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Monday February 6th, 2023

Fitch downgrades Sri Lanka sovereign rating to ‘CCC’ after budget

ECONOMYNEXT – Fitch Ratings has downgraded Sri Lanka’s sovereign rating to ‘CCC’ from ‘B-‘ after a budget for 2021 showed too steep revenue projections after earlier tax cuts and a higher deficit for 2021 than 2020.

“In our view, the budget lacks a credible fiscal consolidation strategy and provides only limited details on the potential revenue impact of some of the measures announced, raising uncertainty about the government’s planned reduction in government debt and budget deficit,” Fitch Ratings said.

“Sri Lanka’s 2021 budget targets a widening deficit of 8.9 percent of GDP, from 7.9 percent of GDP for 2020.

Fitch said there is no outlook or notches after a downgrade to CCC.

Analysts say the deficit target for 2021 is an improvement if past accounting practices were followed, but spending for 2020 was controversially pushed back to 2019.

“In the 2021 budget, the authorities have planned external borrowings of project and programme loans mostly through bilateral and multilateral sources (about USD1.8 billion), as well as foreign commercial loans (about USD1.4 billion) for budget support,” the rating agency said.

“The authorities do not currently anticipate a financing arrangement with the IMF.”

The full statement is reproduced below:

Fitch Downgrades Sri Lanka to ‘CCC’

Fri 27 Nov, 2020 – 4:29 AM ET

Fitch Ratings – Hong Kong – 27 Nov 2020: Fitch Ratings has downgraded Sri Lanka’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘CCC’.

Fitch typically does not assign Outlooks or apply modifiers to sovereigns with a rating of ‘CCC’ or below.

KEY RATING DRIVERS

The downgrade reflects Sri Lanka’s increasingly challenging external-debt repayment position over the medium term. In particular, a sharp rise in the sovereign debt to GDP ratio associated with the coronavirus shock and narrowing financing options have heightened debt sustainability risks.

Sri Lanka’s external funding needs are substantial over the medium term, and in our view, risks to the sovereign’s ability to meet its external-debt service obligations have increased. The government’s external-debt obligations amount to USD23.2 billion between 2021 and 2025 or about USD4 billion annually, against FX reserves at end-October of just USD5.9 billion. The sovereign’s financing and debt service challenges are exacerbated by its existing financing model, which has resulted in very high general government interest to revenues ratios. The average interest to revenue ratio from 2016 to 2020 is about 50%, substantially above the ‘CCC’ peer median of about 11%.

The authorities plan to meet their external-debt obligations in 2021-2025 through a combination of sources, including bilateral, multilateral and commercial financing, but in Fitch’s view, access to such external financing options will become more challenging against the backdrop of already high debt levels and an expected further weakening of government debt dynamics. Meanwhile, Fitch believes that financing conditions for potential market issuance have tightened materially, notwithstanding the reduction in political and policy uncertainty following the completion of parliamentary elections in August 2020 and submission of the draft 2021 budget in November.

We think there are now increasing risks to Sri Lanka’s ability to meet its external-debt repayments as reflected in our forecast of a steady decline in FX reserves in 2021 and 2022. We expect Sri Lanka’s external liquidity ratio, defined as liquid external assets/external liabilities, will remain low at about 63%, against a ‘CCC’ median of about 68% in 2021.

In the 2021 budget, the authorities have planned external borrowings of project and programme loans mostly through bilateral and multilateral sources (about USD1.8 billion), as well as foreign commercial loans (about USD1.4 billion) for budget support. The authorities do not currently anticipate a financing arrangement with the IMF.

Fitch estimates Sri Lanka’s government debt to GDP ratio to increase to about 100% in 2020 from 86.8% in 2019, and to rise further under our baseline scenario to around 116% in 2024.

