S&P affirms SL’s ratings at ‘CCC+/C’; outlook remains stable

• Says SL’s external financing risks remain acute as the country’s high debt burden and large fiscal deficits weigh on investor confidence
• Expects economy to expand modestly by 3.7% this year; uncertainty over the evolution of the COVID-19 pandemic threatens recovery
• Stable outlook reflects S&P’s view Govt. has access to official creditors, but remains dependent on favourable conditions to boost foreign reserves

S&P Global Ratings yesterday affirmed its long-term foreign and local currency sovereign credit ratings on Sri Lanka at ‘CCC+’. It also affirmed the country’s short-term foreign and local currency credit ratings at ‘C’. The transfer and convertibility assessment is ‘CCC+’. The outlook remains stable.

S&P said the stable outlook reflects that, at this rating category, risks to Sri Lanka are relatively balanced over the next 12 months. The threat of external deterioration is partially offset by the country’s access to official funding and accommodative macroeconomic policies, which are likely to boost domestic demand recovery.

“We could lower our ratings if foreign reserves decline by substantially more than we forecast, including if the Government is unable to further boost reserves by issuing Sri Lanka Development Bonds (SLDBs). This would hurt its debt-servicing capacity,” it added.

S&P said it would raise the rating if external buffers were significantly boosted, or if economic recovery is much stronger than expected for the next two years. This could lower the risks associated with the Government’s debt-servicing capacity, it added.

S&P said its ratings on Sri Lanka reflect its assessment that risks to debt-servicing capacity remain elevated, and the Government’s access to external financing is increasingly dependent on official support and favourable economic and financial conditions. The country’s relatively modest income levels, weak external profile, sizable fiscal deficits, heavy government indebtedness, and hefty interest payment burdens, significantly constrain ratings. While the economy is likely to expand this year, uncertainty over the COVID-19 pandemic fallout in Sri Lanka and the surrounding region poses significant headwinds to economic activity and recovery in sectors such as tourism. While expansionary macroeconomic policies will provide relief to the economy, they risk further weakening the Government’s fiscal position and worsening the risks associated with the Government’s already high debt burden.

Following a sharp contraction in 2020, economic activity is expected to recover this year, although more slowly than previously forecast.

The new deadly wave of infections sweeping across the surrounding region will likely keep borders closed for the rest of the year, while vaccine rollout has been hampered by supply issues.

“We expect policies to remain expansionary, as the Government maintains a strong parliamentary majority,” S&P added.

In its statement on the rating decision, S&P also said: “Sri Lanka’s economy recorded its most severe contraction in 2020 as the Government shut down international flights and implemented a nationwide lockdown in response to the COVID-19 outbreak. This resulted in real GDP plunging 16.4% year-on-year (YOY) in second quarter (Q2) 2020. With the lifting of the lockdown and a revival in external demand for goods, Sri Lanka’s economy stabilised in the second half of the year and recorded growth of 1.3% YOY. Although the country experienced a second wave of coronavirus infections in Q4 2020, it was able to finally open its border to travellers in the first few months of this year. However, a third wave of infections that started in late April, which has proven to be the largest so far, has halted international travel again and we do not expect any meaningful uptick in tourism for the rest of the year.

“Nevertheless, economic activity is likely to recover this year from the low base in 2020. We do not expect the Government to reimpose a nationwide lockdown that would severely disrupt economic activity. Instead, it is likely to continue with localised restrictions and ad-hoc curfews to control the spread of the coronavirus. External demand is also likely to support the economy, especially if end-demand markets sustain their economic recovery.

“However, downside risks to growth are still substantial, particularly given the unpredictable nature of the pandemic and the emergence of new infectious variants. A further serious escalation in the sanitary crisis could overwhelm Sri Lanka’s healthcare system, which is already operating at the brink. This could also increase the risk of strict movement restrictions. Meanwhile, due to supply disruptions, the vaccination campaign is likely to proceed more slowly than the Government initially expected.

“We forecast the economy will expand by 3.7% in real terms in 2021, following the 3.6% contraction in 2020. With better vaccination progress in 2022, we expect real GDP growth to accelerate to 4% and average 4.2% from 2022-2024. This will bring per capita income to around $ 3,900 in 2021, translating into real GDP per capita growth of 2% on a 10-year weighted-average basis. Although this growth is in line with peers at a similar income level, it is substantially below Sri Lanka’s potential.

“Sri Lanka’s institutional setting has been a persistent credit weakness over the past few years. Frequent political infighting and occasional unpredictable developments have hindered policy predictability and weighed on business confidence, in our view. While the current administration’s clear victories in both the presidential and parliamentary elections are likely to ease such uncertainty over policy direction, there has been further consolidation of power in the Executive. This could potentially undermine social stability, particularly if divisions along religious or ethnic lines persist, in our view.

