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On 20 November, S&P Global Ratings revised its outlook on the Democratic Socialist Republic of Sri Lanka to Stable from Negative. At the same time, it affirmed its ‘B+’ long-term and ‘B’ short-term sovereign credit ratings on Sri Lanka. It also left its transfer and convertibility risk assessment on Sri Lanka unchanged at ‘B+’.
The Stable Outlook reflects its expectation that the Government will maintain the reform momentum over the next 12 months and smooth the upcoming surge in debt redemptions, particularly in 2019.
Downward pressure on the rating could materialise if the political environment were to become more fractious, derailing the legislative program, especially its liability management reform.
A higher rating is unlikely in the next 12 months, but upward pressure could coalesce if Sri Lanka’s external and fiscal indicators show dramatic improvement. Upside pressure could also materialise if S&P concludes that there has been a substantive improvement in Sri Lanka’s institutional settings, including a continued strengthening of monetary policy credibility and independence at the Central Bank.
S&P revised the outlook to stable based on its assessment that the nascent strengthening of Sri Lanka’s institutions and governance practices is on a more sustainable footing. This assessment is predicated on not only the passage of the Inland Revenue Act (IRA) in September 2017, but also on the expected adoption of further reforms over the next 12-18 months. This includes the passage of the Liability Management Act, which would allow the government to proactively address rising sovereign debt maturities in 2019.
These positive developments are balanced by ongoing rating constraints, which include high external and net general government indebtedness. With GDP per capita estimated to reach approximately $ 4,000 by the end of 2017, Sri Lanka’s economic assessment also represents a rating weakness. This rating constraint weighs against Sri Lanka’s sound growth potential, supported by competitiveness in the garment, tourism, and business process outsourcing sectors.
Although S&P believes reform momentum is improving, S&P continues to observe significant challenges to the policymaking environment owing to legacy institutional constraints and a fragmented political landscape. Therefore, Sri Lanka’s institutional assessment remains a weakness.
Institutional and economic profile: Reforms mark improving trend in governance
The Inland Revenue Act marks a continuation of reform momentum. S&P expects further positive reforms to materialise over the next 12-18 months. Nevertheless, Sri Lanka continues to face impediments to institutional capacity.
Sri Lanka’s relatively low income level remains a rating constraint.
Sri Lanka’s Coalition Government has made progress on economic reforms over the past six months. Most notably, the IRA highlights the Government’s continued adherence to the International Monetary Fund (IMF) reform program, and proves its ability to pass controversial reforms despite a fractious parliamentary landscape. The passage of the IRA also goes to the core of Sri Lanka’s fiscal challenge—it collects little tax.
Deeply-rooted factionalism remains a constraint for Sri Lanka’s institutional assessment, because S&P believes it hinders the Government’s ability to more effectively address the economy’s imbalances. This, in turn, weighs on business confidence, investment plans, and overall growth prospects; the correlation between these conditions and the relative underperformance of the economy has been evident since 2015. That said, the Government has proven itself willing and capable of adopting potentially painful reforms in the wake of more fiscally liberal regimes.
As S&P has noted previously, S&P believes the Central Bank of Sri Lanka’s (CBSL) ability to sustain economic growth while attenuating economic or financial shocks continues to improve. The Central Bank is building a record of credibility, shown in reducing inflation through using market-based instruments to conduct monetary policy and the planned introduction of an inflation-targeting regime. However, S&P does not consider the Central Bank to be independent of other policymaking institutions.
Sri Lanka’s growth outlook is robust, though not strong enough to differentiate the economy from those of other sovereigns at a similar level of development. Growth should be underpinned by rising tourist arrivals, a uniquely specialised garment sector, strong potential in business process outsourcing, and moderate inflation, which S&P expects to remain in the single digits. S&P believes Sri Lanka will most likely maintain real per capita GDP growth of 4.2% per year over 2017-2020 (equivalent to 4.9% real GDP growth). Stronger growth, in S&P’s view, would require improved institutional settings and a pickup in export markets.
Sri Lanka’s external liquidity and debt ratios have stabilised. However, the country’s external debt remains high. Sri Lanka’s debt stock and servicing costs remain very high. However, the trend in debt accumulation is improving, with annual deficits narrowing. Because most public debt is denominated in foreign currency, the external debt-to-GDP ratio is highly sensitive to the exchange rate.
