Fed tightening could complicate deficit financing via domestic means for SL: ICRA Lanka

• Rating agency expects Central Bank to raise interest rates next year 

The tightening of the monetary policy by the US Federal Reserve could prompt South Asian central banks, including Sri Lanka, to follow such policy path, which could complicate the island nation’s deficit financing through domestic debt as these changing conditions put upward pressure on domestic interest rates and dollar debt servicing cost. 

Calling the budget 2022, a “conservative”, rating agency ICRA Lanka Limited said the budget has presented a number of favourable proposals on tax administration and expenditure rationalisation. 

Reminding that the lack of policy consistency remains an impediment in attracting much needed direct investments, the rating agency called the proposed one time surcharge tax intended to be imposed retrospectively would send the wrong signal about the country’s business climate to international investors. 

“We believe that tightening by the Fed may prompt South Asian central banks, including the CBSL, to raise policy rates next year,” ICRA Lanka said. 

“In addition, the government’s over-reliance on the domestic financing amidst tighter market liquidity may put pressure on the yields to go up. These events would lead to substantial increase in the debt servicing cost.

Therefore, recurrent expenditure may grow at a faster pace than what is projected in the budget,” they added. 
The debate is heating up in the developed and emerging markets whether the Federal Reserve is doing enough to arrest the current supply chain bottlenecks and consumer price inflation which surged to 6.2 percent over the 12-months to October, the highest the US had since 1991. 

In this backdrop, the pressure is mounting on its Federal Open Market Committee to accelerate the tapering of its US$ 120 billion dollars a month bond buying programme which began this month and started raising its benchmark interest rates sooner. 

This could soon prompt central banks around the world to follow suit in equivalence or more to prevent foreign capital flight from their markets, raising local borrowing costs higher allowing currencies to depreciate against the dollar. 

Sri Lanka aims at narrowing its budget deficit to 8.8 percent of its estimated Gross Domestic Product next year, from an estimated 11.1 percent this year. But the deficit is almost entirely planned to be met through domestic borrowings. ICRA Lanka doesn’t think this is possible given the weaker economic outlook and stronger than projected expansion in the current expenditure.  While the budget aims at containing the growth in recurrent expenditure to 6.4 percent next year, ICRA Lanka said this was, “too optimistic”, given the 10.7 percent growth in such expenditures every year in the last ten years.  Recurrent expenditure accounts for 77 percent of government’s total expenditure. 

Meanwhile, the State revenues, which are estimated to go up by Rs.718 billion next year from an estimated Rs.1,556 billion this year, is going to be, “somewhat challenging given the subdued economic growth next year and the likelihood of import restrictions continuing through 2022,” ICRA Lanka said.

The rating agency projects Sri Lanka’s economic growth at 4 percent in 2022 whereas the Finance Ministry puts the growth at between 6 to 7 percent, accelerating from a likely 5 percent growth in 2021. 

“In our assessment, for Sri Lanka to achieve meaningful economic outcomes from the budget, far-reaching reforms have to be carried out and the GoSL should have the required political will and restraint to improve fiscal health,” the rating agency added.