CB should hike interest rates faster than desired to limit capital outflows, Moody’s says
Sri Lanka's (B1 negative) elevated debt burden, large fiscal deficits and high external borrowing costs continue to expose the country to potential shocks, Moody’s Investors Service says in a new report.
While the programme with the International Monetary Fund (IMF) has helped establish an ambitious roadmap to fiscal consolidation and structural reform, implementation will be challenging. The negative growth impact of tight fiscal and monetary policy and subdued external demand, combined with uncertain effectiveness of tax-broadening measures, could limit the efficacy of the government's reform efforts aimed at consolidation of public finances and shoring up the country's balance of payments, it said.
“Given its weak fiscal position and demands for growth-enhancing public expenditure on infrastructure and development programmes, plans to increase government revenues will play an important role in bolstering debt sustainability and the overall sovereign credit profile. Revenue mobilisation efforts will likewise be key to creating fiscal space for increased spending and deficit reduction, while tempering external vulnerabilities. The government's 2017 budget proposal is broadly consistent with its fiscal consolidation roadmap with the IMF, and illustrates its commitment to fiscal consolidation and to the IMF programme. The budget relies on significant increases in tax revenues to drive a material narrowing of the deficit, through a mix of implemented and planned measures,” the report added.
It could be difficult for the government to pursue fiscal consolidation at the pace it envisages. The significant fiscal tightening currently envisaged, combined with likely relatively tight monetary policy, may dampen GDP growth to a greater extent than currently projected by the government. Moreover, if the government does not manage to implement tax policy and administrative reforms in full, it could cut back on expenditure to meet its fiscal targets. That would also weigh on GDP growth, which in turn would lower revenue collection.
“Given Sri Lanka's weak fiscal position and need for growth-enhancing public expenditure on infrastructure and development programmes, plans to increase government revenues will play an important role in bolstering debt sustainability and the overall sovereign credit profile. Revenue mobilization efforts will likewise be key to creating fiscal space for increased spending and deficit reduction, while tempering external vulnerabilities,” it said.
The report said that the government projects tax revenues to rise to 13.5 per cent of GDP in 2017 from 11.6 per cent in 2016. That marks a 27 per cent year-overyear rise, compared to only a 5.6 per cent in in 2016. The expected increase is reflected in all major tax components, through a combination of tax rate hikes and exemption exclusions.
The most significant contribution to the overall increase in tax revenues is projected to come from excise, with related revenues to increase by nearly 30 per cent, representing about 32 per cent of total tax revenues. New excise duties will be introduced and some revised while the government expects the efficiency of excise collection to increase through e-invoicing.
The second largest increase stems from higher income tax receipts, accounting for 25 per cent of the total tax revenue rise. Income tax is projected to rise by 42 per cent representing about 18 per cent of total tax revenues.
Receipts from value-added tax (VAT) are projected to rise by nearly 21 per cent to represent about 21 per cent of total tax revenues, consistent with a full year of VAT at the 15 per cent rate following the re-instatement of the rate hike in November 2016, the report said.
“We project GDP growth to be lower, rising to 5.2 per cent in 2018 from 5 per cent in 2017, similar to the IMF projections - 4.8 per cent and 4.9 per cent in 2017 and 2018, respectively. Our real GDP growth forecast takes into account the likely impact of fiscal consolidation and tighter monetary policy over the next few years. A concerted government effort on regaining competitiveness and resumption of foreign direct investment and development of key projects, including the Colombo Port City and Hambantota port, would enhance Sri Lanka's export potential and eventually contribute to higher exports. However, in a global environment of prolonged slow trade, the returns on such policy may be limited,” the report said.
“On the monetary policy front, we believe the Central Bank of Sri Lanka's objectives of price stability and moderate credit growth will likely result in relatively high interest rates and generally tighter financing conditions. This will add to the factors weighing on private domestic investment in the near term. In addition, Sri Lanka's relatively low level of foreign exchange reserves further complicates monetary policy, as the central bank may need to hike rates faster than desired in order to limit capital outflows or attract portfolio inflows in an environment where US interest rates are rising and global investors are generally retreating from emerging markets,” it said.
While the government has demonstrated its commitment to fiscal and structural change, substantial implementation challenges remain, which could slow or derail the reform process. Moving forward, fractious politics and a substantive policy agenda which also includes reform of the constitution and further progress on reconciliation could limit progress on revenue and SOE reforms, resulting in weaker growth, slower fiscal consolidation and losses from SOEs crystallizing on the sovereign's balance sheet. If this happened, foreign investors' confidence may be undermined. This could combine with the expected normalisation of interest rates in the US to result in lower capital inflows in, or capital outflows out, of Sri Lanka. Pressure on the fragile balance of payments would increase. In this scenario, the Central Bank of Sri Lanka's policy of less frequent foreign exchange rate intervention could also be tested, it said.
“Looking forward, medium-term risks remain as foreign debt repayment obligations are large, especially those due between 2019 and 2022. Meanwhile, the Central Bank of Sri Lanka currently borrows a large portion of its reserves through temporary forex swap arrangements with domestic commercial banks, which are subject to rollover risk. As of 30 October 2016, the central bank had a total short foreign currency forward position of $2.81 billion, with combined residual maturity of one month to one year. The IMF has advised Sri Lanka to unwind these swap positions. At this stage, it is not clear how this will be achieved in an environment of fragile capital inflows that may drain rather than inflate foreign exchange reserves,” it added.
“Given Sri Lanka's weak fiscal position and need for growth-enhancing public expenditure on infrastructure and development programmes, plans to increase government revenues will play an important role in bolstering debt sustainability and the overall sovereign credit profile. Revenue mobilization efforts will likewise be key to creating fiscal space for increased spending and deficit reduction, while tempering external vulnerabilities,” it said.