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Sunday June 20th, 2021
Economy

S&P downgrades Sri Lanka sovereign rating to ‘CCC+’, over budget, excess liquidity

ECONOMYNEXT – Standard and Poor’s, said it was downgrading Sri Lanka to ‘CCC+’ saying a high budget deficit and excess liquidity is likely put pressure on the exchange rate and make it more difficult to repay debt.

“The latest expansionary budget measures are likely to further weaken the government’s fiscal position,” the rating agency said.

“High fiscal deficits and excessive domestic liquidity will put downward pressure on the exchange rate and worsen the risks associated with the government’s already-high debt burden. ”

Sri Lanka had in the recent past had seen political infighting hurting policy predictability.

“While the current administration’s clear victory in August’s parliamentary election is likely to ease such uncertainty over policy direction, further consolidation of power in the executive may increase institutional risks,” S&P said.

“This could affect the stability of the legislature or the judiciary system, and in turn, hit policy predictability and business confidence. Social stability could also be undermined, if divisions along religious or ethnic lines persist. ”

The full statement is reproduced below:

Sri Lanka Downgraded To ‘CCC+/C’ On Increasing External Financing Risks And Fiscal Deterioration; Outlook Stable

Overview

• With the implementation of expansionary budget measures in Sri Lanka, we expect the country’s fiscal position to deteriorate materially over the next few years in the absence of favorable economic and financial conditions.

• Existing funding support from official sources do not appear sufficient to cover financing needs. This means that Sri Lanka may need external commercial funding, which can be difficult and costly.

• As a result, we are lowering our long-term sovereign credit ratings on Sri Lanka to ‘CCC+’ from ‘B-‘.

• The outlook is stable, reflecting the risks of external deterioration balanced against accommodative policies over the next 12 months.

Rating Action

On Dec. 11, 2020, S&P Global Ratings lowered its long-term foreign and local currency sovereign credit ratings on Sri Lanka to ‘CCC+’ from ‘B-‘. We also lowered our short-term foreign and local currency credit ratings to ‘C’ from ‘B’. The transfer and convertibility assessment is revised to ‘CCC+’ from ‘B-‘. The outlook is stable.

Outlook

The stable outlook reflects that, at this lower rating level, risks to Sri Lanka are relatively balanced over the next 12 months. Risk of external deterioration is partially offset by accommodative policies that are likely to boost domestic demand recovery.

Downside scenario

We could lower our ratings if external buffers decline substantially more than we currently forecast, or access to external financing proves extremely difficult. This would hurt Sri Lanka’s debt servicing capacity.

Upside scenario

We would raise the rating if external buffers can be significantly boosted, or if the economic recovery is much stronger than we expected, thus helping to improve government revenues and stabilizing debt levels.

Rationale

We lowered our ratings on Sri Lanka based on our assessment that risks to debt servicing capacity have risen, as the government’s access to external financing has become increasingly dependent on favorable business, economic, and financial conditions.

The downgrade stems in part from the impact of COVID-19, which has significantly narrowed the government’s fiscal space and its capacity to generate earnings through sectors such as tourism.

The latest expansionary budget measures are likely to further weaken the government’s fiscal position.

High fiscal deficits and excessive domestic liquidity will put downward pressure on the exchange rate and worsen the risks associated with the government’s already-high debt burden.

Our ratings on Sri Lanka reflect the country’s relatively modest income levels, weak external profile, sizable fiscal deficits, heavy government indebtedness, and hefty interest payment burdens.

Institutional and economic profile: Economy expected to contract sharply in 2020

• We expect a severe economic contraction this year as COVID-19 has devastated external demand and constrained domestic activity.

• A fresh wave of infections in October underscored the fragility of any economic revival prior to widespread availability of a vaccine.

• While parliamentary elections produced a more unified government, recent changes to the constitution will likely further concentrate powers in the president, weakening checks and balances.

Sri Lanka’s economy is suffering another major blow in 2020. Tourism and export activities declined due to COVID-19, and the recovery has been taking longer than expected. The economy entered the pandemic on a weak footing, with growth consistently languishing below potential in recent years, due to a confluence of exogenous shocks and intractable political difficulties.

We forecast the economy will contract sharply by 5.3% in 2020 largely due to the COVID-19 pandemic. Although the negative economic impact likely peaked in the second quarter of 2020, the nascent recovery was derailed by another wave of infections in early October. While the country has not reimposed stringent lockdown measures, leading indicators, including the Purchasing Managers Index, showed a sharp pullback in activity. Given that COVID-19 developments could be unpredictable, with many neighboring countries experiencing repeated waves of infections, any economic recovery before widespread availability of a vaccine is likely to be muted and prone to reversals.

Nevertheless, we believe Sri Lanka’s economy will recover in 2021, boosted by a stabilization in domestic activity and expansionary monetary and fiscal settings. External demand should also recover more strongly, particularly if tourism flows could restart.

