Fitch downgrades Sri Lanka to 'B' with “Outlook Stable”

Fitch Ratings has downgraded Sri Lanka's Long Term Foreign- Currency Issuer Default Rating (IDR) to 'B' from 'B+', with a “Stable Outlook.”

The downgrade reflects heightened external refinancing risks, an uncertain policy outlook, and the risk of a slowdown in fiscal consolidation as a result of an ongoing political crisis following the President's sudden replacement of the Prime Minister on October 26, Fitch said in a media announcement.

“Fitch believes the ongoing political upheaval, which has disrupted the normal functioning of Parliament, exacerbates the country's external financing risks, already challenged by the tightening of global monetary conditions amid a heavy external debt repayment schedule between 2019 and 2022. Investor confidence has been undermined, as evident from large outflows from the local bond market and a depreciating exchange rate,” it said on Tuesday.

The sovereign's foreign currency-denominated debt repayments ( principal and interest), as of end- September 2018 are about US$ 20.9 billion between 2019 and 2022, while its foreign-exchange reserves are currently about $7.5 billion.

Fitch said the authorities plan to raise funds through a combination of bilateral and commercial borrowing and the exercise of foreign-currency swaps, but there are risks to this strategy that could arise from a prolonged period of political uncertainty accompanied by an adverse shift in investor sentiment. In addition, the benefits from the government obtaining Parliamentary approval for an Active Liability Management Bill in October - which raises its borrowing limit and could help smooth upcoming debt maturities - are unlikely to materialise if the political standoff continues.

Fitch said it expects fiscal slippages as the current political climate is likely to lead to delays in setting policy priorities and to disrupt progress on future reforms. The 2019 budget has already been pushed back, while the IMF programme has been put on hold.

“The agency now expects the budget deficit for 2019 and 2020 to be closer to 5 per cent of GDP, up from 4 per cent of GDP in 2019 - forecast at the time of our previous review. The political strife has also exacerbated a depreciation of the Sri Lankan rupee, which had weakened in 2018 by around 17 per cent against the US dollar up until end-November, contributing to a deterioration in the debt profile - with about half the debt denominated in foreign currency. Fitch has therefore revised up our general government debt-GDP forecast to over 80 per cent by end-2018, from 77.2 per cent. We believe a speedy resolution of the political situation and a return to credible macroeconomic policies could eventually lower fiscal risks,” the statement said. MORE

Sri Lanka's 'B' IDR also reflects the following key rating drivers:

Greater exchange- rate flexibility provides a cushion for external finances against shocks. The shift towards more flexibility since 2H15 has helped restore foreign reserve levels, which had fallen to around USD6 billion in 2016. This is despite a weak external balance sheet, characterised by high net external debt, the sovereign's large net debtor position and weak international liquidity. Fitch expects the current account deficit to gradually narrow to 3.4 per cent of GDP by 2020, after widening to 3.7 per cent of GDP in 2018. Our forecasts are based on growth remaining subdued and oil prices recovering moderately. Fitch forecasts oil prices averaging $ 65/ barrel ( bbl) in 2019 and $57.5/bbl in 2020.

Downside risks to our forecasts remain, possibly stemming from a shift towards expansionary fiscal and monetary policies or weaker- than- expected export performance. Monetary policy has been geared towards maintaining macro- stability, under the framework of the IMF programme that began in 2016. The Central Bank hiked its main policy interest rates earlier in December 2018, raising the deposit rate by 75bp and the lending rate by 50bp while reducing the Statutory Reserve Ratio (SRR) applicable on all rupee deposit liabilities of commercial banks by 1.50 percentage points, to 6 per cent. Inflation has been falling steadily this year after weather disruptions pushed up food prices, lifting inflation to 7.7 per cent in 2017, and the agency expects headline inflation to average less than 3 per cent.

The authorities' planned shift towards flexible inflation targeting could enhance monetary policy credibility.

“Under Fitch's baseline assumptions, we forecast overall government debt-GDP to decline marginally in 2019 and 2020, but to remain above 80 per cent, which is far higher than the peer median. Previous revenue reforms such as the VAT rate hike in 2015 and a new Inland Revenue Act effective from 1 April 2018 partly support our expectation of continued primary surpluses, and hence declining debt ratios. Nevertheless, there are downside risks to these assumptions, possibly arising from either a reversal of tax reforms and/or a shift towards more populist policies,” it said.

Downside risks to our forecasts remain, possibly stemming from a shift towards expansionary fiscal and monetary policies or weaker-than-expected export performance. Monetary policy has been geared towards maintaining macro-stability, under the framework of the IMF programme that began in 2016.