First Moody’s, then Fitch, and last week, Standard and Poor downgraded Sri Lanka’s ratings, largely over issues related to its debt sustainability and practicality of proposals.
Despite the Government being largely hailed for not introducing major new taxes, the public is likely to see the implementation of a new special commodity levy and a Goods and Services Tax from the beginning of January 2021. The two taxes are expected to make up part of Rs. 1.7 trillion in both direct and indirect taxes the Government hopes to earn in 2021.
As difficult as this measure is likely to be, it is clear that the increase in public revenue, which will need to grow by as much as 28% by some estimates, is needed to keep the Budget deficit of 8.9% on target.
Yet, there is little doubt the Government is in for a rough ride. As pointed out by Fitch Ratings recently, Sri Lanka has to repay $ 23.2 billion in the next four years, and finding sufficient foreign exchange will be difficult. After each downgrade, the Finance Ministry was quick to dismiss the rating reduction, insisting it was disappointed and terming the new rating as unacceptable. However, markets are unlikely to be moved by the Government, and more credible implementation mechanisms will be needed to bolster confidence.
Fitch estimates the Government debt-to-GDP ratio to increase to about 100% in 2020 from 86.8% in 2019, and to rise further under its baseline scenario to around 116% in 2024. This trajectory is in sharp contrast to the authorities’ medium-term fiscal strategy, which envisages a reduction in the debt-to-GDP ratio to 75.5% in 2025, from their estimate of 95.1% in 2020.
The authorities are forecasting a pick-up in revenues to 14.2% of GDP by 2025, from their estimate of 9.5% in 2020, with GDP growth picking up to 6% or higher over the medium-term. They also project a primary surplus by 2025. It is clear the rating agencies do not find these numbers credible enough to offset concerns caused by COVID-19.
At a macro level, there will be a need for fiscal consolidation measures that will have to be taken forward with long-term reforms in mind. The Government is caught between a rock and a hard place because certain essential reforms for State-owned enterprises (SOEs), labour and investments will be difficult to embark on given the COVID-19 backdrop. However, there will have to be a choice made between domestic growth and debt repayment that cannot be delayed much longer.
Come January, the Government will have to set itself to implement Budget proposals at speed, along with establishing the legal and regulatory frameworks needed. This would also need to be underpinned by stronger accountability measures that do not impact the environment or worsen delicate inter-community balances. Reducing expenditure will be especially hard, given the social welfare challenges if the pandemic persists, but taxing a struggling private sector will come at a cost.
For now, the Government seems set on focusing on indirect taxes, betting on subdued demand to stem inflation and hope for a turnaround before the next large repayment in July. It may be reassuring to the private sector but markets and a struggling public are unlikely to be impressed.