Sri Lanka downgraded by S&P to B on political crisis
ECONOMYNEXT – Standard and Poor’s has downgraded Sri Lanka’s speculative B+ rating to B, saying external conditions had weakened by Ranil Wickremesinghe being sacked as Prime Minister and a disputed administration installed.
"There has been a significant erosion in Sri Lanka’s political settings following the dismissal of Prime Minister Wickremesinghe on Oct. 26, 2018, and the ensuing installation of a new de facto government," S and P said.
"We lowered our rating on Sri Lanka based on our assessment that the current political standoff has weakened the sovereign’s external financing conditions and reduced the likelihood that further reforms will improve Sri Lanka’s macroeconomic fundamentals and institutionalize sustainable policy frameworks over the next 12-18 months."
— There has been a significant erosion in Sri Lanka’s political settings
following the dismissal of Prime Minister Wickremesinghe on Oct. 26, 2018, and
the ensuing installation of a new de facto government. We expect political
uncertainty to persist over the medium term and important structural reforms
envisaged under the International Monetary Fund (IMF) Extended Fund Facility
(EFF) may face delays.
— Sri Lanka’s external position has weakened, reflecting deteriorating
external financing conditions as a weak rupee and high yields constrain the
government’s access to capital markets.
— We are lowering our long-term sovereign credit rating on Sri Lanka to
‘B’ from ‘B+’ on reduced prospects of reform under the fractious political
environment. We are also affirming the short-term rating at ‘B’.
— The outlook is stable, reflecting our view that a modest economic
recovery is still likely despite the political standoff and the ability of the
government to obtain official funding from bilateral and multilateral
On Dec. 4, 2018, S&P Global Ratings lowered its long-term sovereign credit
rating on Sri Lanka to ‘B’ from ‘B+’. We also revised down our transfer and
convertibility risk assessment on Sri Lanka to ‘B’ from ‘B+’. At the same
time, we affirmed the short-term rating at ‘B’. The outlook on the long-term
rating is stable.
We lowered our rating on Sri Lanka based on our assessment that the current
political standoff has weakened the sovereign’s external financing conditions
and reduced the likelihood that further reforms will improve Sri Lanka’s
macroeconomic fundamentals and institutionalize sustainable policy frameworks
over the next 12-18 months.
The stable outlook reflects our view that the Sri Lanka economy will continue
its cyclical recovery over the next 12 months as the effects from
weather-related disruptions dissipate. This also takes into account our
expectation for the government to meet its upcoming debt redemptions in 2019.
We could lower our ratings further if the fiscal policy path deviates
significantly from our current projections, leading to a more rapid increase
in net general government debt. This could further lower confidence and affect
the government’s access to external financing. If the political standoff
results in significant disruptions to economic performance, such that the
medium-term growth forecast is lowered substantially, we could also lower our
Conversely, we could raise our ratings if the political environment recovers
substantially, allowing for more predictable adoption and implementation of
important reforms. We could also raise our ratings in the event that economic
growth significantly outperforms expectations, supporting a sustained
improvement in other key metrics.
In our view, Sri Lanka’s policymaking environment has eroded after the
dismissal of Prime Minister Ranil Wickremesinghe in October. Deep divisions
between political factions have weakened the government’s ability to adopt and
implement key policies.
We believe the fractious policymaking environment will
persist, even if the current political standoff ends. This means that the
legislative process for structural reform, including the institutionalization
of an amended fiscal rule, the formulation of a medium-term debt management
plan, and sustained energy subsidies reform, may slow even further.
Nevertheless, we believe the Sri Lankan economy will continue to recover
modestly, following substantial weather-related disruptions in 2016-2017.
However, the pace of recovery is likely to be affected by the heightened
political uncertainty. In particular, foreign direct investment into Sri Lanka
will probably be hindered.
Institutional and Economic Profile: Political standoff increased policy and
— Disruptions following the sacking of the prime minister have increased
policy uncertainty and undermined the reform agenda championed by the previous
— The current political standoff underscores the fragility of Sri
Lanka’s institutional profile despite progress in passing the Inland Revenue
Act (IRA) and other reform measures over the past few years.
— Sri Lanka’s lower-middle income level also remains a rating
The surprise dismissal of the prime minister, the subsequent appointment of a
new cabinet by the president, and collapse of the ruling coalition have
ignited turmoil in the country and sparked widespread protests against and in
support of the appointed prime minister, Mahinda Rajapaksa.
Political uncertainty has escalated dramatically with separate political factions laying
claim to different parts of the government. Opponents of the president have
rejected the new prime minister and cabinet appointments, while supporters
have rejected the Parliament’s no-confidence motions against Rajapaksa.
The government has been generally unable to adopt and pass measures since the
onset of the political crisis, and the willingness and ability to implement
economic policy is curtailed.
The highly polarized political landscape underscores the weakness of Sri
Lanka’s institutional settings, which remains a constraint on ratings. The
current crisis has exposed several weaknesses and gaps in the country’s legal
and institutional framework. We believe the political uncertainty will persist
for some time because there is currently no consensus on major decisions taken
by key political leaders.
