Sri Lanka polls worsen policy uncertainty, stimulus may widen deficits: Fitch

ECONOMYNEXT – Sri Lanka’s recent elections may worsen policy uncertainty and ambitious growth targets may widen deficits with stimulus, amid planned tax cuts which may reduce revenues, Fitch, a rating agency has warned.

President Gotabaya Rajapaksa’s economic manifesto had targeted an average growth rate of 6.5 percent or higher and promoting commodity and apparel exports, construction and tourism.

“Strengthening growth and exports would be credit positive, but we think there is a risk of a more expansionary fiscal stance after the parliamentary elections,” Fitch ratings said.

“Although detailed economic plans are yet to be announced, we think achieving ambitious growth targets could entail stimulus measures that erode fiscal headroom, which is limited by high public debt (about 83% of GDP).

“This could undermine policy credibility, investor confidence, and potentially complicate relations with the IMF.”

Fitch says the manifesto does not suggest undermining monetary policy credibility, Fitch said.

“An important measure of this commitment will be the status of a planned amendment to the Monetary Law Act, which would establish price stability as the central bank’s primary objective and support the shift towards flexible inflation targeting,” Fitch Ratings said.

However other analysts have shown that monetary instability coming from an unusually unstable soft-peg labeled the ‘flexible exchange rate’ was the key driver of macro-economic instability in the past four years, despite tax increase, market pricing fuel and narrower deficits.

In all unstable developing countries, Latin America, Turkey and oil producing countries such as Iran, soft-pegs are the primary drivers of macro-economic instability.

The draw law does not plan to end fiscal dominance of monetary policy or end the money nor the money-exchange policy contradictions in the ‘flexible exchange rate’ that triggers currency crises as soon as private credit recovers, analysts say.

Gotabaya Rajapaksa’s commitments on social spending and public-sector wages and pensions could jeopardise deficit reduction unless government revenue, which is low at just over 13 percent of GDP increases.

Rajapaksa’s manifesto plans to replace the Inland Revenue Act, unify VAT at 8 percent and cap personal income tax at 15 percent.

“If these lead to revenue losses, they could put Sri Lanka’s medium-term fiscal consolidation plan at risk,” the rating agency said.

“A 4 percent deficit may therefore prove challenging. We forecast the deficit to stabilise at about 5 percent of GDP in 2020-2021, as GDP growth recovers from the April bombings in Colombo.”

“Contingent liabilities from major state-owned enterprises (SOEs) pose risks to debt sustainability.”

“Gotabaya Rajapaksa’s manifesto says that SOEs will not be ‘a burden to the exchequer’ but SOE reform has been difficult to achieve.”

A high share of foreign debt could also pressure debt sustainability, Fitch said.

“The market reaction to the election has been mildly positive,” the agency said. “The Sri Lankan currency has appreciated by about 0.5 percent against the dollar and the Colombo stock index rose by about 2 percent.”

“A row-back on reforms could have implications for Sri Lanka’s IMF programme, which has been extended to June 2020.”