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

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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