Sri Lanka Outlook Revised To Negative On Rising Fiscal And External #B+/B# Ratings Affirmed

Stocks and Financial Services Press Releases Thursday March 10, 2016 16:39
Standard & Poor's--10 Mar--Standard & Poor's

On March 10, 2016, Standard & Poor's Ratings Services revised the outlook on its 'B+' long-term sovereign credit ratings on the Democratic Socialist Republic of Sri Lanka to negative from stable. We also affirmed the long-term rating and the 'B' short-term credit rating and left our transfer and convertibility risk assessment on Sri Lanka unchanged at 'B+'.

RATIONALE

The negative outlook reflects rising pressure on Sri Lanka's external liquidity resulting from a weaker trade balance and remittances, and short-term capital outflows that have eroded its reserve buffers. The outlook also reflects the country's weakened public finances. We expect sizable and rising projected fiscal deficits to push borrowings higher in 2016-2019. In our view, the authorities face significant challenges in effectively addressing the rising imbalance due to institutional constraints and a fragmented political landscape.

The rating constraints on Sri Lanka are the country's weak external liquidity and a high general government net debt burden (at 72% of GDP in 2015). Sri Lanka's general government dedicates a higher share of its revenues to

interest payments and it is among the highest in the world (39% in 2015). With GDP per capita at US$4,000 (2016), Sri Lanka's level of prosperity is low.

Another credit weakness lies in what we consider as an uncertain commitment and capacity to fiscal consolidation following the Aug. 17, 2015, parliamentary elections and the 2016 budget delivered on Nov. 20, 2015. Institutional capacity remains low by international standards and poses risks to the effectiveness and predictability of Sri Lanka's policy choices. These rating constraints weigh against Sri Lanka's robust growth prospects, which are above average for sovereigns at similar levels of development.

Sri Lanka's weakening external liquidity has been driven, inter alia, by the
following trends:
Our expectation of the trade deficit widening to an estimated 11.4% of GDP in 2016, versus 10.2% in 2013-2015.

This development is due partly to a sharp rise in motor vehicle imports for investment purposes and personal use. A reduction in import-related taxes on motor vehicles in the 2016 budget, low interest rates for leasing facilities, and increases in public sector salaries were reasons for the higher demand.Our projection of net current transfers--mostly workers' remittances, of which more than half come from the Gulf states--dropping to 7.2% of GDP in 2016 versus an average 7.7% in the three preceding years.

A pickup in short-term capital outflows.On the financing side, negative net portfolio inflows in 2015. We currently do not expect a recovery before 2017.

We expect external liquidity (measured by gross external financing needs as a percentage of current account receipts [CAR] plus usable reserves) will average 122% over 2016-2019, compared with 111% in 2014-2015. We also forecast that the country's external debt (net of official reserves and financial sector external assets) will be about 143% of CAR this year but will rise gradually to a little below 146% by 2019.

The risks associated with Sri Lanka's weak external settings had previously been mitigated by growing reserve buffers that buttressed the country's external resilience. We estimate, however, that Sri Lanka's gross international reserves (excluding gold deposits) were US$5.5 billion as of January 2016 (over two months coverage of current account payments), compared with an average of US$8.2 billion in 2014 (3.5 months of current account payments). These reserves include a fully drawn contingent currency-swap facility of US$1.1 billion with the Reserve Bank of India (RBI; due for repayment in March 2016) and the US$2.15 billion proceeds from bonds issued in May and October 2015 (both maturing in 2025)

We believe the attendant risks could be mitigated by extending the maturity of the currency-swap facility with the RBI, increasing a US$1.6 billion facility with the People's Bank of China, and a US$400 million financing facility for South Asian Association for Regional Cooperation member country Central Banks.

Securing external liquidity support from the IMF could also ease rising external funding pressure. Other factors that mitigate Sri Lanka's external risks include its low banking sector external borrowings and some exchange rate flexibility (the rupee fell about 9% in 2015, although this has yet to translate into higher export demand).

Fundamental weaknesses remain in the government's fiscal metrics. We project annual growth in general government debt to average 6.2% of GDP for 2016-2019. In view of Sri Lanka's robust nominal GDP growth, we expect net general government debt to remain near current levels of close to 70% of GDP through 2019. Should the rupee depreciate further against the U.S. dollar, the net debt ratio may rise further, given about 60% of government debt is denominated in foreign currencies. In addition, we expect only slow progress in reducing debt-servicing costs, which we project to account for more than 40% of government revenue in 2016. This is the second-highest ratio among all 131 sovereigns that Standard & Poor's currently rates, second only to Lebanon (see "Sovereign Risk Indicators," published Dec. 14, 2015; a free interactive version is available at spratings.com/sri).

The gaps we observe in Sri Lanka's policymaking capacity partly reflect the political uncertainty associated with two elections within seven months. We believe this hinders responsiveness and predictability in policymaking and weighs particularly on business confidence, investment plans, and overall growth prospects. Elsewhere, we believe the Central Bank of Sri Lanka's (CBSL) ability to sustain economic growth while attenuating economic or financial shocks has improved somewhat. Although CBSL is not independent of other policymaking institutions and we continue to consider monetary policy credibility and effectiveness as a weakness, the central bank is building a record of credibility, shown in reducing inflation through the use of market-based instruments to conduct monetary policy.

Sri Lanka's growth outlook continues to be underpinned by government investment (including rebuilding the war-torn northern districts), rising tourist arrivals, and declining inflation, which we expect to remain in the

single digits.

We continue to expect Sri Lanka's growth prospects to be favorable. We believe the country will most likely maintain growth in real per capita GDP of 5.5% per year over 2016-2019 (equivalent to 6.2% real GDP growth). Stronger growth, in our view, would require an improved business environment and a pick-up in

export markets.

Combining our view of Sri Lanka's state-owned enterprises and its small financial system (banks' loans to the private sector account for only a third of GDP), we view the government's contingent liabilities as limited.

OUTLOOK

The negative outlook indicates that we could lower our rating on Sri Lanka in the next 12 months if we see no tangible signs of a substantial and sustained reversal of the weakening of external and fiscal credit metrics we currently project.

We may revise the outlook back to stable if Sri Lanka's external and fiscal indicators improve significantly, or if we conclude that the strength of Sri Lanka's institutions and governance practices is on a significant and   sustained improving trend.


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