Sri Lanka must prepare for LIBOR phase-out: ICRA

ECONOMYNEXT- Sri Lanka would have to prepare early for the abolition of the London Interbank Offered Rate which will impact over a billion dollars of bonds sold by the government and may trigger lawsuits, a rating agency has warned.

“CBSL, banks and companies must assess the impact and the transition should start immediately and in coordinated fashion,” ICRA said in a statement.

“A wider discussion on the transition of LIBOR should be initiated.”

“In addition, CBSL should set up a working group of stakeholders to prepare a transition framework and coordinate the effort of transition.”

“CBSL can also ask companies with substantial exposure to LIBOR to provide details of their preparations to manage risks inherent in the transition from LIBOR to alternative interest rate benchmarks.”

The LIBOR transition could affect some of Sri Lanka’s foreign debt, which was 49 percent at end-2017, as well as floating debt, which was 17 percent of the total.

The sovereign currently also has 1.3 billion US dollars in LIBOR-linked Sri Lanka Development Bonds maturing after 2021, which will fallback to a fixed rate based on the language in the bond agreements.

“…this may not be commercially acceptable to the Central Bank of Sri Lanka (CBSL) or investors.”

“In addition, this may also initiate some litigation against CBSL by bondholders.”

The borrowers should be prepared to increase flexibility to agree to amendments of loan agreement, ICRA said.

The rupee bond market may also be affected due to the LIBOR phase-out, ICRA said.

Foreigners who own rupee bonds have in the past hedged to LIBOR-linked securities to cover against currency risk, and these may be affected if a new derivatives market is not developed for SOFR.

Five Alternative Reference Rates (ARRs) based on five popular global currency will replace LIBOR, and Sri Lankan instruments will mainly fall under the Standard Overnight Funding Rate (SOFR) for US dollars.

ICRA said SOFR is a secured rate expected to be lower than LIBOR, which will require a credit adjustment to make the rate more comparable to the current benchmark.

SOFR has no term rate structure such as overnight, one month, three month and six month present in LIBOR, and the market is yet agree on a similar framework.

While LIBOR is forward looking, SOFR is backward looking and based on daily historical data, which has so far been volatile.

“Publication of SOFR only began in April 2018 and the analysts do not have a good understanding of how it will evolve in future.”

“Historical data shows SOFR is more volatile than LIBOR. The spreads show variations across economic cycle.”

“Lack of advance visibility of SOFR (or any other ARR for that matter) is especially problematic for certain cash products such as loans.”

“As a result, companies may need to hold additional cash balances to buffer any interest rate movement during the interest period, which will have an impact on the current cash management processes.”

ICRA said ARRs are more compatible with derivatives than cash products, and complex arrangements such as cross-currency swaps could trigger multiple ARRs, unlike a single LIBOR rate. (Colombo/Feb05/2020)