S&P revises Sri Lanka’s outlook to negative; ratings affirmed at ’B/B’

• Negative outlook reflects view that larger-than-expected fiscal deficit will increase Govt.’s financing needs, concerns over debt sustainability
• Believes tax cuts risk undermining fiscal and debt sustainability, even if boosting near-term growth
• Policy uncertainty will remain elevated ahead of General Elections; Govt. with new mandate could improve legislative efficiency
  
   

S&P Global Ratings has revised its outlook on the Sri Lanka sovereign credit rating to negative from stable, affirming 'B' long-term and 'B' short-term foreign and local currency credit ratings on Sri Lanka. The transfer and convertibility assessment is affirmed at B.

The negative outlook reflects S&P’s view that Sri Lanka's fiscal trajectory over the next two to three years could deviate from a fiscal consolidation path. The sizeable deficits will add to Sri Lanka's already-large debt stock at a faster pace.

S&P could lower ratings over the next 12 months if the agency believe that the fiscal position could deteriorate further from the current forecast, either due to policy changes or growth underperforming expectations. This will further weaken fiscal sustainability and increase the risks of sudden shifts in investor sentiment or changes in global credit conditions. Similarly the outlook could be revised to stable if credible improvements are seen in the fiscal and debt metrics on a sustained basis.

Rationale

.The ratings on Sri Lanka reflect the country's macroeconomic imbalances, namely weak external profile, sizeable fiscal deficits, and extremely high government indebtedness. Counterbalancing these factors are higher growth prospects. While political risks have not lifted completely, a Government with a clear mandate following the Parliamentary Elections that are likely to be held in the first half of 2020 could improve investor sentiment and boost growth.

Institutional and economic profile: Growth prospects have improved while political uncertainty will likely ease following Parliamentary Elections

Economic growth is likely to improve from its current cyclical weak patch, driven by recovering tourist arrival as well as stronger consumption and investment spending.

Parliamentary Elections could help alleviate uncertainty associated with the persistent factionalism within the current Parliament.

Sri Lanka's economy has been consistently growing below potential in recent years due to a confluence of exogenous shocks and intractable political difficulties. After a brisk uptick in the first quarter of 2019, economic growth was again derailed after the Easter Sunday attacks. Meanwhile, persistent fiscal deficits, a large debt stock, and rising interest servicing cost eroded policy buffers and reduced fiscal capacity to support a slowing economy. S&P forecasts growth in 2019 will slow to 2.7%, the lowest rate in decades.

Barring further unforeseeable exogenous shocks, growth is expected to pick up appreciably to 4% in 2020. This will be supported by several factors. Chiefly, the fiscal stimulus implemented by the interim Cabinet—including steep cuts to the value-added tax (VAT) rate and the elimination of several tax items—is expected to boost private consumption and investment activity.

The tourism sector, which has boomed in recent years, is also likely to see a stronger recovery in the coming quarters. Following sharp declines in arrivals after the attacks, tourist numbers were down merely 4.5% year-on-year in December 2019, which typically marks the start of peak travel season. This will contribute to export performance, which has already benefited from the restoration of the European Union's Generalised System of Preference Plus facility for the textiles and garments sector this year.

Finally, S&P believes that Parliamentary Elections, scheduled to be held in the coming months, could help improve Government processes and legislative efficiency, and resolve to a large degree, political uncertainty in the country associated with deep-rooted factionalism within the government. Persistent political infighting has hindered responsiveness and predictability in policymaking in recent years, and weighed particularly on business confidence, investment plans, and overall growth prospects.

Nevertheless, even with a new Government at the helm, S&P believes Sri Lanka's institutional settings will remain a credit weakness due to concerns over the sustainability of public finances, centralised policy decision-making and uncertain checks and balances between institutions. Perceived widening divisions in civil society in recent years, particularly along ethnic and religious lines also increase the risk to political stability.

Real per capita income is estimated to reach about $4,200 in 2020 and real GDP growth to average 3.8% in 2019-2022. This translates to real GDP per capita growth of 3.0% on a 10-year weighted average basis. Although this growth rate is in line with peers at a similar income level, it is substantially below Sri Lanka's growth potential.

Flexibility and performance profile: Fiscal position has deteriorated and risk on debt sustainability has increased 

Sri Lanka's fiscal position deteriorated following the Easter Sunday attacks. Although a recovery is expected, a widening of the fiscal deficit is expected following the implementation of wide-ranging tax cuts.