Deep-rooted divisions among the different political factions imply that any
new coalition government formed by the existing political parties will have a
fractious working relationship. This will complicate the process in passing
difficult reforms, such as those on fiscal rule and energy subsidies, and
legislative changes to strengthen the constitutional and legal frameworks.
Sri Lanka’s growth outlook fares slightly better than its political outlook,
though not strong enough to differentiate the economy from those of other
sovereigns at a similar level of development. After two years of slow growth
stemming from largely weather-related disruptions to the agriculture sector,
the economy should see some cyclical recovery driven by agricultural output
and stable performances in the specialized garment industry, where Sri Lanka
has some comparative advantage. Tourism, a growing sector in Sri Lanka, is
likely to contribute further to export earnings.
We estimate real per capita income to reach US$4,046 in 2018, with real GDP
growth averaging 4.3% in 2018-2021. This translates to 3.6% growth in real GDP
per capita over the same period. However, the political situation could dampen
this projected growth trajectory significantly, because the uncertainty and
security risks are likely to weigh on business investment and tourism
Flexibility and Performance Profile: External metrics have deteriorated and
risks to fiscal performance have intensified
— Sri Lanka’s external position has declined, given the weak rupee and
rising bond yields have reduced the government’s ability to access
international capital markets.
— We expect fiscal consolidation to be maintained, but the pace may slow
despite modest revenue boost from the IRA. Debt stock and interest servicing
costs remain very high, and will continue to constrain the ratings.
— Institutional capacity at the central bank is improving. Nevertheless,
the central bank is coming under increasing strains due to limited reserves
and exchange rate pressures.
Persistent deficits in Sri Lanka’s fiscal and external positions have been
rating constraints. The general government’s high debt limits its ability to
accumulate policy buffers, which are crucial in times of stress. The
government’s external position has weakened further over the past year.
Additionally, yields on dollar-denominated sovereign bonds have surged by
approximately 200 basis points since July, reflecting a marked deterioration
in the government’s ability to access affordable external financing,
particularly through commercial means.
The Sri Lankan rupee has depreciated significantly in the second half of 2018,
initially due to contagion effects from the global emerging market rout. This
was exacerbated by the political uncertainty following the prime minister’s
sacking. With more than 40% of public debt denominated in foreign currency,
the external position is sensitive to further adverse exchange rate movements.
We forecast the current account deficit to reach 2.9% of GDP in 2018, similar
to 2017. The recovery in agricultural exports has been offset by a higher
import bill associated with higher oil prices and automobile imports. We
expect the deficit to narrow slightly until 2021, particularly if remittances
from Sri Lankans living in the Gulf States improve due to strong oil-related
income. Risks to this outlook are mainly on the downside, as services exports
could underperform if the political volatility persists and security concerns
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 average 120% over 2018-2021. Improvements to this trajectory are
limited due to the pressure on the currency. We also forecast that Sri Lanka’s
external debt (net of official reserves and financial sector external assets)
will average 157% of CAR from 2018-2021, a deterioration from 143% in 2017.
In our baseline scenario, we believe the Sri Lanka government will continue on
a fiscal consolidation path. However, the pace of consolidation may be slower
than previously envisaged under the Fourth Review of the IMF Program. The
passage of the IRA in April 2018 has been an important reform achievement for
the government; we expect this to provide a structural boost to government
revenues starting 2019 due to the gradual broadening of the tax base and
increased tax compliance. We forecast the annual growth in net general
government debt to average 5.7% of GDP for 2018-2021.
The pace of reducing the government’s high debt stock is likely to be slow,
given the high servicing costs and weaker projections for fiscal
consolidation. However, as the government has limited recourse to
international capital markets, the funds needed to meet its substantial
upcoming debt redemptions in 2019 will likely come from bilateral and
multilateral sources, or the central bank’s foreign reserves, as a last
resort. We estimate net general government debt to reach 78% of GDP in 2018.
This will only decline to 73% in 2021, in our view. Meanwhile, we project that
general government interest expenditures will account for 38% of government
revenues in 2018. This is the third-highest ratio among the sovereigns we
currently rate, trailing only Lebanon and Egypt. We expect this ratio to fall
to 32% in 2021.
The current political standoff poses a significant challenge to this projected
fiscal trajectory. Part of the uncertainty could be alleviated by the
conclusion of the Fifth Review of the IMF Program, which will also unlock
another tranche of the IMF EFF disbursements (about US$252 million), easing
some of the near-term external liquidity pressures. If the fiscal policy
trajectory deviates significantly from our current forecasts, such that the
change in net general government debt accelerates, this could exert further
downward pressure on the ratings.
We assess the government’s contingent liabilities from state-owned enterprises
and its relatively small financial system as limited, but risks are rising.
The approval of an automatic fuel pricing formula is an important plank in
energy subsidies reform to reduce fiscal risks from the Ceylon Petroleum Corp.
and Ceylon Electricity Board, which are key state-owned enterprises. However,
the effectiveness of this formula in generating fiscal savings depends on the
passage of an automatic formula on electricity pricing as well. Without this
second step in energy subsidies reform, the risks to the financial
sustainability of Ceylon Electricity Board could intensify and increase the
burden on the government’s resources. At the same time, the national 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%.