The backdrop
In late 2019, Fitch Ratings began what would become a downward spiral of rating downgrades for Sri Lanka, triggered by reckless fiscal policy, high public debt and a fragile external position. The agency noted at the time that there were “external debt obligations totalling approximately USD 19.0 billion coming due between 2020–2023, compared with foreign-exchange reserves of around USD 7.5 billion as of end-November 2019”. S&P Global Ratings and Moody’s followed suit shortly after.
The latest downgrade came on 28 October this year, when Moody’s downgraded the country’s rating to ‘Caa2’ from ‘Caa1’. The agency justified the latest move with “the absence of comprehensive financing to meet the government’s forthcoming significant maturities”. A few months earlier, after revising its own outlook to negative, S&P Global Ratings outlined that “the ability of the government to secure foreign financing over the next two quarters will be crucial to preventing an external liquidity crisis in 2022”. According to Finance Ministry data, the country is facing USD 4.5 billion in debt servicing payments next year.
Wang Ting Seah, Asia country risk analyst at Fitch Solutions, summarized:
“Sri Lanka’s external sector will remain a challenge as official reserve assets have fallen to approximately USD 2.7bn as of end-September, which implies an import cover of about 1.7 months. This is around half the minimum recommended by the IMF and leaves Sri Lanka’s external sector at risk of capital outflows in the event of a sharp rise in global risk aversion, or a faster-than-expected tightening by the Federal Reserve in 2022.”
In addition, analysts at Goldman Sachs said:
“Last year, Sri Lanka screened as one of the sovereigns with the highest left-tail risks on our default probability model, and while Sri Lanka has not defaulted this year, the risks have increased.”
External metrics
Sri Lanka’s external debt is projected to have amounted to 70% of GDP in 2020, with over half of that owed by the general government according to Central Bank data. At the same time, international reserves have declined sharply. However, while there has been an erosion of reserves over the past year, our panelists expect them to increase at a modest pace over the next few years as economic activity recovers from the pandemic-induced slump, and tourism inflows pick back up.
Looking at the current account, the deficit fell in 2020 at the height of the Covid-19 pandemic due to tumbling imports. This more than offset the virtual disappearance of tourism, which continues to struggle to make a comeback due to new variants and still-tough border restrictions. The deficit reached USD 1.5 billion in H1 this year, already surpassing the whole of 2020’s shortfall, as domestic demand recovered. The FocusEconomics Consensus Forecast is for the deficit to reach 3.0% of GDP in 2021. That being said, the trend is set to reverse further ahead, with our panel seeing the current account deficit gradually falling over the forecast horizon, which ends in 2026.
Real sector metrics
The economy has struggled during the pandemic, with tourism hard-hit by global restrictions. The real economy contracted 3.6% in 2020, with losses to nominal GDP worth USD 3.3 billion. Moreover, a public debt-to-GDP ratio of over 100% and a projected fiscal deficit of 11.2% of GDP for this year mean that the risk of a default in the absence of external aid seems likely. Nevertheless, the economy is projected to grow 4.1% in both 2021 and 2022.
What are Sri Lanka’s options?
In July, the country met its obligations by paying USD 1.0 billion worth of loans. However, the country is facing billions more in debt repayments next year. The six-month roadmap presented by the government and the Central Bank on 1 October pledged to find FX sourcing through FDI, remittances, higher exports, new credit lines and swap deals, import substitution and returning tourism.
If the government’s plans outlined in the roadmap fail, there are some potential alternative solutions. Recently, some reports have suggested that the government is mulling an IMF bailout. This could complicate relations with China, but should support business sentiment and currency inflows. Alternatively, the government could request further financing from China, since the port of Colombo plays a crucial role in the Belt and Road Initiative. Sri Lanka already has a three-year USD 1.5 billion swap agreement with the Chinese Central Bank, which it could tap into if needed. Lastly, there is still a possibility that India could come to Sri Lanka’s aid to counter China’s growing influence in the region.
So far the government and Central Bank are attempting to go it alone. But in its latest decision Moody’s considered this to be a risky scenario:
“Ongoing efforts under the authorities’ six-month roadmap to promote macroeconomic and financial stability will likely boost FDI somewhat […]. However, while Sri Lanka’s potential suggests that sizeable foreign exchange receipts could be generated, this potential has remained only partially realised for many years and realising it now is subject to the confidence and risk appetite of investors and travellers, both of which are highly uncertain. Therefore, although reserves are likely to rise slightly over the next few months on the back of some of these inflows materialising, Moody’s expects them to remain insufficient to provide a buffer to meet the government’s external repayment needs.”
Taking stock
Although the six-month roadmap includes well-intended measures aimed at changing the situation, scepticism from rating agencies is likely to continue to weigh on foreign investment. Sri Lanka’s dire external position calls for external aid—be it from China, India or the IMF—along with a profound reshaping of the economy in order to bring both fiscal spending and the external sector onto a more sustainable footing.