Sri Lanka’s rating outlook upgraded to ‘Stable’ by S & P
ECONOMYNEXT – Standard and Poor’s, has lifted the outlook on Sri Lanka’s ‘B+’ rating to ‘stable’ from ‘negative’ as the country raised taxes to pay for salary and subsidy hikes in 2015, leaving behind a balance of payments crisis.
"The stable outlook reflects our expectation that the government will maintain the reform momentum over the next 12 months and smooth the upcoming surge in debt redemptions, particularly in 2019," the rating agency said.
Sri Lanka is to pass a new law to raise more debt to repay some debt, amid much fanfare about ‘bunching’, despite having a mechanism to repay debt with forex reserves, without harming the domestic money supply (monetary policy neutral).
The outlook upgrade however will make it easier and cheaper for Sri Lanka to raise debt in the near term, amid the possibility of a rise in benchmark, dollar yields.
Central Bank Governor Indrajit Coomaraswamy has said he wanted to implement policies that strengthen confidence will compress the risk premium in the future.
Coomaraswamy has brought credibility back to the central bank and has stopped printing money, and is now sterilizing forex purchasing, putting strong upward pressure on the currency to contain inflation.
But analysts have warned that a policy of targeting a real effective exchange rate by weakening the nominal exchange rate could generate higher inflation in the country.
In 2017 also the ‘mid-single digit’ de facto inflation target is expected to be overshot.
"A higher rating is unlikely in the next 12 months, but upward pressure could coalesce if Sri Lanka’s external and fiscal indicators show dramatic improvement," S&P said in a statement.
"Upside pressure could also materialize if we conclude that there has been a substantive improvement in Sri Lanka’s institutional settings, including a continued strengthening of monetary policy credibility and independence at the central bank."
"Downward pressure on the rating could materialize if the political environment were to become more fractious, derailing the legislative program, especially its liability management reform."
S&P said despite a coalition government, an inland revenue law and other reforms were taking place and an International Monetary Fund deal was also in place.
The full statement is reproduced below:
• The Sri Lankan government has maintained its reform momentum, as shown by
the passage of the Inland Revenue Act.
• We expect the government to implement additional measures to smooth the
approaching debt redemption spike in 2019.
• We are therefore revising our outlook on Sri Lanka to stable from
negative and affirming our ‘B+/B’ sovereign credit ratings on Sri Lanka.
• The stable outlook reflects our expectation that the government will
maintain the reform momentum over the next 12 months and smooth the
upcoming surge in debt redemptions, particularly in 2019.
On Nov. 20, 2017, S&P Global Ratings revised its outlook on the Democratic
Socialist Republic of Sri Lanka to stable from negative. At the same time, we
affirmed our ‘B+’ long-term and ‘B’ short-term sovereign credit ratings on Sri
Lanka. We also left our transfer and convertibility risk assessment on Sri
Lanka unchanged at ‘B+’.
The stable outlook reflects our expectation that the government will maintain
the reform momentum over the next 12 months and smooth the upcoming surge in
debt redemptions, particularly in 2019.
Downward pressure on the rating could materialize if the political environment
were to become more fractious, derailing the legislative program, especially
its liability management reform.
A higher rating is unlikely in the next 12 months, but upward pressure could
coalesce if Sri Lanka’s external and fiscal indicators show dramatic
improvement. Upside pressure could also materialize if we conclude that there
has been a substantive improvement in Sri Lanka’s institutional settings,
including a continued strengthening of monetary policy credibility and
independence at the central bank.
We revised the outlook to stable based on our assessment that the nascent
strengthening of Sri Lanka’s institutions and governance practices is on a
more sustainable footing. This assessment is predicated on not only the
passage of the Inland Revenue Act (IRA) in September 2017, but also on the
expected adoption of further reforms over the next 12-18 months. This includes
the passage of the Liability Management Act, which would allow the government
to proactively address rising sovereign debt maturities in 2019.
These positive developments are balanced by ongoing rating constraints, which
include high external and net general government indebtedness. With GDP per
capita estimated to reach approximately US$4,000 by the end of 2017, Sri
Lanka’s economic assessment also represents a rating weakness. This rating
constraint weighs against Sri Lanka’s sound growth potential, supported by
competitiveness in the garment, tourism, and business process outsourcing
Although we believe reform momentum is improving, we continue to observe
significant challenges to the policymaking environment owing to legacy
institutional constraints and a fragmented political landscape. Therefore, Sri
Lanka’s institutional assessment remains a weakness.
INSTITUTIONAL AND ECONOMIC PROFILE: REFORMS MARK IMPROVING TREND IN GOVERNANCE
• The Inland Revenue Act marks a continuation of reform momentum. We expect
further positive reforms to materialize over the next 12-18 months.
• Nevertheless, Sri Lanka continues to face impediments to institutional
• Sri Lanka’s relatively low income level remains a rating constraint.
Sri Lanka’s coalition government has made progress on economic reforms over
the past six months. Most notably, the IRA highlights the government’s
continued adherence to the International Monetary Fund (IMF) reform program,
and proves its ability to pass controversial reforms despite a fractious
parliamentary landscape. The passage of the IRA also goes to the core of Sri
Lanka’s fiscal challenge–it collects little tax.
Deeply rooted factionalism remains a constraint for Sri Lanka’s institutional
assessment, because we believe it hinders the government’s ability to more
effectively address the economy’s imbalances. This, in turn, weighs on
business confidence, investment plans, and overall growth prospects; the
correlation between these conditions and the relative underperformance of the
economy has been evident since 2015. That said, the government has proven
itself willing and capable of adopting potentially painful reforms in the wake
of more fiscally liberal regimes.
