Fitch affirms Sri Lanka at ‘B’; outlook Stable

While affirming Sri Lanka’s Long-Term Foreign-Currency Issuer Default Rating (IDR) at ‘B’ with a Stable outlook, Fitch Ratings warned of policy slippage risks and resurfacing of political tensions closer to the elections, amid an expanded budget deficit forecast and substantial debt obligations. Sri Lanka is entering an election cycle, with presidential elections in November this year, followed by parliamentary elections in 2020.

“Sri Lanka’s ‘B’ rating balances high government debt and contingent liabilities, a challenging external financing profile and subdued economic growth against higher human development standards and per capita income levels compared with peer medians,” Fitch said.

The rating agency said the policy environment has improved after the resolution of last year’s policy standoff, the extension of the Extended Fund Facility (EFF) with the International Monetary Fund (IMF) by one year to June 2020. 

A staff-level agreement was reached last week on the sixth review of the US $ 1.5 billion facility, despite the Sri Lankan government missing the fiscal targets set at the fifth review, largely due to the economic slowdown caused by the Easter Sunday bombings on April 21. Meanwhile, Fitch forecasts a budget deficit of 5.4 percent of GDP in 2019, above the authorities’ target of 4.4 percent, as weak growth partly reflecting the drop in tourists has adversely affected revenue collection.

Fitch expects the deficit to stabilise at about 5 percent of GDP in 2020 and 2021 but said downside risks to its projections could arise from a shift towards a more expansionary fiscal policy.
The rating agency has also revised its growth forecast for 2019 to 2.8 percent, from 3.6 percent at the time of the previous review in December 2018, due to the negative impact of the Easter Sunday bombings had on tourism, which accounts for about 5 percent of GDP. 

Sri Lanka’s economic growth slowed to 2.6 percent in the first half of this year, from 4.2 percent in the first half of the previous year, largely due to the slowdown in services.

However, with the tourism sector showing a recovery faster than expected, Fitch forecasts the economic growth to improve to 3.3 percent in 2020 and 3.4 percent in 2021.
Meanwhile, Fitch Ratings noted that Sri Lanka’s near-term external and fiscal financing constraints have eased somewhat after the resumption of the IMF programme in February and the issuance of US $ 4.4 billion of sovereign bonds to date in 2019. 

Sri Lanka also repaid US $ 1.5 billion in international sovereign bonds and foreign exchange reserves rose to US $ 8.5 billion, after declining to US $ 6.9 billion by end-2018. 
Fitch expects foreign exchange reserve coverage to remain at around three months of current external payments through 2021.

However, Sri Lanka’s external debt obligations, both principal and interest, remain substantial over 2020-2023, with nearly US $ 19 billion due and Fitch noted that the country’s external liquidity ratio remains far weaker than peer medians. “A prolonged period of policy uncertainty accompanied by an adverse shift in investor sentiment could exacerbate Sri Lanka’s external refinancing risks,” the rating agency warned.

High government debt and large interest payments remain a key credit weakness for Sri Lanka. The country’s gross general government debt (GGGD) was about 83 percent of GDP at end-2018, far greater than the current ‘B’ median of 56.4 percent. “Interest payments as a share of revenues were very high at about 44 percent (current peer median 10.4 percent), highlighting the relatively weak structure of Sri Lanka’s public finances. In addition, foreign-currency debt is nearly half of total government debt and leaves public finances vulnerable to renewed currency depreciation,” Fitch noted.

The rating agency expects Sri Lanka’s current account deficit to narrow slightly to 3.1 percent of GDP in 2019, from 3.2 percent in 2018, as the negative impact from lower tourism earnings has been somewhat offset by a drop in imports.“We expect the current account deficit to narrow further to about 2.8 percent of GDP by end-2021 but there are risks to our forecast from a possible shift towards more expansionary fiscal and monetary policies or weaker-than-expected export performance.”

Sri Lanka’s trade deficit narrowed to US $ 4.3 billion in the first seven months, from a deficit of US $ 6.4 billion a year earlier. Inflation has remained subdued so far in 2019. This has led the Central Bank to slash policy rates by a cumulative 100 basis points this year. The monetary policy credibility is expected to further improve with the planned amendment to the Monetary Law Act, which would establish price stability and support the shift towards flexible inflation targeting.  

Meanwhile, Fitch maintains a negative outlook for Sri Lanka’s banking sector amid increased credit risks and capitalisation pressures. Banking sector non-performing loans (NPLs) rose 4.8 percent by end-June 2019 and loans have contracted by 0.5 percent in the first half, after a 20 percent increase in 2018.