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Sri Lanka sovereign rating downgraded on fiscal stimulus, import controls, Covid hit by S&P

ECONOMYNEXT – Standard and Poor’s has downgraded Sri Lanka’s sovereign rating to ‘B-‘ as tax cuts made in January in ‘fiscal stimulus’ which were further worsened by import controls, raising doubts about budget and debt repayment ability as a Coronavirus crisis slowed growth.

The outlook at the lower level is ‘stable’.

“We expect the COVID-19 outbreak to push Sri Lanka’s economy into a recession in 2020, against earlier expectations of a rebound,” S & P said.

“This would weaken Sri Lanka’s already-fragile fiscal position.”

Some progress in government budget had been made under an International Monetary Fund program but the process had been hampered recently.

Instead of waiting for a cyclical recovery to take place after a currency collapse in 2018, Sri Lanka slashed taxes from January in fiscal ‘stimulus’

In Sri Lanka the economy bounces back from a currency collapse induced credit and consumption contraction between 18 to 22 months, analysts who have studied the economy closely have found.

Rates were cut were also made in January despite a widening fiscal deficit.

Large volumes of money were ‘helicopter dropped’ in the banking system to enforce the lower rates in a monetary ‘stimulus’ despite the country having a pegged monetary regime with low credibility.

“We lowered our ratings on Sri Lanka based on our assessment that the country’s fiscal position has weakened substantially amid a COVID-19-induced recession,” the rating agency said.

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“With fiscal space already limited by the wide-ranging tax cuts announced at the end of last year, this deterioration will worsen the risks associated with Sri Lanka’s government debt burden, in our view.”

“With COVID-19 dampening domestic economic activity and lower excise duty earnings due to broad import restrictions, we now expect that government revenues will decline to below 10 percent of GDP in 2020.”

Sri Lanka’s central bank cut rates and printed money in March amid a private credit pick up triggering a run on the rupee which fell to 200 to the US dollar from 182, and then slapped import controls.

There is a persistent belief in Sri Lanka that monetary instability is related to imports, and not money and credit.

However there has been a consumption fall amid curfews and private credit is expected to be low, which will reduce pressure on the currency, analysts say unless the government spends large volumes of printed money overtaking the private credit slowdown as the deficit rises.

S & P said it is keeping the outlook at the lower rating level stable as it expected bilateral financing to come in.

“The stable outlook reflects our expectation that the government still has access to various multilateral and bilateral resources that could augment their foreign exchange reserves to meet immediate debt obligations,” the agency said.

S&P said the impact of Coronavirus in Sri Lanka was uncertain though numbers were still low compared to other countries.

“While Sri Lanka’s number of COVID-19 cases, as measured by official statistics, remain lower than many other countries in the region, and containment measures are being eased, it remains difficult to predict the trajectory of the pandemic,” the rating agency said.

“This creates substantial near-term economic risks.”

Sri Lanka however has been aggressively contact tracing and quarantining, though there has been gaps in testing which has led to spike in cases and missing asymptomatic patients.

The test denials have been gradually relaxed.

Some observers say Sri Lanka is ahead of many countries in its battle against the virus and is not far behind Vietnam, which is the global leader in containing the virus. Vietnam has some risks of illegal crossings from Cambodia and Laos.

Sri Lanka is gradually relaxing controls though authorities are still watching the Western province, where in Colombo in particular there is high population density.

Delaying elections would also create more uncertainty the rating agency said.

The full statement is reproduced below:

Sri Lanka Rating Lowered To ‘B-‘ On COVID-19-Induced Fiscal Deterioration; Outlook Stable

Overview

We expect the COVID-19 outbreak to push Sri Lanka’s economy into a recession in 2020, against earlier expectations of a rebound. This would weaken Sri Lanka’s already-fragile fiscal position.

Uncertainty over the pandemic and the associated economic fallout have increased Sri Lanka’s external financing risks.