The trend is positive for Sri Lanka’s monetary assessment, with improving institutional capacity at the central bank.
Although the fiscal trajectory suggests a decline in the government’s debt stock relative to GDP, there are risks to this expectation. In particular, more than 40% of Sri Lanka’s high stock of central government debt is denominated in foreign currency. S&P’s base-case scenario envisages a gradual depreciation of the Sri Lankan rupee versus the US dollar; a more aggressive weakening of the rupee would cause debt metrics to underperform its forecasts.
Although the Central Bank has shown an increased willingness to allow flexibility in the Sri Lankan Rupee, S&P expects policymakers to focus on exchange rate stability, in view of the proportion of foreign currency-denominated debt dynamics. If Sri Lanka’s public debt were all denominated in its own currency, this would not be a rating constraint.
Sri Lanka’s external liquidity position continues to stabilise, and S&P views the ongoing IMF program as supportive toward this trend. However, the country’s external metrics are still beset with the following weaknesses:
S&P forecasts the current account deficit to amount to 2.9% of GDP in 2017, a slight deterioration from an estimated 2.4% in 2016. The decline is largely due to unusually poor weather conditions, which gave rise to higher agricultural imports. S&P believes the trend will reverse in 2018.
Although remittances have historically supported the current account position, inflows have been somewhat weaker so far in 2017, owing to strong dependence on transfers from Gulf states. S&P forecasts only modest growth in net transfers even if rising oil prices limit downside risk to remittances.
Sri Lanka’s external sovereign debt maturities will rise considerably in 2019. This will put pressure on Government and external accounts, in the absence of proactive liability management.
S&P expects external liquidity (measured by gross external financing needs as a percentage of current account receipts [CAR] plus usable reserves) to average 124% over 2017-2020, compared with 121% in 2015-2016. S&P also forecasts that the country’s external debt (net of official reserves and financial sector external assets) will average 146% of CAR from 2017-2020, a slight deterioration from 142% in 2016.
External liquidity support from the IMF has eased near-term pressures, but structural measures will be needed to address Sri Lanka’s external vulnerabilities over the long run. Although these risks could be further mitigated by allowing the Sri Lankan Rupee to float more freely, it would worsen Sri Lanka’s external debt metrics.
Nevertheless, greater tolerance for a weaker rupee from the CBSL would theoretically allow for a more rapid accumulation of foreign exchange reserves, which remain low despite recent improvements. S&P forecasts the Central Bank’s usable foreign exchange reserves to reach $ 5.4 billion by the end of 2017, versus $ 3.5 billion in 2016. A few factors have strengthened its foreign exchange reserves: the issuance of an international sovereign bond in second-quarter 2017, net foreign exchange purchases equivalent to $ 1.2 billion by the Central Bank so far this year, and a $ 1.0 billion syndicated loan.
During 2017-2020, S&P expects fiscal consolidation to reduce annual borrowing further. Part of its improved projections reflect the expected effect of the IRA in gradually broadening the tax base by eliminating exemptions and reducing evasion, especially of Value-Added Tax (VAT) collection after the introduction of a higher headline VAT rate.
S&P projects annual growth in general Government debt to average 5.4% of GDP for 2017-2020, versus an average of 7.8% annually from 2014-2016. In view of Sri Lanka’s robust nominal GDP growth, S&P projects net general government debt to decline to approximately 72% of GDP by 2020, assuming a gradual rupee depreciation versus the US dollar.
At the same time, S&P expects only slow progress in reducing debt servicing costs, and S&P estimates that general Government interest expenditures will account for more than 36% of Government revenue in 2017. This is the third-highest ratio among the sovereigns S&P currently rates, trailing only Lebanon and Egypt (see “Sovereign Risk Indicators,” published 13 October; a free interactive version is available at spratings.com/sri).
Combining S&P’s view of Sri Lanka’s State-Owned Enterprises and its small financial system, S&P views the Government’s contingent liabilities as limited. Expected reforms to fuel and electricity pricing formulae should improve the financial sustainability of the Ceylon Electricity Board and Ceylon Petroleum Corp., which are key State-Owned Enterprises.
At the same time, the national financial sector has a limited capacity to lend more to the Government without possibly crowding out private-sector borrowing, owing to its large exposure to the Government sector.
