Sri Lanka’s fiscal consolidation path challenging: Moody’s

„Says higher revenue collection and faster economic growth key for fiscal consolidation

„Doubts achieving ambitious fiscal deficit targets in line with IMF programme targets

„Sri Lanka has not had a fiscal deficit below 5% since at least 1990

„Expects government debt to remain around 83% of GDP in 2020

Sri Lanka government’s efforts for fiscal consolidation will be challenging, given its ambitious revenue targets and election spending—which are difficult to do without—and their success will largely depend on policy effectiveness and faster economic growth, according to Moody’s Investors Services (Moody’s).

Issuing a sovereign credit outlook on the back of last week’s budget, Moody’s acknowledged the government’s commitment towards revenueled fiscal consolidation and debt reduction— both of which were considered credit positive.

“After a fiscal deficit of 5.3 percent of GDP in 2018, the government aims to reduce it to 4.4 percent of GDP in 2019 and to 3.5 percent in 2020, in line with its International Monetary Fund programme targets.

However, achieving its deficit and debt targets will be challenging without a significant increase in fiscal policy effectiveness and faster GDP growth,” the rating agency said.

Finance Minister Mangala Samaraweera presented Budget 2019 on March 5, after a fourmonth delay, due to the political crisis that was triggered on October 26 with the sacking of Prime Minister Ranil Wickremesinghe by President Maithripala Sirisena.

This led Moody’s to downgrade Sri Lankan sovereign rating by a notch to B2 from B1, citing heightened debt refinancing risks and a slow pace of the fiscal consolidation process, due to political uncertainty.

Budget 2019 did not provide surprises and broadly stayed the course set by Minister Samaraweera’s previous budget and closely resembled the government’s social-market economy policy tilt.“sri Lanka’s ambitious fiscal consolidation targets – when the country has not had a fiscal deficit below 5.0 percent since at least 1990 – will rely on effective tax collection and administration and increases in some taxes,” Moody’s stated.

Policymakers, academics and business community many a time have expressed dismay over the very little tax compliance in the country. Tax evasion has reached a whole new level in Sri Lanka as there are only little over 125,000 tax files for the eight million labour force.

It is often pointed out that some professional categories evade paying taxes. The government aims to strengthen tax collection by establishing a Revenue Intelligence Unit at the Finance Ministry.

“The government has lifted revenue to 14 percent of GDP in 2018, from as low as 11.6 percent in 2014 by raising the Value-added Tax rate in October 2016 and implementing the Inland Revenue Act (IRA) in April 2018.

The budget anticipates that this trend will continue, projecting revenue increasing to 15.8 percent of GDP in 2019 and 16.8 percent in 2020, which equates to annual growth of about 22 percent in 2019 and 16 percent in 2020 and exceeds what the government has achieved, on average, in recent years,” Moody’s noted.

Although the government slapped heavy taxes on certain industries such as cigarettes, liquor, gambling and vehicles, the revenues may be less than anticipated due to lower consumer demand, Moody’s stated.

Even though the political risks have been laid to rest for the time being, Moody’s doesn’t rule out such risks arising again, which could upset the government’s apple cart.

“Political risk can disrupt fiscal and economic policymaking and restraining spending will be difficult ahead of the presidential election in 2019 and general election in 2020.

Large recurrent spending commitments, which the government estimates will account for around 76 percent of all expenditures in 2019 amid civil servant wage increases, payments for pensioners and subsidies for agriculture, tend to be difficult to curb,” the rating agency said.

Moody’s also sees another caveat in slow GDP growth, which will in turn pull back on the fiscal tightening agenda of the government.

“The government expects real GDP growth to accelerate to 3.5 percent in 2019 and 4 percent in 2020, after a 17-year low of 3 percent in 2018. This is much lower than the 5.6 percent average annual real GDP growth that occurred in Sri Lanka over the 10 years to 2017,” Moody’s stated.

When the economy slows, the capacity to generate revenue hinders, making the government to roll back on its capital expenditure plans, which would in turn hurt the future economic growth and government revenues. “We expect a slower pace of fiscal consolidation, projecting fiscal deficits to gradually narrow below 5 percent of GDP in 2019-20. As a result, we expect that the government debt will remain around 83 percent of GDP in 2020, higher than the government’s projection and higher than many B-rated sovereigns.

Interest payments will continue to absorb around 37-40 percent of Sri Lanka’s government revenue in the next few years, one of the weakest debt-affordability ratios among B-rated sovereigns,” Moody’s noted.