Sunday Dec 15, 2024
Sunday Dec 15, 2024
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S&P Global Ratings said yesterday it has revised its outlook on Sri Lanka’s long-term ratings to negative from stable.
It also affirmed its ‘CCC+’ long-term sovereign credit ratings and ‘C’ short-term ratings on Sri Lanka.
“The negative outlook reflects our expectation that Sri Lanka’s financing environment may get more difficult over the next 12 months. This would affect Sri Lanka’s ability to service its debt,” S&P said.
“We could lower our ratings if Sri Lanka’s attempts to boost reserves through the issuance of SLDBs, asset sales, and other means fall short of the Government’s expectation, leading to higher risk on its ability to service debts,” the rating agency said.
“We may revise the outlook to stable, or raise the rating, if external buffers can be significantly boosted, or if Sri Lanka’s economic recovery is much stronger than we expected. This could lower the risks associated with the Government’s debt-servicing capacity,” it added.
S&P said it revised the outlook to negative to reflect its assessment that risks to Sri Lanka’s debt-servicing capacity are rising, and the Government’s access to external financing is increasingly dependent on favourable economic and financial conditions.
The country’s relatively modest income levels, vulnerable external profile, sizable fiscal deficits, heavy Government indebtedness, and hefty interest payment burdens reflect weak and evolving governance and institutional settings. These factors significantly constrain our ratings.
While expansionary macroeconomic policies have provided some relief to the pandemic-hit economy, they have weakened the Government’s fiscal position and worsened the risks associated with the Government’s already high debt burden.
Following are excerpts from the rest of S&P’s statement on its latest rating action on Sri Lanka.
Institutional and economic profile: Pandemic uncertainty still hinders growth.
Like most other countries, Sri Lanka’s economy continues to be affected by the COVID-19 pandemic.
Real GDP growth rebounded strongly by 4.3% year on year in the first quarter of this year, given COVID-19 cases were more subdued and external demand, particularly for garments and medical gear, recovered. However, COVID infections surged again in May, resulting in the Government re-imposing movement restrictions and closing the country again to international travel.
Following the discovery of the infectious Delta variant in June, Sri Lanka is experiencing another, even more severe wave of infections, forcing the Government to further tighten social mobility restrictions. Meanwhile, vaccination progress has ramped up in recent weeks, with more than 50% of the population receiving at least one dose.
Despite the pandemic being much more severe in Sri Lanka this year compared with last year, we still expect economic activity to recover from the low base in 2020. So far, the Government has avoided a nationwide lockdown, which resulted in real GDP plunging 16.4% year on year in the second quarter of 2020. While the hospitalisation rates are high and the healthcare system has been under severe strain, the vaccination rate is starting to accelerate.
External demand, which has been fairly robust this year, is also expected to support the economy. However, the country has tightened various social restrictions, and that could dampen domestic economic activity in the second half of this year. We do not expect any meaningful recovery in tourism this year.
Downside risks to growth are still substantial, particularly given the unpredictable nature of the pandemic and the emergence of new infectious variants. A steep escalation in new infections could overwhelm Sri Lanka’s healthcare system and increase the risk of even stricter movement restrictions. Weakening external demand, particularly if the pandemic worsens in end-demand markets, could also remove an important source of support for the economy.
We forecast the economy will expand by 4.2% in real terms in 2021, following the 3.6% contraction in 2020, and average 4.2% from 2022-2024. This will bring per capita income to about $ 3,900 in 2021, translating into real GDP per capita growth of 2.1% on a 10-year weighted-average basis. Although this growth is in line with peers at a similar income level, we believe that it is substantially below Sri Lanka’s potential.
Sri Lanka’s institutional setting is a credit weakness, in our view. Recent years have seen frequent political infighting that had occasionally hindered policy predictability. We believe these developments weigh on business confidence. While the current administration’s clear victories in both the Presidential and Parliamentary Elections are likely to ease such uncertainty over policy direction, there has been further consolidation of power in the executive. In our view, this could lead to social tension, particularly if divisions along religious or ethnic lines persist.
Flexibility and performance profile: Falling reserves and uncertain financing conditions increase external funding difficulties.
• The external profile has weakened, with reserves falling below $ 3 billion and financing conditions becoming more uncertain
• Sri Lanka’s fiscal deficit is likely to remain elevated while the pandemic continues to affect growth
• This will likely worsen the Government’s heavy indebtedness and add to the repayment burden.
The country’s external position remains a key vulnerability on the rating. With the bullet repayment of the $ 1 billion International Sovereign Bond in July 2021, the central bank’s reserve holdings have fallen below $ 3 billion, or less than two months import cover. We expect the infusion of the newly approved Special Drawing Rights allocation by the IMF will boost reserves by about $ 800 million. However, this will not be sufficient for the Government to meet upcoming maturities of more than $ 5 billion till the end of 2022.
