Fitch downgrades Sri Lanka to ‘B+’

Fitch Ratings last week dealt a major blow to Sri Lanka’s investor profile when it downgraded the Longterm foreign and local currency Issuer Default Ratings (IDRs) of the Democratic Socialist Republic of Sri Lanka to ‘B+’ from ‘BB-’ (BB minus).

However it said the Outlook is now Stable, as against the negative tag previously. The agency has also downgraded the Country Ceiling to ‘B+’ from ‘BB-’ (BB minus) and affirmed the Short-term IDR at ‘B’.

“The ratings downgrade of Sri Lanka reflects the increased vulnerability of sovereign creditworthiness to adverse shocks associated with rising inflation, persistently large fiscal deficits and worsened terms of trade due to soaring oil prices in the context of greater government recourse to commercial and market-based financing,” said James McCormack, Head of Asia sovereign ratings. Sri Lanka’s ratings remain underpinned by its impeccable debt service record, a business environment that compares favourably to regional and rating peers and a moderate external debt service burden. These strong credit fundamentals provide the policy authorities with ample time and opportunity to implement structural and fiscal reforms that could materially strengthen public finances, and support the Stable Outlook on Sri Lanka’s ratings.

Food and oil price shocks have contributed to a sharp acceleration in consumer price inflation, to 24% yoy in February 2008. High and volatile inflation increases the risk of macroeconomic instability and discourages investment, with negative medium-term growth implications. Increases in inflation and domestic interest rates have led to greater foreign-currency borrowing by the government, along with reductions in the duration of domestic-currency borrowing as investors seek to protect the real value of their investments. Repayments of foreign-currency public debt will amount to USD1.5 billion in 2008, USD600 million of which is domestic debt, equivalent to about 23% of domestic amortization payments. Despite the tightening of monetary policy, Fitch expects inflation to remain relatively high, and the agency believes it will prove challenging to reduce inflation significantly without inducing a sharp slowdown in economic growth that would expose weaknesses in public finances.

The government has contained the direct fiscal cost of rising energy import prices by reducing subsidies on domestic fuel products and raising electricity tariffs. At the same time, the country’s tax administration has been strengthened, as has public expenditure control. In addition, the ratio of government debt to GDP has gradually declined from 91% in 2005 to 86% in 2007, and is projected to fall further. Even so, Fitch believes the strength of the economy in recent years afforded scope for much greater fiscal consolidation that could have released more resources for capital investment and reduced the vulnerability of public finances to adverse shocks. As debt costs have risen in recent years, so has the share of government revenue that is accounted for by interest payments - to 31% in 2007 compared to the ‘B’ median of 5%.

The military campaign against the terrorist ‘Tamil Tigers’ (LTTE) has significantly expanded the territory under government control, isolating the LTTE in its northern stronghold. The government has also sponsored a process to forge a political consensus on constitutional reforms that would address the aspirations of the Tamil community without threatening the integrity of the Sri Lankan sovereign state.

Nonetheless, in Fitch’s opinion a lasting and secure settlement of the conflict is unlikely to be realized in the near term, and the risk of disruptive terrorist attacks, despite the military gains made against the LTTE, cannot be wholly discounted. Moreover, with the management of the conflict being the overriding priority of the President and government, fiscal reforms and other economic policy issues are accorded less attention. While Sri Lanka’s ratings are robust to a further intensification of the conflict, the realisation of a ‘peace dividend’ would be credit positive.

Rating Rationale

• Sri Lankan economic growth has proven resilient to continued conflict between government forces and the Liberation Tigers of Tamil Eelam (LTTE), a terrorist organisation that first took up arms in 1983. Despite a resurgence of violence in 2006, average annual GDP growth since 2005 has been the highest in 30 years.
  
• This impressive economic performance has been supported in part by monetary and fiscal stimulus that is not sustainable in the medium term. Monetary policy was tightened in 2007, but inflation is over 20% and still trending higher. Fiscal deficits are well above the objectives identified in the Fiscal Management Act of 2003. Since Sri Lanka’s ratings were assigned in 2005, the credibility of fiscal and monetary policy has been undercut by the repeated missing of targets.
  
• In early 2008, the government pulled out of a 2002 ceasefire agreement with the LTTE, formalising a de facto end to the accord that took place about two years earlier. The government has made considerable progress in terms of regaining territories in the east and moving ahead with political processes aimed at addressing the country’s ethnic divisions. Fitch Ratings is not certain, however, that military advances by the government accompanied by the various political initiatives necessarily presage an end to the conflict.
  
