Fitch Ratings has affirmed Sri Lanka’s Long-Term Foreign-Currency Issuer Default Rating (IDR) at ‘B+’ with a stable outlook.
The affirmation of Sri Lanka’s sovereign ratings reflects several factors.
Sri Lanka’s revised policy framework supports macroeconomic stability. In Fitch’s view, policies aimed at fiscal consolidation and maintenance of a disciplined monetary stance under the framework of the three-year IMF-supported programme have improved Sri Lanka’s policy coherence and credibility.
Although GDP growth of an estimated 3.9% in 2017 fell short of forecasts due to weather-related supply disruptions, we expect growth to recover and stabilise at around 5% in 2018 and 2019.
The shift towards greater exchange-rate flexibility since 2H15 has strengthened the external position, and the planned shift towards flexible inflation targeting should further enhance monetary policy credibility. Credit growth has declined to a more sustainable level of around 15% in 2017 from a high of 20% in 2016.
Fiscal performance has improved following the approval and implementation of tax reforms. Fitch expects Sri Lanka’s ratio of general government revenue to GDP to improve to 15.5% in 2018 and 16.2% by 2019, from a low of 11.6% in 2014, reflecting the passage of revenue-enhancing measures under the IMF programme.
These include an increase in the VAT rate to 15% in 2016 from 11%, and implementation of a new Inland Revenue Act from 1 April 2018 that aims to simplify tax laws, reduce exemptions and improve the efficiency of the tax system.
“We think the increase in general government revenues will support a further narrowing of the budget deficit to 4.8% of GDP in 2018 and 4% in 2019 from an estimated 5.2% in 2017. While these revenue reforms should be positive for a more credible fiscal framework over time, ineffective implementation and/or weaker-than-expected GDP growth remain downside risks to our fiscal projections,” Fitch said in the report.
Sri Lanka’s interest payments as a share of revenues remain exceptionally high at an estimated 38% at end-2017, far above the medians of 9.4% for ‘B’ and 9.6% for ‘BB’ rated sovereigns. The expected pick-up in general government revenues should lead to lower ratios over time, but we expect this ratio to remain above the ‘B’ and ‘BB’ medians for the foreseeable future. Further, despite the expected improvement in gross general government debt (GGGD) dynamics, GGGD will likely remain above the ‘B’ median over 2018-2019.
GGGD is forecast to decline to 77.2% of GDP in 2018 and 75.8% in 2019, from an estimated 79.5% at end-2017 under our baseline assumptions, mainly on account of sustained primary surpluses and stable GDP growth rates.
However, even after the forecast reduction, government debt would still remain above the ‘B’ and ‘BB’ medians at end-2019.
Further, nearly half of Sri Lanka's government debt is denominated in foreign currency, which increases the risk to debt dynamics in the event of a further depreciation of the Sri Lankan rupee.
Sri Lanka's external balance sheet remains a weakness for the rating, with high net external debt, weak sovereign net foreign assets and a low international liquidity ratio compared with rating peers. Foreign-exchange reserves rose to around USD8 billion at end-2017, representing 3.3 months of current external payments (CXP), from USD6.0 billion (2.7 months) at end-2016, but reserves remain below the rating category median of 3.9 months.
Sri Lanka's external debt service outlook remains challenging over 2019-2022. The sovereign's external debt service payments over this period are around USD15 billion against current reserve levels of about USD7.7 billion. The authorities expect to pass a liability management bill in 2018, which would allow them to smooth debt payments by potentially extending maturities over this period. However, the scale of external refinancing over the next few years creates a potential vulnerability for the sovereign, particularly against a backdrop of expected monetary tightening in developed markets. However, Sri Lanka's track record of accessing international capital markets remains a mitigating factor.
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