“S&P Global Ratings believes evolution of the coronavirus pandemic remains highly uncertain. Reports of vaccines that are highly effective gaining approval in more countries are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunisation, which could come by the middle of next year. 

“The Government’s external financing conditions have become more challenging, and uncertainty over access to official creditors remains high, in our view. The Government recently received $ 500 million in official loans for budgetary support. Sri Lanka is also expected to benefit from the proposal for new Special Drawing Rights allocation by the International Monetary Fund. This is likely to increase Sri Lanka’s foreign exchange reserves by around $ 780 million. The Government is also establishing bilateral credit lines with other central banks. A stronger network of bilateral swap lines will help to augment reserves to some extent.

“However, we see increasing risks that funding from multilateral or bilateral partners will not be sufficient to cover all external financing needs over the next 12 months. While financing conditions on the international capital markets remain difficult, the Government has been able to issue SLDBs to domestic creditors, particularly domestic banks and eligible corporates. Success in rolling over SLDBs will become increasingly crucial to the Government’s debt-servicing capacity. In turn, this will heavily depend on domestic creditors’ ability to access external financing under favourable terms.

“Persistent deficits in Sri Lanka’s fiscal and external positions remain rating constraints. The Government’s heavy debt burden limits its ability to accumulate policy buffers, which are crucial in times of stress. The COVID-19 pandemic has further devastated Government finances by dampening domestic economic activity and lowering excise duty earnings.

“In the latest budget, the Government committed to keeping the wide-ranging tax cuts, including a lower value-added tax (VAT) rate, increasing the VAT turnover threshold, and removing the 2% Nation Building Tax, for five years. Instead of one-off measures to counter the economic impact of the pandemic, these expansionary measures are likely to increase the deficit for an extended period, in our view. In the absence of extremely favourable economic and financial conditions, these measures are expected to constrain revenue growth and could be only partially offset by new revenue measures, such as the Special Goods and Services Tax.

“The Government is planning to significantly ramp up infrastructure spending over the next few years. While recurrent expenditure has been relatively contained, room for further cuts is limited due to the high interest burden. Healthcare-related spending may also increase fiscal pressure, particularly if the hospital system comes under further strain.

“We expect the fiscal deficit to remain elevated at 10.2% of GDP in 2021 and narrow gradually to 8.4% in 2024. If revenue growth disappoints, we believe that the Government has some flexibility to cut capital expenditure to contain the fiscal deficit.

High fiscal deficits over an extended period will worsen the Government’s extremely high debt stock. We expect the increase in net general government debt to average 10.3% over 2021-2024. Net general government debt has exceeded 100% of GDP in 2020 and will continue to increase over the next five years, in our view.

“Sri Lanka’s debt profile is also vulnerable due to the high share of the total debt being denominated in foreign currency, although this has been reducing over the past year. The government has been increasing the share of domestic financing to fund the fiscal deficit. At the same time, domestic interest rates have been kept extremely low through massive liquidity injections by the Central Bank. While this has reduced the effective interest rate on the Government’s domestic debt, an increase in domestic liquidity will also pressure the exchange rate. The Government’s interest payment as a percentage of revenues has reached 68.8% in 2020 – the highest ratio among the sovereigns we rate.

“We assess the Government’s contingent liabilities from State-owned enterprises and its relatively small financial system as limited. However, risks continue to rise due to sustained losses at Ceylon Petroleum Corp., Ceylon Electricity Board, and SriLankan Airlines. Also, Sri Lanka’s financial sector has limited capacity to lend more to the Government without possibly crowding out private sector borrowing, owing to its large exposure to the Government sector of more than 20%.

“The country’s external position remains vulnerable. While the current account deficit has narrowed substantially to 1.3% of GDP in 2020 from 2.2% in 2019, this was achieved through wide-ranging restrictions on non-essential imports. We estimate the current account deficit will rise marginally to 1.9% of GDP in 2021. While most of the import restrictions will likely remain in place, higher fuel prices this year will likely result in a larger import bill, offsetting the earnings from robust workers’ remittances. Latest high frequency data shows a strong recovery in imports alongside sustained improvements in exports.

“Sri Lanka’s external liquidity, as measured by gross external financing needs, as a percentage of current account receipts plus usable reserves, is projected to average 122% over 2021-2024. We also forecast that Sri Lanka’s external debt net of official reserves and financial sector external assets will remain elevated at around 167% in 2021.

“Sri Lanka’s monetary settings remain a credit weakness, although it has seen some structural improvements. The Central Bank of Sri Lanka has been preparing an updated Monetary Law Act in recent years. The passage of this act, which enshrines the Central Bank’s autonomy and capacity, will be crucial to improving the quality and effectiveness of monetary policy, in our view.”