International investors, 40% of them American, purchased all $500 million of Sri Lanka’s first-ever sovereign bond issue, despite domestic opposition efforts to block the sale

Sri Lanka’s debut sovereign bond issue raises $500 million despite domestic criticism, the US Embassy Colombo informed Washington.

The Colombo Telegraph found the related leaked cable from the WikiLeaks database. The unclassified cable discusesSri Lanka’s debut sovereign bond issue. The cable was written by the Ambassador Robert O. Blake on November 01, 2007.

The ambassador wrote; “International investors, 40% of them American, purchased all $500 million of Sri Lanka’s first-ever sovereign bond issue, despite domestic opposition efforts to block the sale. The government offered 8.25% coupon bonds with a five-year maturity, and received orders from investment bankers in Asia, Europe, and the United States totaling about triple the quantity of bonds for sale. The government cited the strong investor interest as an endorsement of Sri Lanka’s economic stability. However, it appears the government chose to set the bond duration to five years because it feared insufficient investor interest in ten-year bonds due to Sri Lanka’s instability. As expected, the opposition United National Party’s threat that a future UNP government would not honor the bonds appeared to have little impact on investor appetite for the bonds.”

“Nevertheless, the opposition continues to question the government’s stated intent to use the bond proceeds entirely to finance infrastructure investment. Central Bank Governor Cabraal assured the Ambassador that the government would indeed use the money for infrastructure. The Rajapaksa government is prone to fiscal irresponsibility, so the opposition’s doubts may be justified. On the other hand, the transparency that international investors require to maintain confidence in Sri Lanka’s sovereign debt may serve as an effective incentive for fiscal discipline.” Blake further said. 

Ambassador Blake wrote; “The opposition United National Party’s threat (ref A) that a future UNP government would not honor the bonds appeared to have little impact on investor appetite for the bonds. Following the sale, the UNP and other critics continued to charge in the media that the bond issue was both imprudent and illegal. They doubted that the government would use the proceeds of the bond to finance infrastructure investment. They claimed that the government could easily have obtained additional concessionary loans from multilateral development banks for infrastructure projects and that therefore the market interest rate and short duration of the bond was an undue burden on public finance. They identified discrepancies in the list of infrastructure projects that the government said it would pursue with the bond proceeds (such as project amounts and whether certain donors had committed funds for the projects.)”

“The opposition and critics also argued that the bond issue had not been conducted in accordance with parliamentary procedure and was therefore illegal.” he further said.

Placing a comment Blake said; “Post’s review of this charge suggests that it would make a good constitutional case — there appear to be reasonable points both in favor of the government’s right to proceed with such debt financing and also in favor of Parliament having a role in the matter, which it basically did not. The claim that the bond sale was illegal simply because it violated the 2003 Fiscal Management Responsibility Act is less convincing, since the act sets forth “objectives” for spending, debt, and deficit, not actual limits.”

Read the cable below for further details;

UNCLAS SECTION 01 OF 04 COLOMBO 001488

SIPDIS

SENSITIVE

SIPDIS

STATE FOR SCA/INS, EEB/IFD/ODF AND EEB/IFD/OMA
STATE PASS USTR FOR ADINA ADLER
COMMERCE FOR JONATHAN STONE
MCC FOR S. GROFF, D. TETER, D. NASSIRY AND E. BURKE
TREASURY FOR LESLIE HULL

E.O 12958: N/A
TAGS: EFIN EINV ECON KMCA CE
SUBJECT: SRI LANKA: DEBUT SOVEREIGN BOND ISSUE RAISES $500 MILLION
DESPITE DOMESTIC CRITICISM

REF: A. Colombo 1218 B. Colombo 1056

¶1. (SBU) Summary and comment: International investors, 40% of them
American, purchased all $500 million of Sri Lanka’s first-ever
sovereign bond issue, despite domestic opposition efforts to block
the sale. The government offered 8.25% coupon bonds with a
five-year maturity, and received orders from investment bankers in
Asia, Europe, and the United States totaling about triple the
quantity of bonds for sale. The government cited the strong
investor interest as an endorsement of Sri Lanka’s economic
stability. However, it appears the government chose to set the bond
duration to five years because it feared insufficient investor
interest in ten-year bonds due to Sri Lanka’s instability. As
expected, the opposition United National Party’s threat that a
future UNP government would not honor the bonds appeared to have
little impact on investor appetite for the bonds. Nevertheless, the
opposition continues to question the government’s stated intent to
use the bond proceeds entirely to finance infrastructure investment.
Central Bank Governor Cabraal assured the Ambassador that the
government would indeed use the money for infrastructure. The
Rajapaksa government is prone to fiscal irresponsibility, so the
opposition’s doubts may be justified. On the other hand, the
transparency that international investors require to maintain
confidence in Sri Lanka’s sovereign debt may serve as an effective
incentive for fiscal discipline. End summary and comment.

