Fitch says Sri Lanka-IMF agreement faces implementation risks

The global rating agency, Fitch Ratings warned yesterday Sri Lanka’s $1.5 billion three-year IMF program eases near-term balance-of-payments risks but will require sustained commitment from the authorities to address long-standing weaknesses in external and public finances.

Therefore, the IMF assistance has no immediate impact on Sri Lanka’s ‘B+’/Negative sovereign rating, the rating agency said in a release Tuesday.

The IMF said the staff-level agreement on an Extended Fund Facility (EFF) would be considered by its executive board in early June. Sri Lanka’s previous IMF program ended in 2012.

“Sri Lanka formally requested IMF support in early February, and we noted the increased likelihood that the sovereign would require external liquidity support when we downgraded it by one notch later that month. The downgrade resulted from rising refinancing risks, a decline in FX reserves, and weakening public finances,” Fitch said.

An EFF could boost investor confidence and reduce Sri Lanka’s vulnerability to shifts in investor sentiment like that of last year, when investors sold off the equivalent of nearly $ 2 billion in local-currency government securities. Foreign-exchange reserves, which were $ 6.2 billion at end-March, would be temporarily bolstered by $ 1.5 billion from the IMF and potentially $ 650 million from other multilateral agencies.

But refinancing risk remains high. Sri Lanka has large external debts to refinance, with over $3 billion of external debt coming due in 2016 and an external liquidity ratio far below the ‘B’ and ‘BB’ category medians.

The program sets ambitious fiscal targets that may be hard to achieve, according to Fitch.

 It aims to slash Sri Lanka’s fiscal deficit to 3.5% of GDP in 2020 from a recently restated 7.4% last year, partly through comprehensive tax system reform. Persistently low government revenue, which has dropped to around 12% of GDP, is a key contributor to fiscal weakness, and implementing reforms to the tax system could be challenging (last November’s budget did not outline any major tax reforms).

A significant pick-up in revenues will be required to meet the 2016 budget’s deficit target of 5.4%, because non-discretionary government expenditure is high: salaries and interest payments account for almost 40% of the total. Potential crystallisation of SOE debt on the sovereign’s balance sheet remains a fiscal risk.

High GDP growth has supported Sri Lanka’s credit profile, but the country is likely to face a period of adjustment under its IMF program that could have a negative effect on economic performance in the short term. Fiscal and monetary tightening could be pro-cyclical, while the Central Bank’s planned shift to an inflation-targeting regime could push total public debt higher in local-currency terms if the rupee weakened, as nearly half of all public debt is foreign-currency denominated. But successful program implementation should set Sri Lanka’s economy on a more sustainable and robust footing once the adjustment is complete.

“We assigned a Negative Outlook to Sri Lanka’s ratings at the same time as the downgrade on 29 February despite the likelihood of agreement with the IMF on a program, in part because of the country’s patchy implementation record with previous programs. We will continue to monitor and assess progress under the program, as it is likely to be key to the evolution of Sri Lanka’s ratings and Outlook,” Fitch said.