This trajectory is in sharp contrast to the authorities’ medium-term fiscal strategy, which envisages a reduction in the debt to GDP ratio to 75.5% in 2025 from their estimate of 95.1% in 2020. The authorities are forecasting a pick-up in revenues to 14.2% of GDP by 2025, from their estimate of 9.5% in 2020, with GDP growth picking up to 6% or higher over the medium term. They also project a primary surplus by 2025.

Our baseline projections are based on more conservative, and we believe, realistic, assumptions for economic growth, revenue and interest payments. Sri Lanka lacks a track record of sustained primary surpluses, its revenue-to-GDP ratio has stayed low and GDP growth has been weak (growth averaged 3.7% in 2015-2019). Accordingly, our baseline assumptions for 2021-2024 incorporate average annual growth of about 4%, a primary deficit of about 2% of GDP, and revenue-to-GDP of about 11%.

Sri Lanka’s 2021 budget targets a widening deficit of 8.9% of GDP, from 7.9% of GDP for 2020.

The budget contains numerous tax incentives for the agricultural sector, and policies to facilitate private investment. It also includes reforms to improve tax collection and administration, and the introduction of a special goods and services tax for alcohol, betting and gaming, telecommunication and vehicles.

In our view, the official revenue projection of nominal revenue growth of about 28% in 2021 is highly ambitious given the lack of major revenue-raising measures and the numerous tax incentives, coupled with the tax cuts announced towards end-2019. The budget also targets a large increase in spending, particularly public investment, raising it from an estimated 2.6% of GDP in 2020 to 6.1% of GDP in 2021.

In our view, the budget lacks a credible fiscal consolidation strategy and provides only limited details on the potential revenue impact of some of the measures announced, raising uncertainty about the government’s planned reduction in government debt and budget deficit. As such, we project the budget deficit to widen to about 11.5% of GDP in 2021 and 2022. This forecast is based on our GDP growth assumption of 4.9% in 2021 compared to the authorities’ 5.5%. Sri Lanka’s low revenue-to-GDP ratio has remained a key weakness in the fiscal profile and we expect it to remain below the ‘CCC’ median of 23% in 2021.

Sri Lanka’s economic performance has been affected by the COVID-19 pandemic through multiple channels, even though the virus has been relatively well contained domestically. Travel and tourism, which is an important driver of the economy has been hard hit and the outlook for its recovery remains uncertain and dependent on the evolution of the pandemic. The direct contribution of tourism to GDP is about 4%, but the indirect spill-over effect is much higher.

Private consumption, which accounts for about 70% of GDP, was weakened by the domestic lockdown in place between March and May2020. GDP contracted by 1.6% in 1Q20, and we expect an even sharper contraction in 2Q (publication of the 2Q GDP data has been delayed).
Overall, we expect GDP to contract by 6.7% in 2020 and to begin recovering in 2021 by 4.9%, partly driven by the low-base effect.

Our forecasts are subject to a high degree of uncertainty related to the path of the pandemic globally and in Sri Lanka. However, recent positive news on vaccine development initiatives has highlighted the potential for the gradual roll-out of a medical solution to the pandemic from early 2021, which could facilitate a return to economic normalisation and mitigate the downside risks to macro forecasts.

Remittances have performed unexpectedly well during the pandemic, growing by about 2.7% yoy between January-October, and have helped support the external position. However, we view this increase as temporary, due to factors such as workers repatriating their savings before returning home, and a shift towards more formal remittance channels. The stronger remittance inflows alongside a decline in imports due to various import controls, has kept Sri Lanka’s current account from deteriorating significantly in 2020. We expect the current account deficit to remain manageable at 2% -3% of GDP in 2021 and 2022 as some of those import controls are likely to remain in place.

Sri Lanka’s basic human development indicators, including education standards, are high compared with the ‘CCC’ median, based on the UN Human Development Index Score, which positions Sri Lanka in the 63rd percentile, well above the 27th percentile for the ‘CCC’ median. The country’s per capita income of USD3,775 estimated by Fitch at end-2020 is above the ‘CCC’ median of USD2,661.

