Fitch downgrades SL’s rating over COVID-19 impact

• Says pandemic will worsen already-high public and external repayment risks
• SL’s external liquidity ratio among weakest in ‘B’ rating category
• Roughly US$ 13.8bn of FX debt will come due over 2021-2023
• Fitch expects budget deficit to widen to 9.3% of GDP in 2020
• Projects government debt/GDP to rise to about 94% in 2020
• Forecasts SL’s GDP to contract by 1.0% in 2020

Fitch Ratings yesterday downgraded Sri Lanka’s Long-Term Foreign and Local Currency Issuer Default Ratings (IDR) to ‘B-’, from ‘B’ with a Negative Outlook, saying that the shocks from the coronavirus pandemic will aggravate the risks associated with the country’s debt sustainability.

“The shock to Sri Lanka’s economy from the coronavirus pandemic will exacerbate the already-rising public and external debt sustainability challenges following tax cuts and an associated shift in fiscal policy late last year. 
The pandemic will especially hurt the tourism sector, which, combined with weaker domestic demand, will further damage Sri Lanka’s public and external finance metrics,” the rating agency said.

Sri Lanka’s external financing challenges have increased in the current environment of global risk aversion and financial market volatility, with large upcoming external debt redemptions and limited foreign-currency 
(FX) reserves. 

The country’s reserves are about US$ 7.2 billion, while the sovereign’s external debt payments from May to December 2020 amount to US$ 3.2 billion, including a US$ 1.0 billion international sovereign bond payment due in October. 

Fitch estimates Sri Lanka’s external liquidity ratio, defined as liquid external assets/external liabilities, at about 64 percent, among the weakest in the ‘B’ rating category.

Authorities are seeking to meet external funding needs in 2020 through multilateral and bilateral support, but securing these funds could be challenging due to the pandemic and its effect on global liquidity and 
financing conditions.

“Our projections assume the sovereign will not have access to international bond markets in 2020. 

Fitch understands that the government is in discussion with various parties, including regional central banks on the use of possible bilateral swap lines and the IMF on its Rapid Financing Instrument for COVID-19-related funding. 
However, even after such support, the country’s FX debt service obligations and financing challenges will remain substantial over the medium term,” the rating agency said.

Official figures suggest roughly US$ 13.8 billion of FX debt will come due over 2021-2023. 

Fitch expects the budget deficit to widen to 9.3 percent of GDP in 2020, from an estimated 6.8 percent in 2019. 
“This is weaker than the authorities’ forecast of 7.5 percent, as we expect significantly lower revenue due to the impact of the pandemic on economic activity and the spillover of tax cuts announced late last year. 

We also anticipate that authorities may need to increase spending over time to support the economy, although they are yet to formalise any large-scale measures beyond 0.2 percent of GDP for relief to vulnerable groups,” Fitch said.

“General government debt is high and the pandemic has increased risks to public debt sustainability. Our baseline forecast is for gross general government debt/GDP to rise to about 94 percent in 2020 and 96 percent in 2021, from an estimated 87 percent in 2019, and to continue rising, increasing the risk of debt distress. 

This will see gross general government debt stay far greater than the ‘B’ median of 52 percent,” it added.

Fitch forecasts Sri Lanka’s GDP to contract by 1.0 percent in 2020, from 2.3 percent growth in 2019, on account of the pandemic. 

Sri Lanka has so far recorded a relatively small number of coronavirus cases, and authorities have begun to loosen lockdown restrictions. 

Nevertheless, Fitch believes that private consumption, which makes up almost 70 percent of GDP, is likely to stay muted as a result of partial lockdowns, domestic travel restrictions, and other social distancing measures. 

“Travel and tourism, which the World Bank says accounts for 12.5 percent of Sri Lanka’s GDP, will be particularly hard-hit, with commercial flights into the country suspended. 

We expect GDP growth of 4 percent in 2021 on the basis of a gradual recovery in tourism receipts beginning in late 2020. 

However, this forecast is subject to an unusually high degree of uncertainty and downside risk, depending on the evolution of the pandemic both within Sri Lanka and globally,” the rating agency said.

Meanwhile, Fitch said the Negative Outlook reflects their view that risks are skewed clearly to the downside. 
Sri Lanka’s Central Bank has responded to market pressures by ensuring liquidity and allowing the currency to adjust, thereby protecting reserves. 

Nevertheless, capital outflow pressure and market refinancing risks remain in the current risk-averse environment. 
The rating agency noted that the potential for an economic recovery in 2021 hinges on an early return of tourism receipts and increasing domestic activity, which is highly uncertain and is dependent on the course of the pandemic. 

However, a second wave of infections that prompt further periodic lockdowns would result in weaker GDP for 2020 and 2021. 

Meanwhile, Sri Lanka’s Parliamentary elections set for April 2020 have been postponed because of health concerns from the pandemic and have been provisionally rescheduled for June, but the timing could be further delayed as circumstances warrant. 

“The delay has prolonged policy uncertainty. This, in turn, has made it difficult to complete the seventh and final review under the IMF Extended Fund Facility arrangement. 

Discussions over a new arrangement may be possible only after the parliamentary elections and once next year’s budget is approved
The discussions could also be complicated by the challenge of reaching an agreement on policies to place Sri Lanka’s public finances on a sustainable path,” Fitch noted.

The rating agency said that a decline in tourism, lower remittances, and weaker exports are likely to widen the current account deficit to 3.3 percent of GDP this year - despite some relief from lower oil prices - from 2.2 percent in 2019, before narrowing to 2.3 percent in 2021, in line with their expectations for a gradual recovery in the global economy. 

Large interest payments as a share of revenue of around 65 percent, according to Fitch estimates for 2020, a low fiscal revenue ratio and high public debt/revenue ratio continue to highlight the weak structure of Sri Lanka’s public finances. 

The government debt/revenue ratio was about 690 percent in 2019, significantly higher than the ‘B’ median of 258 percent.

FX debt continues to be about half of total government debt, leaving Sri Lanka’s public finances vulnerable to renewed currency depreciation. 

Sri Lanka’s basic human development indicators, including education standards, are high compared with the ‘B’ and ‘BB’ medians, based on the UN Human Development Index Score, which positions Sri Lanka in the 60th percentile, well above the 37th percentile for the ‘B’ median. 

The country’s per capita income of US$ 3,939 at end-2019 is also modestly above the ‘B’ median of US$ 3,335. 
Meanwhile, Fitch’s banking sector outlook was revised to Negative in March, reflecting a more challenging operating environment due to the pandemic, which has pressured banks’ asset quality and profitability. 

The rating agency believes that the demand for credit is likely to remain muted in 2020 due to the weaker growth outlook. 

Authorities took a range of measures since the Easter terrorist attacks in 2019 to accelerate loan growth, including lending rate caps and policy rate cuts totalling 100bp, but Sri Lanka’s gross loans rose by just 5.6 percent in 2019, the slowest rate since 2009.