We are lowering our long-term sovereign credit ratings on Sri Lanka to ‘B-‘ from ‘B’ to reflect the fiscal deterioration, which would further weaken the sustainability of Sri Lanka’s debt profile.

The stable outlook reflects our expectation that the government still has access to various multilateral and bilateral resources that could augment their foreign exchange reserves to meet immediate debt obligations.

Rating Action

On May 20, 2020, S&P Global Ratings lowered its long-term foreign and local currency sovereign credit ratings on Sri Lanka to ‘B-‘ from ‘B’.

We affirmed our short-term foreign and local currency credit ratings at ‘B’. The transfer and convertibility assessment is revised to ‘B-‘ from ‘B’. The outlook is stable.

Outlook

The stable outlook reflects our view that Sri Lanka still has access to sufficient resources, including from multilateral and bilateral partners, to meet its debt obligations over the next 12 months.

Downside scenario

We could lower our ratings if we believe that multilateral and bilateral support will not be forthcoming and if external imbalances deteriorate beyond our expectations, leading to a sustained decline in foreign exchange reserves. These could cast doubt on Sri Lanka’s ability to service its debt.

Upside scenario

We would consider raising the rating if we see credible improvements in the fiscal and debt metrics on a sustained basis.

Rationale

We lowered our ratings on Sri Lanka based on our assessment that the country’s fiscal position has weakened substantially amid a COVID-19-induced recession. With fiscal space already limited by the wide-ranging tax cuts announced at the end of last year, this deterioration will worsen the risks associated with Sri Lanka’s government debt burden, in our view.

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

Institutional and economic profile: Economy pushed into recession by COVID-19 while delayed elections increase political uncertainty

Economy likely to be heavily impacted as tourism and some export sectors temporarily grind to a halt amid COVID-19 outbreak, while curfews and containment measures weigh on domestic activity.

Barring further unforeseen shocks, we expect the economy to recover from 2021 onwards

Delays in parliamentary elections likely to prolong political uncertainty, in our view.

Sri Lanka’s economy is suffering another major blow in 2020, as tourism and export activities declined due to COVID-19, against earlier expectations of a strong rebound.

The economy entered the pandemic on a relatively weak footing, as growth has been consistently languishing below potential in recent years, due to a confluence of exogenous shocks and intractable political difficulties.

After a brisk uptick in the first quarter of 2019, economic growth was again derailed after the Easter Sunday attacks.

Meanwhile, expanding fiscal deficits, rising external vulnerabilities, a large debt stock, and ballooning interest servicing cost eroded policy buffers and reduced fiscal capacity to further support a slowing economy.

Barring further unforeseeable exogenous shocks, we forecast the economy to contract by 0.3% in 2020, recording its lowest rate of growth since the civil war ended.

We assume the negative economic impact to peak in Q2-Q3 2020 and activity to gradually normalize towards the end of the year. We expect growth to rebound to 4.6% in 2021 from a low base.

This is expected to be supported by expansionary fiscal and monetary settings, recovering external conditions, and the resolution of political uncertainty following parliamentary elections later this year.

While Sri Lanka’s number of COVID-19 cases, as measured by official statistics, remain lower than many other countries in the region, and containment measures are being eased, it remains difficult to predict the trajectory of the pandemic. This creates substantial near-term economic risks.

In particular, the tourism sector, which has boomed in recent years, might take longer to recover as travelers could remain cautious prior to the development of a lasting medical intervention. A shallower and more protracted global recovery could also reduce external demand for exports.

Meanwhile, the delay in parliamentary elections from the scheduled date in April due to the onset of the pandemic could open up fresh political uncertainty and test the resilience of institutions, in our view.

Persistent political infighting in recent years has hindered policy predictability and weighed on business confidence, investment plans, and overall growth prospects, in our view. A smooth resolution of this political risk is crucial in bringing forward the economic recovery.

