Sri Lanka defaulted on $56 billion of its debt earlier this year. That isn’t a huge amount relative to the trillions of dollars of global sovereign debt, but it is massive compared to the size of its $84 billion economy. Sri Lanka just defaulted on debt equal to 67% of its GDP. It was Sri Lanka’s first debt crisis since it became an independent country in 1948.
How in the world could Sri Lanka default on such a staggering amount of debt relative to its GDP?
As investors, we should take note. Not many likely had any capital in Sri Lanka. We didn’t. Sometimes, though, these little blowups are worth digging into if only to see what went wrong and to examine our portfolio for similar risks.
Remember, it is when hidden risk becomes broadly exposed that vast amounts of capital are lost. Finding hidden risk along with everybody else does no good; the market action once hidden risk becomes exposed is quick and decisive. Capital disappears in a flash. The trick is to find hidden risk when it is still hidden. Only then can capital be preserved. The Sri Lankan debt default is a case study in hidden risk.
Sri Lanka had two big problems: the composition of its debt and the nature of its imports.
A large part of its debt, and all of the $56 billion it defaulted on, was denominated in U.S. Dollars (USD). The Sri Lankan economy, along with the country’s ability to repay its debt, is denominated in Sri Lankan Rupees (SLR). That created a currency mismatch between its debt and its ability to service and repay that debt.
Sri Lanka had a similar situation with respect to its imports. Sri Lanka imports virtually all the commodities it consumes, including 100% of its energy consumption. The prices of most commodities are denominated in USD. That created a currency mismatch between the commodities it needed and its ability to pay for those commodities.
Sri Lanka had to obtain USD to service its USD debt and to pay for its imports. Sri Lanka’s only option to obtain USD was to buy them with SLR. The conversion of SLR into USD posed no threat as long as the USD-SLR exchange rate stayed constant. Hidden risk existed, though, should the SLR weaken relative to the USD.
A weakening SLR would mean more SLR would be required to purchase each USD. Sri Lanka’s source of SLR – its local economy – had little to do with the exchange rate. So, while its source of SLR is relatively fixed, a weakening SLR would mean more and more of those fixed SLRs would have to be converted into USDs in order to buy commodities and service its debt. Eventually, Sri Lanka would run out of SLRs.
When the United States Federal Reserve started increasing interest rates, it created an unfortunate double whammy on countries like Sri Lanka. Not only was the cost of U.S. dollar debt increasing due to higher interest rates, but the increased U.S. rates also strengthened the USD relative to most other currencies, including the SLR. The SLR lost 45% of its value in USD terms over the course of just two months. That meant Sri Lanka would need to spend nearly twice as many SLRs for each USD it needed to service its debt.
The weaker SLR also meant that basic commodities like oil cost about twice as much in SLR terms than they did prior to the devaluation.
Sri Lanka literally ran out of SLRs. It had no choice but to default on its debt.
The hidden risk that investors should have seen was the currency mismatch between Sri Lanka obligations and the source of funds to pay for those obligations. A currency mismatch like that is a risk. That currency-mismatch risk existed for years. Nobody cared. The S&P 500 Sri Lankan stock index was up 2x in USD terms in the two years following the COVID lock down in early 2020. Then, as the SLR started depreciating versus the USD and news of a possible default spread, the Sri Lankan Index lost nearly 75% in USD-terms practically overnight. By then, of course, it was too late to take action to protect capital. Poof. It was gone.
Two lessons here for investors.
First, be vigilant about searching for hidden risk. We won’t always be successful in finding it, but every hidden risk we find before the competition is capital saved.
Second, steer clear of countries with sizable obligations in currencies other than their own. Those currency mismatches are hidden risks that should be avoided.
