Sri Lanka: Downgrade from 5/7 to 6/7 for medium- to long-term political risk

• Covid-19 has brought Sri Lanka’s poor public finances to unsustainable levels.
• Challenging debt repayments amid pressures on the rupee and foreign exchange reserves are increasing the risk of a sovereign debt default.
• With no market access, financial dependence on China will increase. 
• IMF financial rescue and debt restructuring might be needed.
• Credendo has downgraded MLT political risk from 5/7 to 6/7.

Public finances, Sri Lanka’s Achilles heel

Over the past 30 years, fiscal deficits and public debt have averaged 6.8% and 80% of GDP respectively while government revenues have been on a slow downward path from less than 18% of GDP in the early 1990s to 12.6% in 2019. During this period, several IMF financial programmes – the last one ending in mid-2020 – have brought stability rather than really improved public finances sustainability. The Covid-19 shock has caused this dire situation to deteriorate sharply with government debt-to-GDP ratio crossing the 100% threshold – i.e. the third highest level in Asia – and expected to peak at 107% in 2023. At the same time, public revenues are at a nadir below 10% of GDP before potentially rising to 12% of GDP in the coming years, which highlights the structurally weak revenue capacity. Hence, the public debt-to-revenue ratio is expected to remain above 900% and net interest payment charges will consume 60% of revenue until 2024, which is the highest ratio in the world. 

The situation is made more challenging by the fact that an estimated 45% share of the government debt is external while the Sri Lankan rupee continues to face depreciating pressures. Despite this unsustainable picture, the Rajapaksa administration has so far not announced any significant future fiscal adjustments to tackle it. Neither are the authorities in favour of seeking a new deal with the IMF that would require fiscal consolidation and hinder the government’s fiscal policy freedom. In addition, based on the G20 “Common Framework for debt treatment”, the IMF option could mean preliminary debt restructuring (and/or exceptional bilateral support) as public debt seems to be unsustainable. Conversely, at the end of 2019, the new government quickly reversed the fiscal tightening measures taken by the previous government and implemented an expansionist fiscal policy amid the Covid-19 pandemic. 

Furthermore, the prolonged impact of Covid-19 and a currently worse third wave hitting the country since April will continue to affect current account receipts – particularly the important tourism sector, which has been further hit by travel restrictions – which the government counts on to improve public finances and help meet external financing needs. Although Colombo is determined to preserve its positive reputation of having never defaulted on its external debt, the country has never had such high (external and public) debt and interest payment ratios, at least since 1990. Last year, Colombo’s request for a debt suspension to China and India yielded nothing. Rather, China might prefer to grant new loans or, if necessary, seize some state assets.  

An increasing risk of sovereign debt default   

While local banks are temporarily financing the fiscal deficit and assuming that any arrears would probably be first domestic, it is not ruled out that the government might eventually have to come to the IMF as a last resort. However, this scenario is unlikely to materialise in the very near future. Indeed, last year the authorities’ request for emergency financial support from the IMF to help fight the pandemic was dropped due to disagreement about the requested policy commitments. In the short term and without market access, Sri Lanka will essentially rely on bilateral financing support, first from China (via new loans and a 3-year currency swap line of an equivalent of USD 1.5bn agreed last March) and then India, and use its foreign exchange reserves to honour its external debt obligations and finance the current account deficit (expected to widen to 2.3% of GDP this year before gradually narrowing). By opting for debt accumulation instead of fiscal consolidation, there is a risk that public finances could worsen (with an external share potentially exceeding the domestic one), the debt spiral could continue and financial dependence on China could increase. In 2019, about 10% of external public debt was owed to China and this share is undoubtedly going to rise. 

Opting to use gross foreign exchange reserves is also a risky strategy. Last year, reserves dropped by 21.4%, and by a further 15% in January-April 2021. They cover around 2 months of imports (i.e. a record low since 2008) and barely around half of the short-term external debt. The extra loan of USD 500m granted by China in March improved the liquidity situation in the short term. However, the situation remains precarious taking into account that Sri Lanka lacks access to financial capital markets. 

The economic outlook remains uncertain. In its April forecasts, the IMF expected a 4% real GDP growth rebound in 2021 after a 3.6% contraction in 2020. However, this might be revised down due to the sharper Covid-19 wave since spring and given the slow vaccination roll-out. The protracted impact of the pandemic will continue to weigh on exports and recovery in the important tourism sector, which might also suffer from the recent environmental disaster caused by the sinking of an oil cargo ship. Also taking into account weak capital inflows and large scheduled sovereign bond repayments, external liquidity is likely to remain under strain beyond 2021. In the coming years, their level is projected to stay below the forecast external debt service (estimated to be close to USD 30bn in 2021-2025). Therefore, the authorities could use extra tools to support foreign exchange reserves such as further tightening import restrictions and might even impose capital controls and eventually call the IMF to the rescue. The gloomy public finances, the sharp deterioration of external and public debt ratios and expected external debt repayment stress amid eroding liquidity have increased Sri Lanka’s MLT political risks and led Credendo to downgrade the country from 5/7 to 6/7. OECD premium categories were also raised from 6/7 to 7/7 in early July. 

Analyst: Raphaël Cecchi – r.cecchi@credendo.com