Pakistan and Sri Lanka: The Debt Outlook

It has been an eventful year for both Pakistan and Sri Lanka. Both emerged from years of political and economic crisis but in different ways. One defaulted on its external debts; the other didn’t. One elected a new leader peacefully; one did so contentiously. Traveling to both countries, as I did recently, gave me the opportunity to gain new insights about their outlooks from very smart people in both the private and public sectors.

Pakistan: Now or Never

Investment sentiment in Pakistan turned upbeat on decisive steps taken by Prime Minister Shehbaz Sharif’s administration to push through a revenue-generating reform agenda and the International Monetary Fund (IMF) approving Pakistan a 37-month, $7 billion extended fund facility (EFF) loan in September.

The EFF is designed to help countries facing serious financial problems by providing financial support over an extended period, allowing the country to stabilize its economy and implement necessary economic reforms to address the root causes of its financial difficulties. Many believe that this might be the last time Pakistan needs such support.

The IMF set several tough conditions for Pakistan’s EFF, but despite these challenges, the new coalition government between the Pakistan Muslim League-Nawaz (PML-N) and Pakistan People’s Party (PPP) coalition government accepted these terms to secure the program’s approval.

However, some targets may be missed at the start of the program. For instance, the revenue target for the first quarter of 2024-2025 might not be met initially but could be achieved later.

Pakistan’s growth target of 3% is modest for an emerging market, and its fiscal deficit, currently around 7%, will need to be reduced further.

Maintaining a low current account deficit and hitting the primary surplus target appear within Pakistan’s reach.

On the positive side, maintaining a low current account deficit and hitting the primary surplus target appear within Pakistan’s reach. Pakistan’s gross foreign-exchange reserves stand at $9.5 billion, enough to cover four months of imports. Although reserves rely heavily on cash deposits from China, Saudi Arabia, and the United Arab Emirates, these countries have assured the Pakistani government that their deposits will remain in place throughout the tenor of the IMF program.

But perhaps the most positive takeaway from my trip is the widespread support for Pakistan’s 25th IMF reform program. Everyone we spoke with, including government officials, members of ruling and opposition parties, local political advisors, investors, and banks, agreed that this is the last chance for the country to turn its economy around.

On the political front, many believe that former Prime Minister Imran Khan, who is currently in jail for corruption, political misconduct, and defiance of state authority, will not stay there for long, provided he agrees to make a deal with the military.

Although he currently refuses to do so, and his being in jail may benefit the country’s stability, keeping him locked up is not ideal, given his public support (stemming in part from the widespread belief that the February election was stolen from him), his open challenge to the military, and his foreign policy stance diverging from alignment with the United States.

There are also concerns about the stability of the coalition government and the independence of the Supreme Court. While these are important issues, they are considered secondary risks for now.

The market has already priced in expectations that the State Bank of Pakistan will close the significant policy rate and inflation gap sooner rather than later.

Meanwhile, Pakistan’s dollar credit curve is currently flat, which we believe makes the bonds maturing in 2026 and 2027 an attractive option. The risk of default has now been reduced, in our opinion, which may add to their value.

Pakistan Water and Power Development Authority (WAPDA) bonds appear undervalued in our view. While their underlying financial metrics might be weak, these bonds are backed by the WAPDA Act of 1958, giving them some level of implicit government support. We believe this makes them look similar to sovereign bonds in terms of risk.

For Pakistan Treasury bills and government bonds, the market has already priced in expectations that the State Bank of Pakistan will close the significant policy rate and inflation gap (currently 600 to 700 basis points) sooner rather than later. We believe this limits the upside potential for government bonds, Treasury bills are still a decent option, in our opinion.

Regarding the Pakistani rupee, a gradual depreciation is expected during the IMF program period, based on experiences from previous programs. However, local sentiment is that the currency will be well supported in the medium term due to strong remittances and increased portfolio inflows into domestic bonds and equity markets.

