Shiran Fernando sets the scene for Sri Lanka’s credit rating outlook in the year that lies ahead

On 18 December 2019, Fitch Ratings downgraded its outlook for Sri Lanka’s Long-Term Foreign Currency Issuer Default Rating (IDR) to ‘Negative’ from ‘Stable’ while its ‘B’ rating was retained.Sri Lanka was downgraded by one level in December 2018, 12 months prior to the recent change in outlook. It saw a downgrade (of one notch) before that too at the end of February 2016. Since 2016, the island nation has witnessed its credit rating being lowered twice from ‘non-investment speculative’ to ‘highly speculative’ in the non-investment grade.

Sri Lanka risks another rating downgrade to the lowest category in the highly speculative grade depending on its fiscal, debt and growth trajectories, which calls for an examination of the challenges it faces on these fronts this year.

MAJOR DRIVERS The main driving force behind the negative outlook and downgrades is concern about meeting future external debt obligations, particularly on the rollback of revenue based fiscal consolidation whereby in recent years, the budget deficit was met through increases in tax revenue.

A reduction in VAT announced in November, and other changes to Nation Building Tax (NBT), PAYE and so on, could lead to a shortfall in revenue.

However, the government is of the view that the reduction in tax would boost growth to a higher trajectory – and in the medium to long terms, this will lead to higher tax revenues. And it has called for a cutback in non-priority public investments to help bring the deficits under check as well.

The downgrade in 2018 was also due to concerns over debt refinancing as a result of the political crisis that ensued for 52 days in October that year. Fitch Ratings’ concern in both its statements isn’t only about the impact that policy measures will have on refinancing existing debt alone but also, how it might affect the country’s overall external debt-GDP ratio.

FUTURE FORECASTS Fitch expects Sri Lanka’s budget deficit to widen to 6.5 percent and 6.2 percent of GDP in 2020 and 2021 respectively. This is much higher than the five percent that it had previously projected for both years.

In its rebuttal of the credit rating agency’s change in outlook, the government stated that it expected the budget deficit to be only 5.5 percent of GDP, which is one percent lower than Fitch’s estimates.

As for growth, both Fitch and the government expect an increase in 2020. GDP growth for the first nine months of 2019 was 2.6 percent and is likely to be higher in the last quarter (October-December) of 2019 with an increase in consumption.

Fitch expects growth to rise to 3.5 percent in 2020 and 3.7 percent in 2021 from the 2.8 percent forecasted for 2019 (full year). This is on the back of a short-term boost to consumption as a result of tax revisions, a recovery in tourism and an improvement in agricultural output. The Treasury expects growth to be between four and 4.5 percent in 2020, boosted by the fiscal stimulus provided by tax revisions.

On the debt side of things, the rating agency is concerned that gross general government debt, which stands at around 85 percent of GDP, will rise in the medium term.

The government is of the view that higher growth will be positive for the nation’s overall debt dynamics. This could possibly be due to expectations that the denominator (GDP) will grow at a faster pace than the numerator (external debt), thereby lowering the overall debt-GDP ratio in the medium term.

DEBT DYNAMICS According to Fitch, Sri Lanka has approximately US$ 19 billion in debts maturing between this year and 2023. In the period from November 2019 to October 2020, the country has to refinance six billion dollars, according to the Central Bank of Sri Lanka – of which US$ 1 billion will be a sovereign debt obligation in October 2020 and another 950 million dollars in Sri Lanka Development Bonds (SLDBs) spread mainly in the first half of this year.

While this appears to be manageable, given that reserves have remained consistently under US$ 9 billion, it will require Sri Lanka to access international capital markets to maintain an adequate buffer. And investors may consider if the final phase of the IMF loan facility will be successfully completed before reentering the local market.

BOOM AND BUST In the past, similar fiscal and monetary stimuli have resulted in economic boom and bust cycles – and the political and economic cycles of 2010/11 and 2015/16 are examples of this.

While there may be an increase in growth this year, it should not come at the cost of sharp adjustments to currency or interest rates after the second half of 2020.