SRI LANKA JOINS THE RANKS OF
EMERGING MARKET BOND ISSUERS
—————————-

¶2. (U) Sri Lanka successfully sold its $500 million debut sovereign
bond issue to international investors the week of October 15. The
bond, priced at 8.25% for five-years, was oversubscribed —
investors offered to purchase nearly triple the government’s $500
million target. The bond offering was joint lead-managed by JP
Morgan, HSBC, and Barclays Capital, and is listed and traded in
Singapore. Sri Lankan Central Bank Governor Nivard Cabraal told
Ambassador November 1 that U.S. investors had bought 40% of the
bonds, with Asian and European buyers taking about 30% each. Prior
to the sale, Cabraal and other Central Bank officials joined
representatives of the three financial firms for a “road show” to
seven cities in Asia, Europe, and the United States.

¶3. (U) On the road show, Governor Cabraal pitched possible investors
on the Sri Lanka “story,” which included the following highlights:

– Sri Lanka is poised to grow along with India in fields like
information technology and business process outsourcing.

– Sri Lanka’s free trade agreements with India and Pakistan position
it as both an export and investment platform into those two
markets.

– Sri Lanka’s resilience — demonstrated by economic growth of 7.4%
in 2006 — is the untold story of the well-known ethnic conflict.

– The ethnic conflict is confined to the North and East, which
cumulatively account for less than ten percent of the economy.

– Sri Lanka has an unblemished debt service record; it is one of
only five “emerging market” countries that have never defaulted on
domestic or external debt.

¶4. (SBU) JP Morgan’s Colombo representative described the successful
bond sale to EconOff as remarkable on two counts: both for the
strong demand for Sri Lankan debt, and for the fact that this demand
existed despite reduced investor interest in emerging market debt
following the onset of the sub-prime loan crisis. He noted that
this was the first emerging market bond floated since the sub-prime
crisis hit, and that its timing was fortuitous, as markets had
fallen dramatically during the week after the bond issue. He cited
as a critical boost for the bond the Standard & Poor’s credit rating
agency’s August revision of its Sri Lanka rating outlook to “stable”
from “negative” (ref A). In the week since the bond was listed in

COLOMBO 00001488 002 OF 004

Singapore, he added, it has traded well — volume has been good and
its price has remained around par.

¶5. (U) (Note: Sri Lanka has sold about $800 million worth of
dollar-denominated “Sri Lanka Development Bonds” to international
investors, but these were not sovereign bonds tradable in
international markets. They were domestic debt sold in Sri Lanka
subject to Sri Lankan law and tradable only in the Sri Lankan
market. Sri Lanka has also allowed foreign investors to purchase up
to 5% of total domestic Rupee-denominated debt, currently totaling
about $350 million.)

OPPOSITION CHALLENGE: BOND LIKELY TO BE USED
IRRESPONSIBLY AND VIOLATED PARLIAMENTARY PROCEDURE
——————– —————————–

¶6. (U) The opposition United National Party’s threat (ref A) that a
future UNP government would not honor the bonds appeared to have
little impact on investor appetite for the bonds. Following the
sale, the UNP and other critics continued to charge in the media
that the bond issue was both imprudent and illegal. They doubted
that the government would use the proceeds of the bond to finance
infrastructure investment. They claimed that the government could
easily have obtained additional concessionary loans from
multilateral development banks for infrastructure projects and that
therefore the market interest rate and short duration of the bond
was an undue burden on public finance. They identified
discrepancies in the list of infrastructure projects that the
government said it would pursue with the bond proceeds (such as
project amounts and whether certain donors had committed funds for
the projects.)

¶7. (SBU) Ambassador asked Cabraal about these charges. Cabraal
assured the Ambassador that the government would be able to show
that it had spent the $500 million on infrastructure. He explained
that Sri Lanka has $4.5 billion worth of infrastructure projects in
the “pipeline,” and that it needed “buffer funds” to avoid
unnecessary delays in projects. The Government would use the funds
for steps like acquiring land before the start of a project, for
example, he said, adding that investors “could see the logic of
this.”

¶8. (SBU) The opposition and critics also argued that the bond issue
had not been conducted in accordance with parliamentary procedure
and was therefore illegal. (Comment: Post’s review of this charge
suggests that it would make a good constitutional case — there
appear to be reasonable points both in favor of the government’s
right to proceed with such debt financing and also in favor of
Parliament having a role in the matter, which it basically did not.
The claim that the bond sale was illegal simply because it violated
the 2003 Fiscal Management Responsibility Act is less convincing,
since the act sets forth “objectives” for spending, debt, and
deficit, not actual limits.)

GSL: TRUST US, BOND PROCEEDS FOR INFRASTRUCTURE,
NOT DEFENSE OR CURRENT SPENDING
——————————————— —

¶9. (U) The Government continues to insist that it intends to spend
the bond funds on infrastructure projects. The offering circular
for the bond stated:

“The Government will use the net proceeds from the issue of the
Bonds to supplement available concessional funds to develop
infrastructure projects that have been previously approved by the
Government and included in the current 2007 Budget. Such
infrastructure projects include but are not limited to: electricity
generation, transmission, distribution, and substation facilities;
roads and bridges; water supply, sanitation and sewage facilities;
port facilities; and highways and railway lines…. A portion of the
net proceeds will be used for bridging finance for such projects….
Nevertheless, the Government is subject to budgetary and funding
limitations and there is no assurance that all the net proceeds will
ultimately be used only for these projects.”