The operating environment for banks in Sri Lanka remains challenging and we expect banks’ financial profiles to come under stress. The sector regulatory non-performing loan (NPL) ratio rose to 4.7% by end-2019, prior to the economic disruptions from the pandemic, and reached 5.4% by end-1H20. Underlying asset-quality stress could continue to build, despite the regulatory relief in the form of a moratorium for affected customers that has to a large extent halted the recognition of credit impairment. Sri Lankan banks could also face increased challenges in the access to – and pricing of – foreign-currency funding stemming from the deteriorating sovereign credit profile.

ESG – Governance: Sri Lanka has an ESG Relevance Score of ‘5’ for Political Stability and Rights as well as for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns.

These scores reflect the high weight that the World Bank Governance Indicators have in our proprietary Sovereign Rating Model. Sri Lanka has a medium World Bank Governance Indicator ranking in the 46th percentile, reflecting a recent record of peaceful political transitions, a moderate level of rights for participation in the political process, moderate institutional capacity, established rule of law and a moderate level of corruption.

RATING SENSITIVITIES

The main factors that could, individually or collectively, lead to positive rating action/upgrade are:
-External Finances: Improvement in external finances, supported by higher non-debt inflows or a reduction in external sovereign refinancing risks from an improved liability profile.

– Public Finances: Stronger public finances, accompanied by a sustained decline in the general government debt to GDP ratio, closer to the ‘B’ median, underpinned by a credible medium-term fiscal consolidation strategy

– Structural: Improved policy coherence and credibility, leading to more sustainable public and external finances and a reduction in the risk of debt distress

The main factors that could, individually or collectively, lead to negative rating action/downgrade:

– Increased signs of a probable default event, for instance from severe external liquidity stress, potentially reflected in an ongoing erosion of foreign exchange reserves and reduced capacity of the government to access external financing.

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  1. VELUPPILLAI Thangavelu says:

    Sri Lanka is engulfed in an ethnic crisis long after the war ended in May. 2009. Though the President is considered a technocrat who wants to modernize the economy, he cannot do it when the country is facing internal conflicts and divisions. In fact, he speaks just like a tribal leader when he says that he is the President of the majority Sinhala – Buddhists who voted for him to office. Even African tribal leaders do not speak openly in such terms. The government of Sri Lanka little realizes that it cannot make economic progress unless there is political stability. Today, the country is divided along ethnic lines pulling the country apart.

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  1. VELUPPILLAI Thangavelu says:

    Sri Lanka is engulfed in an ethnic crisis long after the war ended in May. 2009. Though the President is considered a technocrat who wants to modernize the economy, he cannot do it when the country is facing internal conflicts and divisions. In fact, he speaks just like a tribal leader when he says that he is the President of the majority Sinhala – Buddhists who voted for him to office. Even African tribal leaders do not speak openly in such terms. The government of Sri Lanka little realizes that it cannot make economic progress unless there is political stability. Today, the country is divided along ethnic lines pulling the country apart.

Sri Lanka’s banks may have to re-structure loans caught in progressive tax

ECONOMYNEXT – Sri Lanka’s banks should explore restructuring loans of salaried employees hit by progressive tax, Central Bank Governor Nandalal Weerasinghe said as progressive income taxes were imposed at lower thresholds amid high inflation following a sovereign default.

There have been complaints mainly by picketing state enterprise executives and also other workers of such agencies such Sri Lanka Port Authority that high progressive taxes were putting their bank accounts into overdraft after loan installments were cut.

“Yes, they have mentioned that,” Governor Weerasinghe said responding to questions from reporters.

“We have told the banks earlier as well. Because the interest rates are high and their business being reduced, the SME sector, the repaying capability has reduced.

“We have told them to explore their repaying capabilities and restructure their loans in order to safe guard both sides. At this time also we are asking the banks to do that.”

In the case of some state enterprises, the Pay-As-You-Earn tax, through which income tax is deducted from salaried employees in the past was not paid by the employee but the SOE.

