S&P Credit Rating Update - Sri Lanka
Posted 2,June

By Chaveendra Dunuwille

In Local News

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S&P Global Ratings yesterday affirmed its long-term foreign and local currency sovereign credit  ratings on Sri Lanka at ‘CCC+’. It also affirmed the country’s short-term foreign and local  currency credit ratings at ‘C’. The transfer and convertibility assessment is ‘CCC+’. The outlook  remains stable. 

S&P said the stable outlook reflects that, at this rating category, risks to Sri Lanka are relatively  balanced over the next 12 months. The threat of external deterioration is partially offset by the  country’s access to official funding and accommodative macroeconomic policies, which are  likely to boost domestic demand recovery. 

S&P said it could lower the ratings if foreign reserves decline by substantially more than they  forecast, including if the Government is unable to further boost reserves by issuing Sri Lanka  Development Bonds (SLDBs). They exclaimed that this could hurt Sri Lanka’s debt-serving  capacity.  

S&P further stated that it would raise the rating if external buffers were significantly boosted, or  if economic recovery is much stronger than expected for the next two years. This could lower the  risks associated with the Government’s debt-servicing capacity.  

S&P said its ratings on Sri Lanka reflect its assessment that risks to debt-servicing capacity  remain elevated, and the Government’s access to external financing is increasingly dependent on  official support and favourable economic and financial conditions. While the economy is likely  to expand this year, uncertainty over the COVID-19 pandemic fallout in Sri Lanka and the  surrounding region poses significant headwinds to economic activity and recovery in sectors  such as tourism. While expansionary macroeconomic policies will provide relief to the economy,  they risk further weakening the Government’s fiscal position and worsening the risks associated  with the Government’s already high debt burden. 

Following a sharp contraction in 2020, economic activity is expected to recover this year,  although more slowly than previously forecast. 

“We expect policies to remain expansionary, as the Government maintains a strong  parliamentary majority,” S&P added. 

In its statement on the rating decision, S&P also said: “Sri Lanka’s economy recorded its most  severe contraction in 2020 as the Government shut down international flights and implemented a  nationwide lockdown in response to the COVID-19 outbreak. This resulted in real GDP plunging  16.4% year-on-year (YOY) in second quarter (Q2) 2020. With the lifting of the lockdown and a  revival in external demand for goods, Sri Lanka’s economy stabilised in the second half of the  year and recorded growth of 1.3% YOY. Although the country experienced a second wave of  coronavirus infections in Q4 2020, it was able to finally open its border to travellers in the first  few months of this year. However, a third wave of infections that started in late April, which has  proven to be the largest so far, has halted international travel again and we do not expect any  meaningful uptick in tourism for the rest of the year.

“Nevertheless, economic activity is likely to recover this year from the low base in 2020. We do  not expect the Government to reimpose a nationwide lockdown that would severely disrupt  economic activity. Instead, it is likely to continue with localised restrictions and ad-hoc curfews  to control the spread of the coronavirus. External demand is also likely to support the economy,  especially if end-demand markets sustain their economic recovery. 

“We forecast the economy will expand by 3.7% in real terms in 2021, following the 3.6%  contraction in 2020. With better vaccination progress in 2022, we expect real GDP growth to  accelerate to 4% and average 4.2% from 2022-2024. This will bring per capita income to around  $ 3,900 in 2021, translating into real GDP per capita growth of 2% on a 10-year weighted average basis. Although this growth is in line with peers at a similar income level, it is  substantially below Sri Lanka’s potential. 

“The Government’s external financing conditions have become more challenging, and  uncertainty over access to official creditors remains high, in our view. The Government recently  received $ 500 million in official loans for budgetary support. Sri Lanka is also expected to  benefit from the proposal for new Special Drawing Rights allocation by the International  Monetary Fund. This is likely to increase Sri Lanka’s foreign exchange reserves by around $ 780  million. The Government is also establishing bilateral credit lines with other central banks. A  stronger network of bilateral swap lines will help to augment reserves to some extent. 

“However, we see increasing risks that funding from multilateral or bilateral partners will not be  sufficient to cover all external financing needs over the next 12 months. While financing  conditions on the international capital markets remain difficult, the Government has been able to  issue SLDBs to domestic creditors, particularly domestic banks and eligible corporates. Success  in rolling over SLDBs will become increasingly crucial to the Government’s debt-servicing  capacity. In turn, this will heavily depend on domestic creditors’ ability to access external  financing under favourable terms. 

“Persistent deficits in Sri Lanka’s fiscal and external positions remain rating constraints. The  Government’s heavy debt burden limits its ability to accumulate policy buffers, which are crucial  in times of stress. The COVID-19 pandemic has further devastated Government finances by  dampening domestic economic activity and lowering excise duty earnings. 

“In the latest budget, the Government committed to keeping the wide-ranging tax cuts, including  a lower value-added tax (VAT) rate, increasing the VAT turnover threshold, and removing the  2% Nation Building Tax, for five years. Instead of one-off measures to counter the economic  impact of the pandemic, these expansionary measures are likely to increase the deficit for an  extended period, in our view. In the absence of extremely favourable economic and financial  conditions, these measures are expected to constrain revenue growth and could be only partially  offset by new revenue measures, such as the Special Goods and Services Tax. 

“We expect the fiscal deficit to remain elevated at 10.2% of GDP in 2021 and narrow gradually  to 8.4% in 2024. If revenue growth disappoints, we believe that the Government has some  flexibility to cut capital expenditure to contain the fiscal deficit.

High fiscal deficits over an extended period will worsen the Government’s extremely high debt  stock. We expect the increase in net general government debt to average 10.3% over 2021-2024.  Net general government debt has exceeded 100% of GDP in 2020 and will continue to increase  over the next five years, in our view. 

“Sri Lanka’s debt profile is also vulnerable due to the high share of the total debt being  denominated in foreign currency, although this has been reducing over the past year. The  government has been increasing the share of domestic financing to fund the fiscal deficit. At the  same time, domestic interest rates have been kept extremely low through massive liquidity  injections by the Central Bank. While this has reduced the effective interest rate on the  Government’s domestic debt, an increase in domestic liquidity will also pressure the exchange  rate. The Government’s interest payment as a percentage of revenues has reached 68.8% in 2020  – the highest ratio among the sovereigns we rate. 

“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 sustained  losses at Ceylon Petroleum Corp., Ceylon Electricity Board, and Sri Lankan Airlines. Also, Sri  Lanka’s financial sector has 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 country’s external position remains vulnerable. While the current account deficit has  narrowed substantially to 1.3% of GDP in 2020 from 2.2% in 2019, this was achieved through  wide-ranging restrictions on non-essential imports. We estimate the current account deficit will  rise marginally to 1.9% of GDP in 2021. While most of the import restrictions will likely remain  in place, higher fuel prices this year will likely result in a larger import bill, offsetting the  earnings from robust workers’ remittances. Latest high frequency data shows a strong recovery  in imports alongside sustained improvements in exports. 

“Sri Lanka’s external liquidity, as measured by gross external financing needs, as a percentage of  current account receipts plus usable reserves, is projected to average 122% over 2021-2024. We  also forecast that Sri Lanka’s external debt net of official reserves and financial sector external  assets will remain elevated at around 167% in 2021. 

“Sri Lanka’s monetary settings remain a credit weakness, although it has seen some structural  improvements. The Central Bank of Sri Lanka has been preparing an updated Monetary Law Act  in recent years. 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.”