As we have noted previously, we believe the Central Bank of Sri Lanka’s (CBSL)
ability to sustain economic growth while attenuating economic or financial
shocks continues to improve. The central bank is building a record of
credibility, shown in reducing inflation through using market-based
instruments to conduct monetary policy and the planned introduction of an
inflation-targeting regime. However, we do not consider the central bank to be
independent of other policymaking institutions.
Sri Lanka’s growth outlook is robust, though not strong enough to
differentiate the economy from those of other sovereigns at a similar level of
development. Growth should be underpinned by rising tourist arrivals, a
uniquely specialized garment sector, strong potential in business process
outsourcing, and moderate inflation, which we expect to remain in the single
digits. We believe Sri Lanka will most likely maintain real per capita GDP
growth of 4.2% per year over 2017-2020 (equivalent to 4.9% real GDP growth).
Stronger growth, in our view, would require improved institutional settings
and a pickup in export markets.
FLEXIBILITY AND PERFORMANCE PROFILE: EXTERNAL METRICS STABILIZE, WHILE FISCAL PERFORMANCE GRADUALLY IMPROVES
• Sri Lanka’s external liquidity and debt ratios have stabilized. However,
the country’s external debt remains high.
• Sri Lanka’s debt stock and servicing costs remain very high. However, the
trend in debt accumulation is improving, with annual deficits narrowing.
• Because most public debt is denominated in foreign currency, the external
debt-to-GDP ratio is highly sensitive to the exchange rate.
• The trend is positive for Sri Lanka’s monetary assessment, with improving
institutional capacity at the central bank.
Although the fiscal trajectory suggests a decline in the government’s debt
stock relative to GDP, there are risks to this expectation. In particular,
more than 40% of Sri Lanka’s high stock of central government debt is
denominated in foreign currency. Our base-case scenario envisages a gradual
depreciation of the Sri Lankan rupee versus the U.S. dollar; a more aggressive
weakening of the rupee would cause debt metrics to underperform our forecasts.
Although the central bank has shown an increased willingness to allow
flexibility in the Sri Lankan rupee, we expect policymakers to focus on
exchange rate stability, in view of the proportion of foreign
currency-denominated debt dynamics. If Sri Lanka’s public debt were all
denominated in its own currency, this would not be a rating constraint.
Sri Lanka’s external liquidity position continues to stabilize, and we view
the ongoing IMF program as supportive toward this trend. However, the
country’s external metrics are still beset with the following weaknesses:
• We forecast the current account deficit to amount to 2.9% of GDP in 2017,
a slight deterioration from an estimated 2.4% in 2016. The decline is
largely due to unusually poor weather conditions, which gave rise to
higher agricultural imports. We believe the trend will reverse in 2018.
• Although remittances have historically supported the current account
position, inflows have been somewhat weaker so far in 2017, owing to
strong dependence on transfers from Gulf states. We forecast only modest
growth in net transfers even if rising oil prices limit downside risk to
• Sri Lanka’s external sovereign debt maturities will rise considerably in
2019. This will put pressure on government and external accounts, in the
absence of proactive liability management.
We expect external liquidity (measured by gross external financing needs as a
percentage of current account receipts [CAR] plus usable reserves) to average
124% over 2017-2020, compared with 121% in 2015-2016. We also forecast that
the country’s external debt (net of official reserves and financial sector
external assets) will average 146% of CAR from 2017-2020, a slight
deterioration from 142% in 2016.
External liquidity support from the IMF has eased near-term pressures, but
structural measures will be needed to address Sri Lanka’s external
vulnerabilities over the long run. Although these risks could be further
mitigated by allowing the Sri Lankan rupee to float more freely, it would
worsen Sri Lanka’s external debt metrics.
Nevertheless, greater tolerance for a weaker rupee from the CBSL would
theoretically allow for a more rapid accumulation of foreign exchange
reserves, which remain low despite recent improvements. We forecast the
central bank’s usable foreign exchange reserves to reach US$5.4 billion by the
end of 2017, versus US$3.5 billion in 2016. A few factors have strengthened
its foreign exchange reserves: the issuance of an international sovereign bond
in second-quarter 2017, net foreign exchange purchases equivalent to US$1.2
billion by the central bank so far this year, and a US$1.0 billion syndicated
During 2017-2020, we expect fiscal consolidation to reduce annual borrowing
further. Part of our improved projections reflect the expected effect of the
IRA in gradually broadening the tax base by eliminating exemptions and
reducing evasion, especially of value-added tax (VAT) collection after the
introduction of a higher headline VAT rate. We project annual growth in
general government debt to average 5.4% of GDP for 2017-2020, versus an
average of 7.8% annually from 2014-2016. In view of Sri Lanka’s robust nominal
GDP growth, we project net general government debt to decline to approximately
72% of GDP by 2020, assuming a gradual rupee depreciation versus the U.S.
At the same time, we expect only slow progress in reducing debt servicing
costs, and we estimate that general government interest expenditures will
account for more than 36% of government revenue in 2017. This is the
third-highest ratio among the sovereigns we currently rate, trailing only
Lebanon and Egypt (see "Sovereign Risk Indicators," published Oct. 13, 2017; a
free interactive version is available at spratings.com/sri).
Combining our view of Sri Lanka’s state-owned enterprises and its small
financial system, we view the government’s contingent liabilities as limited.
Expected reforms to fuel and electricity pricing formulae should improve the
financial sustainability of the Ceylon Electricity Board and Ceylon Petroleum
Corp., which are key state-owned enterprises. 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.