• SL’s long-term foreign and local currency sovereign credit ratings lowered to ‘B-’ from ‘B’; Outlook Stable
• Says move on account of COVID-19-induced fiscal deterioration
• Opines COVID-19 outbreak to push SL economy into recession in 2020, against earlier expectations of rebound; recession will weaken country’s already-fragile fiscal position
• Uncertainty over pandemic and associated economic fallout have increased Sri Lanka’s external financing risks
• Says Stable Outlook reflects expectation that Govt. still has access to various multilateral and bilateral resources that could augment their foreign exchange reserves to meet immediate debt obligations

Citing COVID-19 fiscal deterioration, S&P Global Ratings yesterday lowered Sri Lanka’s long-term foreign and local currency sovereign credit ratings to ‘B-’ from ‘B’ with Outlook Stable whilst warned of recession in 2020

S&P affirmed short-term foreign and local currency credit ratings at ‘B’. The transfer and convertibility assessment is revised to ‘B-’ from ‘B’. The Outlook is Stable.

The stable outlook reflects our view that Sri Lanka still has access to sufficient resources, including from multilateral and bilateral partners, to meet its debt obligations over the next 12 months.

S&P said it could lower ratings if it believes that multilateral and bilateral support will not be forthcoming and if external imbalances deteriorate beyond our expectations, leading to a sustained decline in foreign exchange reserves. 

“These could cast doubt on Sri Lanka’s ability to service its debt,” it added. S&P also would consider raising the rating if it sees credible improvements in the fiscal and debt metrics on a sustained basis.

It said ratings were lowered on Sri Lanka based on the assessment that the country’s fiscal position has weakened substantially amid a COVID-19-induced recession.

It also issued the following commentary.

With fiscal space already limited by the wide-ranging tax cuts announced at the end of last year, this deterioration will worsen the risks associated with Sri Lanka’s Government debt burden, in our view. Our ratings on Sri Lanka reflect the country’s relatively modest income levels, weak external profile, sizable fiscal deficits, extremely high government indebtedness, and extremely large interest payment burdens.

Economy pushed into recession by COVID-19 while delayed elections increase political uncertainty

Economy likely to be heavily impacted as tourism and some export sectors temporarily grind to a halt amid COVID-19 outbreak, while curfews and containment measures weigh on domestic activity

Barring further unforeseen shocks, we expect the economy to recover from 2021 onwards

Delays in Parliamentary Elections likely to prolong political uncertainty, in our view

Sri Lanka’s economy is suffering another major blow in 2020, as tourism and export activities declined due to COVID-19, against earlier expectations of a strong rebound. The economy entered the pandemic on a relatively weak footing, as growth has been consistently languishing below potential in recent years, due to a confluence of exogenous shocks and intractable political difficulties.

After a brisk uptick in the first quarter of 2019, economic growth was again derailed after the Easter Sunday attacks. Meanwhile, expanding fiscal deficits, rising external vulnerabilities, a large debt stock, and ballooning interest servicing cost eroded policy buffers and reduced fiscal capacity to further support a slowing economy.

Barring further unforeseeable exogenous shocks, we forecast the economy to contract by 0.3% in 2020, recording its lowest rate of growth since the civil war ended. We assume the negative economic impact to peak in Q2-Q3 2020 and activity to gradually normalise towards the end of the year. 

We expect growth to rebound to 4.6% in 2021 from a low base. This is expected to be supported by expansionary fiscal and monetary settings, recovering external conditions, and the resolution of political uncertainty following parliamentary elections later this year.

While Sri Lanka’s number of COVID-19 cases, as measured by official statistics, remain lower than many other countries in the region, and containment measures are being eased, it remains difficult to predict the trajectory of the pandemic. This creates substantial near-term economic risks.

In particular, the tourism sector, which has boomed in recent years, might take longer to recover as travelers could remain cautious prior to the development of a lasting medical intervention. A shallower and more protracted global recovery could also reduce external demand for exports.

Meanwhile, the delay in Parliamentary Elections from the scheduled date in April due to the onset of the pandemic could open up fresh political uncertainty and test the resilience of institutions, in our view. Persistent political infighting in recent years has hindered policy predictability and weighed on business confidence, investment plans, and overall growth prospects, in our view. A smooth resolution of this political risk is crucial in bringing forward the economic recovery.

We estimate real per capita income to reach about $ 4,000 in 2021 and real GDP growth to average 3.3% in 2020-2023. This translates to real GDP per capita growth of 2.5% on a 10-year weighted average basis. Although this growth rate is in line with peers at a similar income level, it is substantially below Sri Lanka’s growth potential.

