FITCH: Political risks still challenge Sri Lanka’s emergence from default

The successful formation of a government under the new president, Ranil Wickremesinghe, is an important precondition for resolving Sri Lanka’s debt default, but many challenges remain as the country seeks financing support from the IMF and debt restructuring from private and official bilateral creditors, Fitch Ratings said in a statement on Thursday.

The new president was confirmed by a large majority in parliament, and his government has drawn in some opposition members. This gives some hope that it will have sufficient support to negotiate and carry out difficult reforms as part of efforts to restore macroeconomic stability and debt sustainability. Such reforms could unlock funding support from the IMF, which we view as important for Sri Lanka’s emergence from default, it said.

The government’s parliamentary position appears strong, but public support for the government is weak. President Wickremesinghe was prime minister in the previous administration under President Gotabaya Rajapaksa, who was brought down by protests. Parliament and the government also remain dominated by politicians from the Sri Lanka People’s Freedom Alliance, which is closely affiliated with the Rajapaksa family. This may increase the risk of further destabilising protests if economic conditions do not improve and/or reforms generate public opposition.

“We expect any reform package agreed with the IMF by the government to include elements such as higher taxes, expenditure rationalisation and a commitment to a greater degree of exchange-rate flexibility. There is a significant risk that such reforms could cause public opposition that might impede their implementation. In the absence of an IMF deal, we expect Sri Lanka to face a very strained external position in the near term. The country has little foreign exchange to pay even for essential imports such as fuel, food and medicines, with official reserve assets at just US$1.9 billion (just over one month of imports) as of end-June,” Fitch said.

In a statement on 30 June, the IMF noted that it assessed Sri Lanka’s public debt as unsustainable, and confirmed that it would require adequate financing assurances from Sri Lanka’s creditors that debt sustainability would be restored.

Debt negotiations could be complicated by debt owed to China. This amounted to $5 billion at end-2020, including bilateral official lending and loans from the China Development Bank and Export-Import Bank of China, accounting for around 13% of Sri Lanka’s external debt, according to the IMF. China has traditionally preferred to offer relief for large loans through deferrals such as maturity extensions, payment rescheduling or grace periods, rather than through write-downs. However, this approach could increase challenges for Sri Lanka to successfully negotiate debt restructuring with other creditors, including private creditors that delivers the debt sustainability sought by the IMF.