Fitch downgrades Sri Lanka to 'B+', Central Bank disagrees

The Central Bank (CB) took issue with Fitch Ratings this week concerning the agency’s downgrading of long-term foreign and local currency Issuer Default Ratings (IDRs) as well as the country ceiling in Sri Lanka.

The CB stated that the downward revision of ratings is based on Fitch's 'pessimistic views on the security situation, inflation and foreign currency borrowings' and is not in line with the recent improvements in the country's macroeconomic fundamentals and its future outlook. Head of Fitch’s Asia Sovereign Ratings James McCormack said the downgrading was due to 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.

Fitch downgraded the long-term foreign and local currency IDR's of Sri Lanka to 'B+' from 'BB-' (BB minus). The Outlook is now Stable. The agency has also downgraded the Country Ceiling to 'B+' from 'BB-' (BB minus) and affirmed the Short-term IDR at 'B'.

According to Fitch, 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.

Fitch stated that food and oil price shocks have contributed to a sharp acceleration in consumer price inflation, to 24% YOY (Year on Year) 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 US$1.5 billion in 2008, US$600 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 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 CB stated that Fitch's concern on the repayment of foreign currency debt is not valid since out of the US$1.5 billion foreign currency debt repayment in 2008, a total of around US$600 million is to domestic banks. Hence, the roll-over risk is practically nil. Moreover, the CB argued that 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 with two state banks. In addition, for 2008, the CB said that worker remittances are expected to increase to US$2.8 billion, foreign inflows to the government to USD2 billion and the Foreign Direct Investment (FDI) to US$700 million. In fact, during the first three months of 2008, net international reserves of Sri Lanka have increased by over US$420 million from their level as at end 2007.

Fitch also said 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%.

Fitch further stated that 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 realised 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 realization of a 'peace dividend' would be credit positive.

The CB said the Sri Lankan authorities also do not agree with Fitch's opinion on the security situation 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 CB stated that the government has expanded its control in the entire East and is now moving towards the North and has already regained certain areas in the North, such as in Mannar.