Upgrade upside

• In a major boost for Sri Lanka’s investment profile two agencies yesterday upgraded the country’s sovereign ratings ahead of US$ 1 billion Bond Issue marketing of which was concluded last week in US and Europe.

Fitch Ratings upgraded Sri Lanka’s Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) to ‘BB-’ three notches below investment grade from ‘B+’.  The outlooks on these ratings are ‘Stable’.  Further, Fitch has upgraded the Country Ceiling to ‘BB-’ from ‘B+’ and affirmed the Short-Term Foreign-Currency IDR at ‘B’.

Meanwhile, Moody’s Investors Service has upgraded outlook of Sri Lanka’s B1 foreign currency sovereign rating (four notches below investment grade) from ‘Stable’ to ‘Positive’.

The Central Bank in a statement welcoming the upgrade, said it “is confident that the measures taken towards the macroeconomic stability and improvement of the economy over the past several years would yield further favourable results in coming years.”

“The upgrade reflects the stabilisation and recovery of the economy under the country’s IMF programme and increased efforts to address the chronic budget deficit position,” said Art Woo, Director in Fitch’s Asia Sovereign Ratings group.

Real GDP grew an impressive 8% in 2010, up from a 3.5% rise in 2009 as Sri Lanka’s post-war economic transformation, particularly the integration of the war-torn northern and eastern provinces, continued to gain traction. In tandem, the current account position has held up well, with a deficit of 2.9% of GDP in 2010, compared with the peak shortfall of 9.5% in 2008. Moreover, the positive economic momentum extended into 2011: GDP rose 7.9% yoy in the first quarter due in part to strong demand for exports, particularly garments and textiles. As a consequence, Fitch forecasts real GDP to grow 7.5%-8% in 2011 and 2012.

Consumer price inflation, which has historically proven to be both high and volatile, has been relatively well behaved, rising 7.5% yoy in H111, compared with a 6.2% rise in 2010. The benign outcome is especially encouraging given that the domestic agriculture sector suffered a sharp downturn in output earlier in the year and global food and energy prices remain elevated. Fitch forecasts CPI to be 7.5% in 2011 and 6.8% in 2012.

Sri Lanka has also made some important headway in consolidating its fiscal deficit, which is one of the sovereign’s key rating weaknesses, particularly when compared with ‘BB’ rating category peers. The budget deficit was brought down to 8% of GDP in 2010, from 9.9% in 2009. Moreover, many recommendations by the Presidential Commission on Taxation, which was formed in mid-2009 to review the country’s tax system, were implemented in the 2011 budget. This should enable the authorities to achieve, or at least come close to, the budget deficit targets of 6.8% of GDP for 2011 and 5.2% for 2012.

If Sri Lanka is able to continue consolidating the fiscal position, its public debt dynamics should be placed on a more sustainable path. Fitch notes that Sri Lanka’s public debt-to-GDP ratio stood at 82% of GDP in 2010, which is well above the ‘B’ and ‘BB’ peer rating group medians of 40% and 41% respectively.

Weak external finances also weigh on Sri Lanka’s ratings. Net external debt was 30% of GDP in 2010, which is well above the ‘B’ and ‘BB’ range medians of 9.4% and 7.4% respectively. However, official foreign exchange reserves have recovered to USD7.2bn in April 2011, from a trough of USD1.3bn in March 2009 before Sri Lanka entered into a USD2.6bn stand-by arrangement with the IMF. The ability to attract non-debt capital inflows, specifically foreign direct investment (FDI), would not only help reduce Sri Lanka’s reliance on external debt but could also improve the overall competitiveness of the economy. However, FDI following the end of the civil war has been surprisingly weak, totalling just USD478m (or 1% of GDP) in 2010.

Fitch would view the authorities’ ability to continue consolidating the budget deficit, by both enhancing the tax revenue base and rationalising expenditures, and in tandem lowering the level of public debt as supportive for Sri Lanka’s ratings. A sustained period of strong economic growth, particularly if accompanied by an improvement in the investment climate and private sector capital spending, would also be supportive for the ratings. In contrast, continued double-digit inflation or deterioration in political stability would put downward pressure on Sri Lanka’s ratings.

Moody’s in a statement said key drivers for its decision were: An increasingly evident peace dividend reflected in greater macroeconomic and financial stability; a policy orientation of fiscal reform and economic growth, supported by a successful IMF programme; an improving external payments position; and a reduction in political event risk following the end of the civil war in 2009.

With regard to the rationale for the outlook change to positive Moody’s said after the long-running civil war ended two years ago, Sri Lanka has started to reap a peace dividend that has accrued to the economy and the security environment. The economy is expected to grow sustainably at around 8 to 9 percent over the medium-term as confidence is further bolstered and investment picks up.

Greater macroeconomic stability is seen in a downward trend in inflation from very high levels evident during the civil war. The re-integration of the northeastern part of the country formerly controlled by the separatist Tamil movement is helping to raise food supply.

Although the government budget has not directly gained from the end of the conflict as defence mobilisation remains high, a benefit is being realised by the sharp tightening in yields on government bonds. Nevertheless, the budget deficit is gradually declining in line with annual targets set out in the government’s IMF programme.

External vulnerabilities are also expected to ease in the near term. Relatively moderate current account deficits should continue to be easily financed, in part by rising inflows of foreign direct investment, as reflected in small balance of payment surpluses that have led to a steady rise in foreign exchange reserves. Merchandise export performance and tourism receipts have been especially buoyant early this year. In addition, Sri Lanka is rapidly building up its port cargo capacity, exploiting its strategic location astride the main shipping lane between the Middle East, South Asia, and Southeast Asia.

Commenting on rating constraints Moody’s said the main challenge facing the government is the reduction of its large debt overhang and the consequently large debt servicing costs. Among non-investment grade credits, only Lebanon, Jamaica, Ireland, and Portugal surpass Sri Lanka in terms of general government debt as a share of GDP. On a net present value basis, however, the debt burden is lower owing to a considerable share of concessional debt. Nonetheless, Sri Lanka is well-placed to grow out of its debt given its robust outlook for growth.

Re-integration of the Tamil minority in the war-torn northeast region is progressing, namely in the provision of humanitarian assistance and supporting development projects. However, the process of political reconciliation is at an early stage and will need to advance further to ease persisting concerns about political risk. As such, Moody’s assessment of event risk remains somewhat elevated, but at a moderate level in our global bond methodology framework.

Moody’s also said continued deficit reduction as targeted by the government coupled with the containment of inflation amidst sustained high rates of growth would be credit positive developments over the 12-18 month rating horizon. Such developments would lead to a steady reduction in the government’s debt burden and would enlarge the government’s fiscal space to cope with future contingencies or shocks.

In other words, a longer track record in effective policy management by the post-civil war government would be viewed as credit positive.