We estimate real per capita income to reach about US$4,000 in 2021 and real GDP growth to average 3.3% in 2020-2023. This translates to real GDP per capita growth of 2.5% on a 10-year weighted average basis. Although this growth rate is in line with peers at a similar income level, it is substantially below Sri Lanka’s growth potential.

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

Sri Lanka’s fiscal deficit is expected to widen further due to revenue shortfalls as COVID-19 dampens economic activity.

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

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 heavy government debt limits its ability to accumulate policy buffers, which are crucial in times of stress. While some progress toward fiscal consolidation has been achieved under the IMF Extended Fund Facility (EFF) program that started in 2016, recent events have severely hampered such progress.

The government’s fiscal position weakened in 2019 as the Easter Sunday attacks stymied economic activity and reduced tourism earnings. Government revenue growth came in significantly below expectations while expenditure also increased due to higher security-related and election spending.

The wide-ranging tax cuts announced by the government following the presidential elections in 2019 is expected to extend this one-off underperformance on both the revenue and expenditure fronts. We expected the main components of the tax cuts, including lowering the value-added tax (VAT) rate, increasing the VAT turnover threshold and removing the 2% Nation Building Tax, to reduce revenue earnings.

However, we had also expected that a much stronger rate of growth could help to offset some of the revenue slippages.

With COVID-19 dampening domestic economic activity and lower excise duty earnings due to broad import restrictions, we now expect that government revenues will decline to below 10% of GDP in 2020.

Meanwhile, expenditure could be relatively contained this year as the government is operating on an interim budget with no new expenditure items for the first half of the year. Disbursements are also likely to be slower due to curfews and disruptions to economic activities. The stimulus measures to support the economy thus far have been relatively targeted and restrained, reflecting in part the limited fiscal space. The burden to support the economy has fallen mostly on the central bank, which has reduced policy rates by 150 basis points this year, drastically increased liquidity in the banking system and relaxed some prudential measures for banks.

This would widen the fiscal deficit to 8% in 2020 from 6.8% in 2019. Factoring in adverse exchange rate movements, we estimate the change in net general government debt will exceed 9% in 2020. Based on our expectations of a growth rebound next year, we estimate that the fiscal deficit will narrow marginally from 2021 onward, but will remain high in the absence of new revenue measures.

A much weaker fiscal position will add to the government’s extremely high debt stock. We expect net general government debt to exceed 90% of GDP in 2020 and remain at an elevated level, depending on the new government’s budget and medium-term fiscal plans. Meanwhile, interest burden has also increased due to adverse currency movements and a smaller revenue base. We estimate interest payment to reach 67.2% of revenues in 2020. This is the second-highest ratio among the sovereigns we currently rate, trailing only Lebanon.

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 the sustained losses at the Ceylon Petroleum Corp. (CPC), Ceylon Electricity Board (CEB) and the Sri Lankan Airlines (SLA). While CPC and CEB have recorded improvements in 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, the country’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 external position has also deteriorated from the time of our last review. Following an improvement in 2019, we expect the current account deficit to widen to 3.4% of GDP in 2020 due to weak external demand for both goods and services.

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 115% 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 195% in 2020, in part due to poor export earnings.

The government’s external financing conditions also remain challenging, in our view. With 50% of total public debt denominated in foreign currency, the external position is vulnerable to adverse exchange rate movements, and shifts in global credit conditions. Both conditions have materialized in recent months and have resulted in a sharp deterioration in the government’s ability to access the international capital markets.

However, at the moment, we believe that the government has sufficient funds to cover its external debt obligations over the next 12 months. As of end-April 2020, foreign exchange reserves stood at US$7.1 billion. We expect that assistance and additional credit lines from multilateral and bilateral sources could help to augment the central bank’s resources.

Sri Lanka’s monetary settings remain a credit weakness, although there have been some structural improvements in recent years, as the Central Bank of Sri Lanka prepares 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) factors relevant to the rating action:

Health and safety

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