Although the Central Bank has signed a number of bilateral currency swap arrangements with partnering central banks, including a CNY 10 billion swap line with the People’s Bank of China, the adequacy of reserves will still be tenuous without additional means to boost reserves. The ability of the Government to secure foreign financing over the next two quarters will be crucial to preventing an external liquidity crisis in 2022.
Financing conditions on the international capital markets remain challenging for Sri Lanka. These conditions are unlikely to improve in the short term due to rising inflation pressures, and prospects of a faster-than-expected policy tightening in advanced economies. While the Government has been able to issue SLDBs to domestic creditors, demand for these SLDBs could be uncertain. Success in rolling over SLDBs is crucial to the Government’s debt-servicing capacity. In turn, this will heavily depend on domestic creditors’ ability to access external financing under favourable terms.
Due to wide-ranging import restrictions and stable exports growth, the current account deficit has narrowed substantially to 1.3% of GDP in 2020 from 2.2% in 2019. We estimate the current account deficit will rise marginally to 1.6% of GDP in 2021. While most of the import restrictions will likely remain in place, higher fuel prices this year will lead to a larger import bill, offsetting the earnings from workers’ remittances. Latest high-frequency data shows a strong recovery in imports alongside sustained improvements in exports. We expect these trends to be sustained despite new waves of the pandemic.
Sri Lanka’s external liquidity, as measured by gross external financing needs as a percentage of current account receipts plus usable reserves, is projected to average 129% over 2021-2024. We also forecast that Sri Lanka’s external debt net of official reserves and financial sector external assets will remain elevated at around 173% in 2021.
Persistent deficits in Sri Lanka’s fiscal position also remain a rating constraint. The Government’s heavy debt burden limits its ability to accumulate policy buffers, which are crucial in times of stress. The COVID-19 pandemic has further devastated Government finances by dampening domestic economic activity and lowering excise duty earnings.
In the last budget, the Government committed to keeping the wide-ranging tax cuts, including a lower value-added tax (VAT) rate, increasing the VAT turnover threshold, and removing the 2% Nation Building Tax, for five years. Instead of affecting the fiscal position only temporarily, these expansionary measures are likely to increase the deficit for an extended period, in our view. In the absence of extremely favourable economic and financial conditions, these measures are expected to constrain revenue growth and could be only partially offset by new revenue measures, such as the Special Goods and Services Tax.
The Government is planning to significantly ramp up infrastructure spending over the next few years. While recurrent expenditure has been relatively contained, room for further cuts is limited due to the high interest burden. Healthcare-related spending may also increase fiscal pressure, particularly if the hospital system comes under further strain.
We expect the fiscal deficit to remain elevated at 10.2% of GDP in 2021 and narrow gradually to 8.4% in 2024. If revenue growth disappoints, we believe the Government has some flexibility to cut capital expenditure to contain the fiscal deficit.
High fiscal deficits over an extended period will worsen the Government’s extremely high debt stock. We expect the increase in net general government debt to average 10.3% over 2021-2024. Net general government debt has exceeded 100% of GDP in 2020 and will continue to increase over the next five years, in our view.
Sri Lanka’s debt profile is also vulnerable due to the high share of the total debt being denominated in foreign currency, although this has been reducing over the past year. The Government has been increasing the share of domestic financing to fund the fiscal deficit. At the same time, domestic interest rates have been kept extremely low through massive liquidity injections by the Central Bank. While this has reduced the effective interest rate on the Government’s domestic debt, an increase in domestic liquidity will also pressure the exchange rate.
With the Central Bank starting to increase policy rates, this will worsen the Government’s interest burden at the margin. The Government’s interest payment as a percentage of revenues has already reached 68.8% in 2020 — the highest ratio among the sovereigns we rate.
We assess the Government’s contingent liabilities from State-owned enterprises and its relatively small financial system as limited.
However, risks continue to rise due to sustained losses at Ceylon Petroleum Corp., Ceylon Electricity Board, and SriLankan Airlines. Also, Sri Lanka’s financial sector has limited capacity to lend more to the Government without possibly crowding out private sector borrowing, owing to its large exposure to the Government sector of more than 20%.
Sri Lanka’s monetary settings remain a credit weakness, although it has seen some structural improvements. The Central Bank has been preparing an updated Monetary Law Act in recent years. The passage of this act, which enshrines the Central Bank’s autonomy and capacity, will be crucial to improving the quality and effectiveness of monetary policy, in our view.