Sri Lanka: New President Brings Uncertainty

Sri Lanka’s reform process is more complicated, as the new president of the National People’s Power (NPP) and Janatha Vimukthi Peramuna (JVP) coalition, Anura Kumara Dissanayake (AKD), lacks governing experience. Additionally, there are uncertainties about the timeline for debt restructuring, and the next disbursement of IMF funding could be delayed by the November 14 parliamentary election.

We visited Sri Lanka just four days after AKD took office, so it’s too early to determine if the NPP-JVP party is ready to govern effectively. However, one positive sign is that AKD quickly confirmed that Central Bank of Sri Lanka (CBSL) Governor Nandalal Weerasinghe would remain in his post; AKB also reappointed Treasury Secretary Mahinda Siriwardana. This move indicates that AKD understands the importance of maintaining economic stability.

The situation also highlights a potential “key-man risk” for Sri Lanka’s economic future. Both Weerasinghe and Siriwardana, along with their teams, are crucial players in managing the country’s external debt restructuring and ensuring the successful completion of the IMF program. Any changes in their roles could significantly affect the process.

Despite these political uncertainties, the economic situation is positive in Sri Lanka.

Despite these political uncertainties, the economic situation is positive. Growth momentum is strong, with expectations of a 4% to 5% gross domestic product (GDP) increase in 2024-2025. Headline inflation has fallen below 1%, with technical deflation expected in the next month or two. Additionally, the country’s primary surplus has already exceeded the IMF’s requirements for this fiscal year, and there is good progress in rebuilding foreign-exchange reserves, targeting $7 billion next year.

The new budget for 2025 is expected in the first quarter of next year and will be crucial, as it will indicate the new government’s commitment to the agreements made under the previous EFF program with the IMF.

Views on the timeline for external debt restructuring are mixed. AKD’s three-man cabinet has signaled its intention to continue with the IMF agreements, potentially including a last-minute agreement in principle (AIP) restructuring deal with external debt holders made just before the election. However, there are concerns about whether the new government fully understands what this entails.

Technically, the Ministry of Finance can launch the bond exchange program as soon as the Office of the Comptroller of Currency (OCC) approves the AIP, which the IMF has "unofficially" acknowledged as compliant with debt comparability standards.

That said, pushing forward with the deal before the new parliament is formed could cause political backlash for AKD. This means debt restructuring might not be concluded until April or May, which could potentially delay the next IMF disbursement and slow down progress on securing new bilateral support.

Despite these uncertainties, there is still hope. Some elected party members have expressed that AKD is eager to complete the country’s debt restructuring as soon as possible. If this is true, there’s a chance the debt exchange program could be announced before the November election.

Meanwhile, we believe prices for Sri Lanka’s external debts collapsed in the weeks before the presidential election. The unexpected win by leftist candidate AKD further shocked the markets, but a strong relief rally occurred when AKD confirmed Weerasinghe and reappointed Siriwardana.

We believe any upside movement may depend on whether the OCC approves the September restructuring proposal. If approved, the Ministry of Finance could quickly announce a bond exchange program, even before the new parliament is formed. However, a further rally could trigger profit-taking flows.

The yield curve for Sri Lankan Treasury bills and government bonds has flattened significantly since the election. I believe the governor of the Central Bank of Sri Lanka and his team showed foresight and caution by holding interest rates steady during their September policy meeting, when they forecast that headline inflation could revert to around 5% from its current level of under 1% by the middle of next year. I believe there is still room for local bills to perform well.

As for the Sri Lankan rupee, there don’t appear to be major market forces that would significantly move the currency from its current level in either direction. The CBSL will likely continue accumulating U.S. dollars to build foreign-exchange reserves beyond $7 billion next year. Additionally, we expect that strong tourism, remittances, and a resumption of foreign direct investment and portfolio flows should help keep the currency stable.

Clifford Lau, CFA, is a portfolio manager on William Blair’s emerging markets debt team.