HSBC bullish on Lanka than rating firms

Confirming it was more bullish on Sri Lanka, HSBC, has upgraded its own rating on country’s 2011 sovereign credit from B+ positive to BB-/Stable, which is above those given by major rating agencies.

The upgrade has been disclosed in HSBC Global Research latest edition on Asia’s Bond Markets.  In comparison to BB-/Stable rating of HSBC, S&P’s rating on Sri Lanka sovereign is B+/Stable, Moodys is B1/(Stable) and B+/(+ve) by Fitch.

HSBC backed its upgrade over Sri Lanka’s improving external profile saying it underpins higher credit rating. It also noted that structural reforms by Sri Lanka should sustain faster economic growth.

It also said that its upgrade reflects initiatives on the Government’s fiscal consolidation and continued efforts to stimulate private sector capital formation.  

Analysts said the sovereign rating upgrade from HSBC Global Research represents a very positive development for Sri Lanka in the international bond markets, which has further enhanced positive sentiment amongst investors globally towards the country.                                                                            

“With this upgrade to BB-, HSBC Global Research is now one step ahead of Moody’s, S&P and Fitch, and this is likely to add pressure on the rating agencies themselves to upgrade Sri Lanka too,” analysts opined.

HSBC, which styles itself globally as ‘the world’s local bank’ in its Global Research Asia’s Bond Markets publication said that the Sri Lankan government’s focus has been squarely on bolstering economic growth in 2010 by stimulating private sector investments and rebuilding war-ravaged public sector infrastructure. As a result, HSBC Economics projects real GDP growth in 2010 doubling to 7% from an anemic 3.5% a year earlier. From the external credit metric side, HSBC Economics projects import coverage to rise to 5.3 months in 2010 from a low of 2 months in 2008 on the back of rapid foreign exchange reserves accumulation.

These were the key two factors triggering S&P to lift Sri Lanka’s rating by one notch to B+/stable and encouraged Fitch to raise the outlook to ‘positive’ from ‘stable’ on its B+ sovereign rating.

Looking to 2011, the HSBC sovereign model upgrades Sri Lanka’s credit rating to BB-/stable from B+/positive to reflect initiatives on fiscal consolidation and continued efforts to stimulate private sector capital formation.

To be specific, HSBC said the government projects a budget deficit of 6.8% of GDP compared with an 8% shortfall in 2010, although HSBC Economics see risks to this target due to the planned tax cuts.

Apart from the headline budget deficit improvement, we view favourable simplifying of the tax structure and broaden the tax base to increase revenues as a share of GDP.

“On the expenditure, we believe the IMF has influenced the government to slow recurrent expenditure while holding public sector investment steady as share of GDP. These budgetary steps should persuade Fitch to upgrade Sri Lanka by one notch in 2H11,” the report said.

However, it said that “we are concerned by the lack of concrete programmes to integrate the minority Tamil population back into the broader society. Also, we are troubled that the political institutional framework has been weakened by the parliament abolishing presidential term limits, eliminating the supervisory Constitutional Court and gives the president authority to directly appoint officials.”

HSBC noted that Sri Lanka’s growth is powering ahead as anticipated and hitting all the high notes. Growth has in 2010 benefited from the peace dividend and the global economic recovery. It has been broad based and is expected to reach more than 7% in 2010.

Growth is expected to hold up well in 2011 supported by accommodative fiscal and monetary policies. Improved labour market conditions and tax cuts announced in the 2011 budget are likely to lift personal consumption. Moreover, investment activity will continue to gain momentum as rebuilding efforts pick up pace and as mega infrastructure projects in the pipeline are implemented. Exports may consolidate a bit, partly due to the loss of preferential trade agreement with the EU and the strengthening of the currency. However, this could be partly offset by continued growth in tourism.

The current account deficit is expected to widen in response to the strong growth in domestic demand, partly in response to tax cuts for consumer durables implemented mid-2010.

However, strong remittance flows will provide some cushion.

Inflation has been increasing, primarily in response to rising food prices. However, with the economy rebounding as quickly as it has, there is a risk that broader demand-led prices could build.

Agreed, the slack in world output, a stronger currency and improved agricultural supply from the war affected areas in the North will help slow inflation. However, the domestically generated demand pressures are expected to become more prominent next year and could push inflation above the comfort zone. The Central Bank will, therefore, have to step in and we expect that they will begin to tighten monetary policy, no later than the second half of 2011.

On the fiscal side, the Sri Lankan government’s consolidation efforts are at risk. The 2011 budget is relying on raising revenues through a growth windfall from cutting taxes and simplifying the tax structure. According to the government’s estimates, the improvement in economic activity due to lower taxes is expected to raise tax buoyancy and help lower the budget deficit to 6.8% of GDP in 2011 from 8% expected in 2010.

Cutting taxes to raise revenues, textbook “Reaganomics,” has been done before and success or failure of this approach is controversial to say the least. Before taking this route, the government should have taken a more cautious approach to fiscal consolidation through further efforts to broaden the narrow tax base.

On the expenditure, there is not much help either.

Expenditures are budgeted to grow 11% y-o-y, partly because of an increase in public sector employment and a 5% salary hike for public sector employees. This is only partly countered by spending restraint for subsidies and a budgeted decline in interest payments.

Bottom line, the peace dividend from the end of the war is expected to deliver strong growth in excess of 7% next year. However, there are a number of risks on the horizon. Inflation could rise more than anticipated. Moreover, the fiscal consolidation strategy faces risks related to a tax strategy, which may not pay off. If these risks materialise, it will raise concerns about macroeconomic stability and could hurt growth prospects.