (3 months) to 19% (1 year) to 15.5% (5 year) -- some of the highest nominal interest rates in the region. The nominal rates are high because inflation in Sri Lanka has been above twenty percent for over a year. ¶3. (SBU) The Central Bank said in a press release that the objective of the current move was to "widen and diversify the government debt market and enhance competition in the Treasury bill market." A Central Bank research department source told EconFSN however that the primary reason for the liberalization was to reduce the government's cost of borrowing. ¶4. (U) Analysts say foreign buyers are increasingly reluctant to invest in longer term instruments due to Sri Lanka's persistent high inflation and fears that the Sri Lankan Rupee could lose value against the dollar over the longer term. They predict Treasury bills will likely be easier to sell than bonds. If the Rupee remains relatively stable, the 18% interest rate will be attractive to hedge funds and other investors with an appetite for emerging market exposure. The Central Bank expects the Rupee to remain stable in 2008 on the strength of Sri Lanka's currently comfortable reserves and positive balance of payments. The Rupee has held steady at around 108 to the US dollar so far this year. ¶5. (U) On May 7, in the first Treasury bill sale since the opening of the market, yields on three-month Treasury bills fell by 42 basis points to 18.09%. Yields on other maturities also declined, with one-year bills falling by 21 basis points to 19%. According to the Central Bank's public debt office, foreign investors subscribed to Rs. 500 million worth of Treasury bills, out of a total of Rs 8.6 billion sold in the day's auction. Central Bank sources expect yields to come down further in the next few weeks. ¶6. (U) The opening of the debt market came not long after warnings by international credit rating agencies regarding Sri Lanka's sovereign creditworthiness. Fitch Ratings cited debt worries as a key reason for its April downgrade of Sri Lanka's rating from BB- to B+, four levels below investment grade (reftel). Standard & Poor's also recently revised its outlook on Sri Lankan debt to negative (indicating a likelihood of a rating downgrade in the future) and this week included Sri Lanka along with Indonesia and Vietnam among Asian emerging market countries to "keep an eye on" because they might be tempted to borrow excessively to cope with worsening economic conditions. S&P said of Sri Lanka: "The rising share of external debt, estimated at about 49 percent of total, and within that, the proportion of more expensive and shorter-maturity COLOMBO 00000450 002 OF 002 commercial funds, is gradually eroding what has so far been a relatively favorable debt profile." ¶7. (U) Locally, primary market dealers expressed mixed sentiments about the Central Bank's allowing foreign investment in Treasury bills. Ajith Fernando, former Chairman of the Primary Dealers Association, told EconFSN that, while the move could be regarded as further liberalization of the capital account, it could lead to a drain on foreign exchange as bills matured and foreign investors converted their proceeds into dollars and withdrew from the market. Other primary dealers speaking to newspapers also cautioned about the need to manage the outflow of funds at maturity. Fernando predicted the market opening would likely stabilize the Treasury bill market in the short term, though he felt it premature to comment on the likely volume of foreign buying of the bills. ¶8. (SBU) Comment: By limiting foreign purchases to ten percent of both the overall bill and the bond stock, Sri Lanka is protecting itself against sudden large cash outflows -- the "hot money" problem that drove the 1997 Asian financial crisis. Nevertheless, with the government unable to rein in its persistent budget deficits, the move also reflects the government's continuing effort to find new buyers for its debt. This is exactly why the credit rating agencies are watching carefully and why investors may be more comfortable with short-term debt. BLAKE