We expect real GDP growth to accelerate to 4.3% in 2021, albeit from a low base, and average 4.5% in 2021-2023. Our estimate for real per capita income is about US$3,900 in 2021. This translates to real GDP per capita growth of 1.8% on a 10-year weighted average basis. Although this growth is in line with peers at a similar income level, it is substantially below Sri Lanka’s growth potential.

Sri Lanka’s institutional setting has been a persistent credit weakness over the past few years. Frequent political infighting and at-times unpredictable developments have hindered policy predictability and weighed on business confidence, in our view.

While the current administration’s clear victory in August’s parliamentary election is likely to ease such uncertainty over policy direction, further consolidation of power in the executive may increase institutional risks.

This could affect the stability of the legislature or the judiciary system, and in turn, hit policy predictability and business confidence. Social stability could also be undermined, if divisions along religious or ethnic lines persist.

S&P Global Ratings believes evolution of the coronavirus pandemic remains highly uncertain. Reports of vaccines that are highly effective gaining approval in more countries are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunization, which could come by the middle of next year.

We use this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Flexibility and performance profile: Fiscal position has deteriorated further and risk over debt sustainability has increased

• Sri Lanka’s fiscal deficit is likely to remain elevated due to medium-term measures announced in the budget.

• This will likely worsen the government’s heavy indebtedness and add to repayment burden.

• 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 government’s heavy debt limits its ability to accumulate policy buffers, which are crucial in times of stress.

COVID-19 has further devastated government finances by dampening domestic economic activity and lowering excise duty earnings. Instead of one-off measures to counter the economic impact of COVID-19, the expansionary measures introduced in the Sri Lanka’s 2021 budget are likely to increase the deficit for an extended period, in our view.

In the latest budget, the government has committed to keeping the wide-ranging tax cuts, including a lower value-added tax (VAT) rate, increasing the VAT turnover threshold and removing the 2% Nation Building Tax, for five years.

In addition, the government also plans to provide various tax exemptions and incentives to boost domestic production and encourage import substitution.

In the absence of extremely favorable economic and financial conditions, these measures are expected to constrain revenue growth and could only be partially offset by new revenue measures, such as the Special Goods and Services Tax.

On the expenditure front, the government is planning to significantly ramp up infrastructure spending over the next few years. While recurrent expenditure will be relatively contained, room for further cuts is limited due to the high interest burden. Healthcare and security-related spending may also increase fiscal pressure.

We expect the fiscal deficit to remain elevated at 10.2% of GDP in 2021 and narrow gradually to 8.4% in 2023.

A high portion of Sri Lanka’s government debt is denominated in foreign currency, and the country’s exchange rate may weaken further. Higher fiscal deficits over a longer period will add to the government’s extremely high debt stock. For those reasons, we expect the increase in net general government debt to average 11% over 2020-2023. By our estimate, net general government debt will exceed 100% of GDP in 2021 and remain elevated over the next five years.

The government intends to increase the share of domestic financing to fund the fiscal deficit. At the same time, domestic interest rates have been kept extremely low through massive liquidity injection by the central bank. This has reduced the effective interest rate on the government’s domestic debt. We estimate interest payments to reach 60% of government revenues in 2020, slightly lower than what we expected previously. Nevertheless, this is one of the highest ratios among the sovereigns we rate.

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

Although CPC and CEB have improved 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, Sri Lanka’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 country’s external position has deteriorated compared with our last review due to current account receipts declining more than we had expected. However, lower oil prices and wide-ranging import restrictions imposed by the government have also kept the import bill under control. We estimate the current account deficit will widen marginally to 2.7% of GDP in 2020.

Sri Lanka’s external liquidity, as measured by gross external financing needs as a percentage of current account receipts (CAR) plus usable reserves, is projected to average 117% 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 206% in 2020, partly due to poor export earnings.

The government’s external financing conditions have become more challenging, and uncertainty over access to official creditors has increased, in our view. The government has received US$500 million in official loans for budgetary support so far this year. Credit lines with other central banks have also helped to augment foreign exchange reserves to some extent.

However, we see increasing indications that funding from multilateral or bilateral partners will not be sufficient to cover external financing needs over the next 12 months. The government has had to repeatedly draw on reserves to meet its external debt obligations.

As of end-October 2020, foreign exchange reserves stood at US$5.9 billion, down from US$7.6 billion at the start of the year. This might be enough to cover maturities over the next 12 months, but it would bring reserves down to a dangerously low level.

If economic and financial conditions turn even more negative, we believe the government’s external debt-servicing capacity could be severely impaired.

Sri Lanka’s monetary settings remain a credit weakness, although it has seen some structural improvements in recent years. The Central Bank of Sri Lanka is preparing 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.

Environmental, social, and governance (ESG) credit factors for this credit rating change:
• Health and safety

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