Fitch revises SL’s Outlook to ‘Negative’ over tax cuts

Fitch Ratings yesterday revised the Outlook on Sri Lanka’s ‘B’ rating to Negative from Stable on debt repayment concerns arising from the recent economic stimulus announced by the government by slashing taxes significantly, which is set to leave a hole in the government revenue.

 “Revision of the Outlook to Negative from Stable reflects rising risks to debt sustainability from a significant shift in fiscal policy and the potential for roll-back of fiscal and economic reforms in the aftermath of November’s Presidential elections.

“We believe the departure from the previous revenue-based fiscal consolidation path has created policy uncertainty and increased external financing risk for the sovereign, particularly given the large external debt repayments due in 2020 and beyond,” the rating agency said.

 Newly elected President Gotabaya Rajapaksa announced sweeping tax cuts soon after taking office, including a revision of the Value-Added Tax (VAT) rate to 8 percent from 15 percent, an increase in the liable limit for VAT registration to Rs.300 million, scrapping of the Nation Building Tax (NBT), lowering the income tax rate for the highest income bracket to 18 percent from 24 percent and changing the withholding tax regime, among others.

 Fitch said its preliminary estimates showed the VAT rate change, the scrapping of NBT could alone lower government revenue by as much as 2 percent of GDP. VAT accounted for 24 percent of government revenue in 2018.

 The government believes offsetting revenue and expenditure measures would make the tax revenue neutral. These include a hike in excise duty on liquor and cigarettes, which account for about 10 percent of VAT revenue and increase in Ports and Airports Development Levy (PAL) to 10 percent from 7.5 percent.

 However, the 15 percent VAT on financial services will not be affected by the rate cut. Authorities project the expenditure adjustment to come mainly from a cutback in 
public investment.

 Fitch expects these offsetting measures, such as adjustments to excise taxes and spending cuts on non-priority public investment and recurrent expenditure, to mitigate part of the revenue loss from the tax announcement.

 However, the agency nevertheless expects the deficit to widen by about 1.5 percent of GDP relative to our previous forecasts.

 Fitch has revised its budget deficit projection to 6.5 percent of GDP for 2020 and 6.2 percent for 2021, which are higher than the authorities’ estimates, from 5.0 percent previously in both years.

 Following the tax cuts, Fitch projects the gross general government debt, currently at about 85 percent of GDP, will be on an upward trajectory over the medium-term in the absence of off-setting measures.

 Fitch casts doubts over the government’s aim to reduce the deficit below 4 percent of GDP over the medium-term as the tax cuts create uncertainty about the feasibility of these plans.
The rating agency also said the outlook for the completion of the seventh and final review under the Extended Fund Facility (EFF) arrangement with the IMF now seems uncertain and discussions about a new programme after the parliamentary elections expected in April next year could be complicated by the tax cuts.

Fitch acknowledged the tax cut announcement had come during the early period of the new administration and that further policy announcements would follow, which could mitigate some fiscal issues.

“However, we believe initial evidence of a roll-back of the revenue-driven fiscal consolidation path is negative for the sovereign’s creditworthiness,” the rating agency said.
Fitch expects Sri Lanka’s growth to pick up to 3.5 percent in 2020 and 3.7 percent in 2021, from 2.8 percent in 2019.

These forecasts reflect Fitch’s expectation of a boost to growth in the short-term from the tax cuts, higher agricultural output and an ongoing recovery in tourism following last April’s terrorist bombings.

Remittances are also likely to remain supportive of domestic demand.

Sri Lanka’s external balance sheet is weak, with external debt obligations totalling approximately US$ 19.0 billion due between 2020-2023, compared to foreign-exchange reserves of around US$ 7.5 billion as of end-November 2019.

With the strengthening of domestic demand, Fitch expects Sri Lanka’s current account deficit to widen to about 3.0 percent of GDP in 2020 and 2021, from an estimated 2.2 percent in 2019.

“Large interest payments as a share of revenue, at about 46 percent (current peer median 10.2 percent), a low revenue ratio and a very high public debt/revenue ratio of 643 percent continue to highlight the 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 said.

However, Sri Lanka’s basic human-development indicators, including education standards, are high compared to the ‘B’ median, as it ranks in the 60th percentile of the UN’s Human Development Index compared to the 35th percentile of the current ‘B’ median.

Furthermore, the country’s per capita income of US$ 4,023 (Fitch estimate as of end-2019) is somewhat higher than the current ‘B’ median of US$ 3,311.