This will likely worsen the Government's heavy indebtedness and add to repayment burdens.

The external profile remains weak given that the high share of dollar-denominated debt exposes the Government to sudden shifts in risk sentiments.

Persistent deficits in Sri Lanka's fiscal and external positions have been rating constraints. The heavy Government debt limits its ability to accumulate policy buffers, which are crucial in times of stress. The Government's fiscal position has weakened over the past year as the Easter Sunday attacks stymied economic activity and reduced tourism earnings. As a result, Government revenue growth came in significantly below initial expectations of a sizeable increase due to the implementation of the Inland Revenue Act (IRA). At the same time, Government expenditure also increased due to higher security-related and election spending.

It is believed that this one-off underperformance on both the revenue and expenditure fronts will now continue over the next few years if the wide-ranging tax cuts announced by the interim Cabinet are implemented without sufficient offsetting measures. The main components of the tax cuts—which involve lowering the VAT rate to 8% from 15% for most sectors, increasing the turnover threshold for VAT by four-fold, and removing the 2% National Building Tax—will likely reduce revenue earnings significantly. This will be temporarily cushioned by the Government's intention to curtail expenditure, such as the purchase of vehicles, as well as sizeable reduction in the capital expenditure.

It is estimated that the overall impact of the tax measures will further widen the fiscal deficit by about 0.8%-1.0% of GDP in 2020, even after taking into account benefits from higher growth prospects. Beyond 2020, it is believed it could be difficult for the Government to sustain a fiscal consolidation path without new revenue measures. As a base case, the change in net general government debt is estimated to reach 6.7% of GDP on average over 2019-2022. While the risk of large increases in the fiscal deficit could be mitigated by a faster rate of growth, the pace of consolidation will slow. The tax cuts could also jeopardise progress under the IMF Extended Fund Facility (EFF), which counts the IRA as a key achievement in improving the country's fiscal settings.

A weaker fiscal position will add to the Government's extremely high debt stock. S&P does not expect the Government to start paring down its debt stock at least until after 2020, depending on the new Government's budget and medium-term fiscal plans. Net general Government debt is estimated to reach 83.1% of GDP in 2020 while general government interest expenditure is expected to account for 46.1% of revenues. This is the third-highest ratio among the sovereigns currently rated by S&P, trailing only Lebanon and Egypt.

S&P assesses the Government's contingent liabilities from State-Owned Enterprises and its relatively small financial system as limited. However, risks continue to rise, particularly if the automatic fuel pricing formula that has helped to stem losses at Ceylon Petroleum Corp. is removed. Moreover, the effectiveness of this formula in generating fiscal savings depends on the passage of an automatic formula on electricity pricing as well. Without this second step in energy subsidies reform, the risks to the financial sustainability of Ceylon Electricity Board could intensify and increase the burden on the government's resources. The country's financial sector also has a 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%.

Compared to S&P’s last review, the external position has improved marginally. The current account deficit (CAD) is expected to narrow to 2.7% of GDP in 2019, compared with 3.2% in 2018, despite much lower tourism earnings, due to the robust performance in industrial goods exports, and a severe contraction in import expenditure.

The Government's external financing conditions remain challenging, due to the large share of external debt and sensitivity to external shocks, such as rising oil prices. With more than 40% of total public debt denominated in foreign currency, the external position is vulnerable to adverse exchange rate movements and shifts in global credit conditions, which could result in a sharp deterioration in the government's access to external financing. However, at the moment, it is believed that the Government has sufficient funds to cover its near-term external debt obligations, partly due the issuance of two international sovereign bonds sized at a combined $4.4 billion in 2019.

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 117% over 2019-2022. Sri Lanka's external debt (net of official reserves and financial sector external assets) is forecasted to average 148% of CAR from 2019-2022, a slight improvement from 157% expected in S&P’s previous review.

Sri Lanka's monetary settings remain a credit weakness, although there have been structural improvements in recent years, as the Central Bank of Sri Lanka (CBSL) prepares to transition to a flexible inflation-targeting regime under the proposed Monetary Law Act. The passage of this Act that enshrines the central bank's autonomy and capacity will be crucial to improving the quality and effectiveness of monetary policy.