S&P cuts Sri Lanka’s rating on weakened fiscal position

• Lowers rating to ‘B-’, from ‘B’ while keeping outlook ‘Stable’
• Says ‘Stable’ outlook reflects sufficient resources to meet debt obligations over next 12 months
• Expects COVID-19 outbreak to push SL’s economy into a recession in 2020
• Forecasts economy to contract by 0.3% in 2020, recording its lowest rate of growth 
• Says delay in parliamentary elections could open up fresh political uncertainty
• Notes govt. has sufficient funds to cover its external debt obligations over next 12 months

Standard & Poor’s (S&P) yesterday lowered Sri Lanka’s sovereign rating to ‘B-’ on the country’s weakened fiscal position amid COVID-19 recession while kept the outlook ‘Stable’ as the island nation still has access to sufficient resources to meet its debt obligations over the next 12 months.

“We lowered our ratings on Sri Lanka based on our assessment that the country’s fiscal position has weakened substantially amid a COVID-19-induced recession. With fiscal space already limited by the wide-ranging tax cuts announced at the end of last year, this deterioration will worsen the risks associated with Sri Lanka’s government debt burden, in our view,” S&P said.

“Our ratings on Sri Lanka reflect the country’s relatively modest income levels, weak external profile, sizable fiscal deficits, extremely high government indebtedness and extremely large interest payment burdens,” it added.
The rating agency said the Stable outlook reflects its view that Sri Lanka still has access to sufficient resources, including from multilateral and bilateral partners, to meet its debt obligations over the next 12 months.
S&P expects the COVID-19 outbreak to push Sri Lanka’s economy into a recession in 2020, against the earlier expectations of a rebound. This would weaken Sri Lanka’s already fragile fiscal position.

Barring further unforeseeable exogenous shocks, the rating agency forecasts the economy to contract by 0.3 percent in 2020, recording its lowest rate of growth since the civil war ended. 

“We assume the negative economic impact to peak in 2Q-3Q 2020 and activity to gradually normalise towards the end of the year. 

We expect growth to rebound to 4.6 percent in 2021, from a low base. This is expected to be supported by expansionary fiscal and monetary settings, recovering external conditions and the resolution of political uncertainty, following the parliamentary elections later this year,” the rating agency said.

S&P noted that the tourism sector, which has boomed in recent years, might take longer to recover, as travellers could remain cautious prior to the development of a lasting medical intervention. 

“A shallower and more protracted global recovery could also reduce external demand for exports,” the rating agency said.

Meanwhile, S&P pointed out that the delay in parliamentary elections from the scheduled date in April, due to the onset of the pandemic, could open up fresh political uncertainty and test the resilience of institutions.

“Persistent political infighting in recent years has hindered policy predictability and weighed on business confidence, investment plans and overall growth prospects, in our view. A smooth resolution of this political risk is crucial in bringing forward the economic recovery,” the rating agency pointed out.

Meanwhile, S&P expects the government revenue to decline to below 10 percent of GDP this year, amid dampening economic activity and lower excise duty earnings, due to broad import restrictions.

As the government is operating on an interim budget, the rating agency pointed out that the burden to support the economy has fallen mostly on the Central Bank, which has reduced policy rates by 150 basis points this year, drastically increased liquidity in the banking system and relaxed some prudential measures for banks.

“This would widen the fiscal deficit to 8 percent in 2020, from 6.8 percent in 2019. Factoring in adverse exchange rate movements, we estimate the change in net general government debt will exceed 9 percent in 2020. 

Based on our expectations of a growth rebound next year, we estimate that the fiscal deficit will narrow marginally from 2021 onward but will remain high in the absence of new revenue measures,” the rating agency said.

S&P expects net general government debt to exceed 90 percent of GDP in 2020 and remain at an elevated level, depending on the new government’s budget and medium-term fiscal plans. 

Due to adverse currency movements and smaller revenue base, Sri Lanka’s interest burden has also increased. S&P estimates interest payment to reach 67.2 percent of revenues in 2020.

“This is the second-highest ratio among the sovereigns we currently rate, trailing only Lebanon.”

S&P assesses the government’s contingent liabilities from state-owned enterprises and its relatively small financial system as limited. 

However, the rating agency pointed out that risks continue to rise due to the sustained losses at Ceylon Petroleum Corporation (CPC), the Ceylon Electricity Board (CEB) and SriLankan Airlines (SLA). 

Meanwhile, S&P noted that Sri Lanka’s external position has also deteriorated from the time of its last review.
“Following an improvement in 2019, we expect the current account deficit to widen to 3.4 percent of GDP in 2020, due to the weak external demand for both goods and services.”

Sri Lanka’s external liquidity, as measured by gross external financing needs as a percentage of current account receipts (CAR) plus useable reserves, is projected to average 115 percent over 2020-2023. 

We also forecast that Sri Lanka’s external debt net of official reserves and financial sector external assets will rise sharply to 195 percent in 2020, in part due to the poor export earnings,” the rating agency said.  S&P further pointed out that the government’s external financing position also remains challenging, with 50 percent of total public debt denominated in foreign currency.

The rating agency said the external position is vulnerable to adverse exchange rate movements and shifts in global credit conditions.  “Both conditions have materialised in recent months and have resulted in a sharp deterioration in the government’s ability to access the international capital markets.”

However, at the moment, S&P believes that the government has sufficient funds to cover its external debt obligations, over the next 12 months. 

“As of end-April 2020, foreign exchange reserves stood at US $ 7.1 billion. We expect that assistance and additional credit lines from multilateral and bilateral sources could help to augment the Central Bank’s resources,” the rating agency said.