Flexibility and performance profile:

Fiscal position has deteriorated further and risk over debt sustainability has increased

Sri Lanka’s fiscal deficit is expected to widen further due to revenue shortfalls as COVID-19 dampens economic activity

This will likely worsen the Government’s heavy indebtedness and add to repayment burdens

The external profile remains weak, given that the high share of dollar-denominated debt exposes the Government to shifts in risk sentiments

Persistent deficits in Sri Lanka’s fiscal and external positions remain rating constraints. The heavy Government debt limits its ability to accumulate policy buffers, which are crucial in times of stress.

While some progress toward fiscal consolidation has been achieved under the IMF Extended Fund Facility (EFF) program that started in 2016, recent events have severely hampered such progress.

The Government’s fiscal position weakened in 2019 as the Easter Sunday attacks stymied economic activity and reduced tourism earnings. Government revenue growth came insignificantly below expectations while expenditure also increased due to higher security-related and election spending.

The wide-ranging tax cuts announced by the Government following the Presidential Elections in 2019 is expected to extend this one-off underperformance on both the revenue and expenditure fronts. We expected the main components of the tax cuts, including lowering the value-added tax (VAT) rate, increasing the VAT turnover threshold and removing the 2% Nation Building Tax, to reduce revenue earnings. 

However, we had also expected that a much stronger rate of growth could help to offset some of the revenue slippages. With COVID-19 dampening domestic economic activity and lower excise duty earnings due to broad import restrictions, we now expect that Government revenues will decline to below 10% of GDP in 2020.

Meanwhile, expenditure could be relatively contained this year as the Government is operating on an interim budget with no new expenditure items for the first half of the year. Disbursements are also likely to be slower due to curfews and disruptions to economic activities. The stimulus measures to support the economy thus far have been relatively targeted and restrained, reflecting in part the limited fiscal space. 

The burden to support the economy has fallen mostly on the Central Bank, which has reduced policy rates by 150 basis points this year, drastically increased liquidity in the banking system and relaxed some prudential measures for banks.

This would widen the fiscal deficit to 8% in 2020 from 6.8% in 2019. Factoring in adverse exchange rate movements, we estimate the change in net general Government debt will exceed 9% in 2020. Based on our expectations of a growth rebound next year, we estimate that the fiscal deficit will narrow marginally from 2021 onward, but will remain high in the absence of new revenue measures.

A much weaker fiscal position will add to the Government’s extremely high debt stock. We expect net general Government debt to exceed 90% of GDP in 2020 and remain at an elevated level, depending on the new Government’s budget and medium-term fiscal plans.

Meanwhile, interest burden has also increased due to adverse currency movements and a smaller revenue base. We estimate interest payment to reach 67.2% of revenues in 2020. This is the second-highest ratio among the sovereigns we currently rate, trailing only Lebanon.

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 the sustained losses at the Ceylon Petroleum Corp. (CPC), Ceylon Electricity Board (CEB) and the Sri Lankan Airlines (SLA).

While CPC and CEB have recorded improvements in their financial positions as a result of the drastic decline in global oil prices, SLA is likely to continue accumulating losses due to the impact on air travel. Also, the country’s 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 of more than 20%.

The external position has also deteriorated from the time of our last review. Following an improvement in 2019, we expect the current account deficit to widen to 3.4% of GDP in 2020 due to weak external demand for both goods and services.

Sri Lanka’s external liquidity, as measured by gross external financing needs as a percentage of current account receipts (CAR) plus useable reserves, is projected to average115% over 2020-2023. We also forecast that Sri Lanka’s external debt net of official reserves and financial sector external assets will rise sharply to 195% in2020, in part due to poor export earnings. 

The Government’s external financing conditions also remain challenging, in our view. With 50% of total public debt denominated in foreign currency, the external position is vulnerable to adverse exchange rate movements, and shifts in global credit conditions. Both conditions have materialised in recent months and have resulted in a sharp deterioration in the Government’s ability to access the international capital markets.

However, at the moment, we believe that the Government has sufficient funds to cover its external debt obligations over the next 12 months. As of end-April, foreign exchange reserves stood at $ 7.1 billion. We expect that assistance and additional credit lines from multilateral and bilateral sources could help to augment the Central Bank’s resources.

Sri Lanka’s monetary settings remain a credit weakness, although there have been some structural improvements in recent years, as the Central Bank of Sri Lanka prepares to transition to a flexible inflation-targeting regime under the proposed Monetary Law Act. 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.

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