• The 2007 fiscal deficit was 6.9% of GDP, marginally lower than in the previous two years. Meaningful fiscal improvement is impeded by the extensive use of tax concessions and exemptions, and Fitch forecasts deficits averaging about 7% of GDP for 2008 and 2009. The 2008 budget is based on unrealistic projections for tax collection, and spending will need to be cut to prevent a major overrun. Fiscal flexibility is extremely limited, as wages plus interest payments were equivalent to 70% of revenue (excluding grants) in 2007.
  
• Sri Lanka’s government debt, at 86% of GDP at end2007, is more than twice the ‘BB’ and ‘B’ medians, and among the highest of any rated sovereign. Debt ratios have been falling in recent years, but this is offset by the emergence of other risks. Government borrowing in foreign currency is increasing, setting Sri Lanka apart from most other emerging markets, which are relying more on local currency debt. In addition, the duration of domestic debt has been falling since 2005 — a deterioration in the debt structure that is unlikely to be reversed at least until monetary credibility is restored.
  
  
  
  Key Rating Drivers
  
  
• Definitive, peaceful resolution of Sri Lanka’s ethnic differences could transform the country’s economic prospects, displacing the inevitable constraints on growth and development that are associated with prolonged conflict. These constraints also affect public finances, and, in Fitch’s view, the willingness and ability of policymakers to enact economic reforms that may involve transition costs. With positive implications for economic growth and public finances, a more stable security situation would support sovereign creditworthiness.
  
• Sri Lanka’s external debt service burden is relatively low, forecast at 11% of current external earnings (CXR) in 2008. The country’s international liquidity ratio, however, is also low, at about 100%. Moreover, the projected gross external financing need in 2008 is equivalent to 88% of end2007 foreign exchange reserves. Such a weak external financial position is vulnerable to shocks, and a significant external shock would likely exert downward pressure on the sovereign ratings. (Fitch)

CB says what is right and wrong in Fitch’s rating

Central Bank last week in a statement listed what was right and wrong in Fitch’s rating decision. Following is the full text of the statement.

Fitch has revised the outlook on the Foreign and Local Currency Issuer Default Ratings to Stable from Negative reflecting the improvements in investment climate in Sri Lanka. Fitch has also acknowledged the fiscal consolidation efforts of the government including revenue enhancing measures, containment of expenditure on subsidies, improvement in debt ratios, and the tightening of monetary policy by the Central Bank. In addition, Fitch has recognised that food and oil price shocks have contributed to sharp acceleration in consumer price inflation in Sri Lanka. The country’s impeccable debt service record has also been highlighted together with the improvement of the business environment in comparison to its regional and rating peers, and the moderate external debt service burden.

Notwithstanding these improvements, Fitch has downgraded Sri Lanka’s ratings, which is not consistent with improvements in several macroeconomic fundamentals which have been also acknowledged by the Fitch.

It is stated that Fitch has a concern on the repayment of foreign currency debt. This statement is not valid since, out of US dollars 1.5 billion foreign currency debt repayment in 2008, a total of around US dollars 600 million is to domestic banks. Hence, the roll-over risk is practically nil. Moreover, even if these domestic foreign currency loans were repaid, it will not change the total external reserves of the country as these foreign currency loans are assets of domestic commercial banks, particularly the two state banks. In addition, for the year 2008, worker remittances are expected to increase to US dollars 2.8 billion, foreign inflows to government to US dollars 2.0 billion and the FDI to US dollars 700 million. In fact, during the first three months of 2008, net international reserves of Sri Lanka have increased by over US dollars 420 million from their level as at end 2007.

The Sri Lankan authorities also do not agree with Fitch’s opinion on the security situation in Sri Lanka to the effect that the risk of disruptive terrorist attacks, despite the military gain, cannot be wholly discounted. As stated by Fitch in its report, the government has expanded its control in the entire East and now is moving towards the North and has already regained certain areas in the North, such as in Mannar.

The downward revision of ratings is based on Fitch’s pessimistic views on the security situation, inflation and foreign currency borrowings. In view of the above facts, Sri Lankan authorities believe a downgrade in ratings is not in line with the recent improvements in the country’s macroeconomic fundamentals and its future outlook.