Standard Chartered Bank Credit Alert on Sri Lanka

• Following is the chapter on Sri Lanka in the Standard Chartered Bank’s Asian region Credit Alert issued on Monday titled ‘Asia sovereign credit comparator—Fading value’.
• Sri Lanka (B1/Pos; B+/Sta; BB-/Sta)

Credit outlook – Stable

We have a Stable view of Sri Lanka as a credit. The multiple policy initiatives undertaken in early 2012, helped to restore macroeconomic stability via slowing credit growth, a smaller current account deficit and improving FX reserves.

Political stability will enable the authorities to push through structural reforms, and we expect GDP growth to improve to 7.2% in 2013. Gradual fiscal consolidation is underway, and the deficit is likely to narrow to 6.5% of GDP in 2013 (7% in 2012).

While Sri Lanka’s external position has stabilised, it could come under pressure from a slowdown in exports, modest FX reserves and a high external debt stock. That said, near-term external debt maturities appear manageable.

Key credit considerations

• Policy correction has restored macroeconomic stability: Sri Lanka’s external position came under threat in early 2012 due to a high current account deficit (7.8% of GDP in 2011 versus 2.2% in 2010) and the depletion of FX reserves (US$ 5.9 billion versus US$ 8.1 billion in August 2011).

    Policy measures introduced in February 2012, the abolition of the de facto exchange rate peg, tightening of monetary and credit policy, and fuel and electricity price increases have restored macroeconomic stability. The IMF’s disbursal of the last two tranches of the US$ 2.6 billion Stand-by Arrangement increased the FX reserves to US$ 7.1 billion as of September 2012.

• Improved growth prospects: The end of two-and-a-half decades of civil conflict in 2009 has put Sri Lanka on a higher, more sustainable growth trajectory. However, GDP growth likely slowed to 6.8% in 2012 from 8.3% in 2011 due to a slowdown in exports, lower agricultural output and tight credit conditions.

We expect growth to pick up to 7.2% in 2013, supported by higher investment spending, strong remittance inflows, and steady growth in the tourism and construction sectors. Given that credit growth has slowed and inflation is expected to moderate by Q2-2013, the Central Bank is likely to ease monetary policy to support growth in 2013.

• Fiscal consolidation is underway: Fiscal discipline has historically been weak due to a narrow tax base, large interest payments (25% of expenditure), extensive subsidies (15% of expenditure) and a bloated public sector.

The Government targets reducing the fiscal deficit to 4.5% by 2015 (7.0% in 2012) and improving debt/GDP to below 75% (81.3% in 2012). The Government’s 5.8% fiscal deficit target for 2013 is based on a 19.2% increase in revenue, which will be difficult to achieve, in our view.

The poor performance of the state oil and electricity companies will continue to act as a fiscal drag (the combined losses of the two entities were 1.5% of GDP in 2011). We expect the deficit to come in at 6.5% of GDP in 2013.

• External debt is high: Domestic funding of the deficit is largely captive, as local banks and contractual savings institutions are required to invest in government securities. However, as of December 2011, Sri Lanka’s external debt was high at US$ 28.9 billion (or 48.8% of GDP) c.76% of this was government debt.

That said the maturity profile appears manageable, with short-term external debt at only c.9% of total external debt. Also, the bulk of the external debt is from multilateral and bilateral creditors at concessional rates, which lowers the debt-servicing burden.

However, as Sri Lanka rises to middle-income status, the incremental share of concessional funding is declining (48.4% in 2011, versus 80% in 2008).

•  BoP position has improved, but risks persist: In 9M-2012, the trade deficit remained high at c.10% of GDP (a 3.3% y/y decline in imports was offset by an export contraction of 5.8%), while FDI flows remained below potential (US$ 452 million versus a target of US$ 1.4 billion). However, remittances (up 16.8% y/y) and tourism receipts (up 22.6% y/y) were buoyant, while the IMF disbursal and the USD one billion Eurobond should keep the FX reserves at c.US$ 7 billion at end-2012.

While Sri Lanka’s External Vulnerability Indicator remains high (128% in 2012, according to Moody’s), the stabilisation of the trade balance and a potential pick-up in capital inflows should keep the BoP position steady in 2013. A new IMF program would provide an additional buffer and improve investor sentiment.

•  Political stability: The Government continues to enjoy widespread popularity, as reflected in its strong performance in provincial council elections in 2012.

However, it faces ongoing international criticism for its role towards the end of the civil war in 2009, and political reconciliation with the Tamil minority is still at an early stage. Also, the Parliament’s recent initiation of impeachment proceedings against the Chief Justice has raised concerns about institutional credibility.