COLOMBO 00001488 003 OF 004

¶10. (SBU) A mid-level Central Bank source explained to EconFSN that
the final clause was included not to give the government wiggle room
to spend the funds on whatever it wants, but to allow the government
to use the money for temporary purposes until it is needed for
specific projects.

BOND WILL EASE PRESSURE ON RUPEE AND
INTEREST RATES, BUT COULD ADD TO INFLATION
——————————————

¶11. (U) The Central Bank asserted in its October monetary policy
statement that the bond sale would ease recent Rupee depreciation,
high interest rates and high inflation. Indeed, since the issuance
of the bond, the Rupee has strengthened against the dollar to about
112 from a low of about 114 on October 14 (just before the bond
sale). The prime lending rate is now 17.6% after having reached
20.5% on October 10.

¶12. (SBU) Comment: The strengthening of the Rupee follows from there
now being a greater supply of dollars in Sri Lanka. The easing of
interest rates follows from the government’s reduced need to borrow
funds domestically. However, the Central Bank’s assertion that
inflation will ease due to the stronger Rupee’s effect in reducing
the cost of imports is probably too optimistic. The influx of
dollars, when converted to Rupees and given to the government, will
add to the money supply and thereby contribute to the demand-driven
portion of Sri Lanka’s current 17% inflation. This could be avoided
if the Central Bank “sterilizes” by selling local bonds and thereby
absorbing Rupees from private hands. However, a senior Central Bank
official told Econoff he doubted the Bank would fully sterilize the
influx.

BOND WON’T SERIOUSLY ADD TO SRI LANKA’S
FOREIGN CURRENCY DEBT BURDEN
—————————————

¶13. (SBU) Critics cited the large figures for Sri Lanka’s total
outstanding external debt (about $12 billion) and external debt as a
percentage of GDP (about 46%) as additional reasons that the bond
sale was imprudent. While true that Sri Lanka owes a lot of money
both domestically and externally, the $500 million bond will not
drastically change Sri Lanka’s overall debt service burden. Sri
Lanka’s debt service ratio of 12.7% (2006) is manageable because a
large majority of its external debt — about 96% — is on
concessionary terms. Nor is the country in imminent danger of a
balance of payments crisis. Sri Lanka consistently runs a balance
of payments surplus thanks to continued strong inflows of
remittances, donor funding, and even growing foreign direct
investment. It receives little portfolio investment — so called
“hot money” that could be pulled out quickly if the country lost
favor with investors. Thus Sri Lanka’s balance of payments surplus
and its ability to service this debt and the rest of its debt
appears secure — all reasons why international investors snapped up
the bonds with their attractive 8.25% return.

COMMENT: AN “EXERCISE IN FISCAL DISCIPLINE”
——————————————

¶14. (SBU) The opposition and other critics are not wrong to be
concerned that the government would use the money irresponsibly.
The Rajapaksa government is likely to spend the money on projects
run by state-owned or -connected enterprises that are inefficient
and, in some cases, incompetent. It is likely to pursue projects
that Americans would recognize as political “pork” designed to
deliver benefits to favored constituents, not to be economically
viable. In fact, these are reasons why the critics were wrong to
charge that the government could easily have received more
concessionary loans for the infrastructure it wants to build. It
could not have, because donors like the Asian Development Bank and
World Bank would not finance the types of projects the government
wants, though they are already financing plenty of infrastructure
and other projects here. The government may also be tempted to
spend some of the money to cover current expenses like salaries for

COLOMBO 00001488 004 OF 004

the bloated civil service and subsidies for the loss-making Ceylon
Electricity Board and Ceylon Petroleum Corporation. As long as it
continues to run a budget deficit, it will have to borrow from
somewhere to cover such costs. In financial terms, it is not
significant whether money used for these particular expenses is
borrowed at home or abroad.

¶15. (SBU) More significant would be if the government uses the
dollars it raised in the bond sale to finance weapons purchases,
which generally must be paid for with hard currency. The local HSBC
head told EconOff that he directly warned the government against
this when HSBC first evaluated whether to seek the bond management
role. He said use of the bond proceeds for military procurement
would be the surest way to lose investors’ confidence and
willingness to purchase future debt.

¶16. (SBU) Ironically, the government’s likely interest in returning
to international markets to borrow more in the future is the main
factor that could keep it from frittering the money away on useless
infrastructure, current expenses, or military hardware. As the JP
Morgan rep told EconOff, the government being free to do what it
wants with the money makes the bond sale an “exercise in fiscal
discipline.” With credit ratings services scrutinizing Sri Lanka’s
accounts, he asserted, investors will know before long if the
government fails to spend the money wisely. Thus, while we share
concerns that the Rajapaksa government may not use the money
responsibly, we think the long-term implications of the government’s
borrowing in international markets could be healthy for Sri Lanka,
by creating a functional incentive for greater transparency and
accountability.
BLAKE