Bad loans of the banking system overall had risen after the rupee collapsed, reducing the spending power in the economy, while rates also went up as money printing was scaled back, foreign funding stopped and the budget deficit widened.

The rate hike has prevented possible hyperinflation and a bigger implosion of the economy by stabilizing the external sector in the wake of previous mis-targeting of interest rates.

In the current currency crisis a delay in an IMF program due to China not giving debt assurances as well as fears of domestic debt re-structure has kept interest rates elevated.

Sri Lanka’s economic bureaucrats in 2020 cut taxes and also printed money, in a classic ‘Barber Boom’ style tactic implemented by UK economists and Chancellor Anthony Barber in 1971 to boost growth and employment.

The ‘Barber Boom’ ended in a currency crisis (at the time the UK did not have a floating rate and the Bretton Woods system was just starting to collapse under policies of Fed economists) and inflation of around 25 percent in the UK.

The UK implemented a three-day working week to conserve energy after stimulus while Sri Lanka saw widespread power cuts as forex shortages hit.

Read more:

Anthony Barber budget of 1971

Anthony Barber budget of 1972

Similar policies saw a worldwide revival as the US Fed economists injected money during the Covid crisis mis-using monetary policy to counter a real economic shock and boost employment while the government gave stimulus checques.

Now the world is facing an output shock as a hangover the Covid pandemic recedes.

The re-introduction of progressive tax at a maximum rate of 36 percent while tax brackets high jumped with the rupee collapsing from 200 to 360 to the US dollar had reduced disposable incomes further.

Salaries employees were encouraged to get loans in 2020 with the central bank mandating a 7 percent ceiling rate for five years.

However, any borrower who got loans on floating rates long before the scheme are now facing higher rates. (Colombo/Feb06/2023)

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Sri Lanka to address SME tax problems at first opportunity: State Minister

ECONOMYNEXT – Problems faced by Sri Lanka’s small and medium enterprises from recent tax changes will be addressed at the first opportunity, State Minister for Finance Ranjith Siyambalapitiya said.

Business chambers had raised questions about hikes in Value Added Tax, Corporate Income Tax and the Social Security Contribution Levy (SSCL) that’s been imposed.

It should be explored on how to amend the Inland Revenue Act, Siyamabalapitiya said, adding that the future months should be considered as a period where the country is being stabilized.

Both the VAT and SSCL are effectively paid by customers, but the SSCL is a cascading tax that makes running businesses difficult.

In Sri Lanka SMEs make up a large part of the economy, accounting for 80 per cent of all businesses according to according to the island’s National Human Resources and Employment Policy.

(Colombo/ Feb 05/2023)

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Sri Lanka revenues Rs158.7bn in Jan 2023 up 51-pct

ECONOMYNEXT – Sri Lanka’s government revenues were 158.7 billion rupees in January 2023 but expenditure and debt service remained high, Cabinet spokesman Minister Bandula Gunawardana said.

In January 2022 total revenues were Rs104.5 billion according to central bank data.

Sri Lanka’s tax revenues have risen sharply amid an inflationary blow off which had boosted nominal GDP while President Ranil Wickremesinghe has also raised taxes.

Departing from a previous strategy advocated by the IMF expanding the state and not cutting expenses, called revenue based fiscal consolidation, he is attempting to do classical fiscal consolidation with spending restraint.

President Ranil Wickremesinghe has presented a note to cabinet requesting state expenditure to be controlled, Gunawardana told reporters.

State Salaries cost 87.4 billion rupees.

Pensions and income supplements (Samurdhi program) were29.5 billion rupees.

Other expenses were 10.8 billion rupees.

Capital spending was   21 billion rupees.

Debt service was 377.6 billion rupees for January which has to be done with borrowings from Treasury bills, bonds and a central bank provisional advance of 100 billion rupees, Gunawardana said.

Interest costs were not separately given. (Colombo/Feb05/2023)

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