Fitch Ratings-Hong Kong/Singapore-14 November 2017: Sri Lanka’s budget for 2018 sticks broadly to the targets for fiscal deficit reduction under its three-year IMF programme, which began in June 2016. However, high government debt and the large cost of debt servicing weigh heavily on Sri Lanka’s credit profile and will require sustained fiscal consolidation over the long term, says Fitch Ratings.
The recently announced budget targets a fiscal deficit of 4.8% of GDP in 2018, which is only slightly above the 4.7% target agreed with the IMF and continues the consolidation that began in 2016. Floods and drought weighed on the economy and public finances during 2017, and contributed to the government missing its initial 2017 fiscal deficit target of 4.6% of GDP. Nevertheless, the authorities still expect the 2017 deficit outturn to fall to 5.2% of GDP, from 5.4% in 2016. Consolidation in 2017 has been driven by measures to boost tax revenue, including a hike in the value-added tax (VAT) to 15% in November 2016 from 11%.
The government expects revenue to rise strongly again in 2018, to 15.7% of GDP, from 14.7% in 2017. Revenue should be supported by an Inland Revenue Act passed in September 2016, provided implementation is effective. The act, which will come into effect from 1 April 2018, aims to simplify the tax laws and improve the efficiency of the system. Despite these positive reforms, we see downside risks to the government’s revenue projections, given that they are based on a GDP growth assumption of 5%-6% for next year, compared with our own of 4.5%.
On the expenditure side, the government expects public investment spending to rise by 20% in 2018, while recurring spending is forecast to decline. Interest payments are expected to account for more than one-third of total revenue, which is a key weakness in the fiscal profile.
Addressing long-standing weaknesses in Sri Lanka’s public finances will require an extended commitment to consolidation from the authorities. In particular, we highlighted the importance of a stabilisation of government debt ratios when we affirmed Sri Lanka’s rating at ‘B+’ with a Stable Outlook in February 2017.
The government debt/GDP ratio rose to 79.3% of GDP in 2016 – well above the 60.9% median for sovereigns rated ‘B’ or lower – and we estimate that it will increase again in 2017. Our baseline projection is still that government debt ratios will stabilise within the next couple of years, but these forecasts are vulnerable to fiscal slippage or an economic downturn. Exchange rate depreciation could also push up the local-currency value of government debt, given around 40% of the total was denominated in foreign currency at end-2016, according to Fitch estimates.
Sri Lanka’s external position was the other factor that led the government into an IMF programme. Foreign-exchange reserves rose to USD7.5 billion at end-October, from USD 6.1 billion at end-2016, and we estimate reserves could be sufficient to cover 3.3 months of current account payment by end-2017. However, the external liquidity ratio, at 65.6%, is still well below the ‘B’ median of 134.2%, according to our estimates. Sri Lanka faces a challenging external debt service schedule in the near term, with very large external debt maturities coming up over 2019-22.
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