Fitch revises Sri Lanka’s rating outlook to ‘Negative’ from ‘Stable’

Fitch Ratings has revised the outlook on Sri Lanka's Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘Negative’ from ‘Stable’ and has affirmed the IDR at 'B'.

“Revision of the outlook to ‘Negative’ from ‘Stable’ reflects rising risks to debt sustainability from a significant shift in fiscal policy and the potential for roll-back of fiscal and economic reforms in the aftermath of November's Presidential elections. We believe the departure from the previous revenue-based fiscal consolidation path has created policy uncertainty and increased external financing risk for the sovereign, particularly given the large external debt repayments due in 2020 and beyond,” the rating agency said on Thursday.

Newly appointed President Gotabaya Rajapaksa announced sweeping tax cuts soon after taking office, including a revision of the value-added tax (VAT) rate to 8 per cent from 15 per cent (the rate applicable to financial services has been kept at 15 per cent), an increase in the liable limit for VAT registration to Rs.300 million, scrapping of the Nation Building Tax, lowering the income tax rate for the highest income bracket to 18 per cent, from 24 per cent, and changing the withholding tax regime, among others.

Fitch said its preliminary estimates show that the VAT rate change and the scrapping of the nation building tax could alone lower revenue by as much as 2 per cent of GDP in the absence of off-setting measures; VAT accounted for 24 per cent of government revenues in 2018. The authorities have identified offsetting revenue and expenditure measures that they believe would make these tax cuts revenue neutral. These include a hike in the excise duty on liquor and cigarettes, which accounts for about 10 per cent of VAT revenue, and an increase in the Ports and Airports Development Levy to 10.0 per cent, from 7.5 per cent. In addition, financial services, which account for 15 per cent of VAT, will not be affected by the rate cut. The authorities project the expenditure adjustment to come mainly from a cutback in public investment.

Fitch expects these offsetting measures, such as adjustments to excise taxes and spending cuts on non-priority public investment and recurrent expenditure, to mitigate part of the revenue loss from the tax announcement. However, the agency nevertheless expects the deficit to widen by about 1.5 per cent of GDP relative to our previous forecasts.

Fitch has revised its budget deficit projection to 6.5 per cent of GDP for 2020 and 6.2 per cent for 2021, which are higher than the authorities' estimates, from 5 per cent previously in both years. Following the tax cuts, Fitch projects that gross general government debt, currently at about 85 per cent of GDP, will be on an upward trajectory over the medium-term in the absence of off-setting measures.

“Fitch believes the authorities still aim to reduce the deficit to below 4 per cent of GDP over the medium-term in line with their previous consolidation plans. However, the announced tax measures create uncertainty about the feasibility of these plans. The outlook for the completion of the seventh and final review under the Extended Fund Facility arrangement with the IMF now seems uncertain and discussions of a new programme after the parliamentary elections expected in April 2020 could be complicated by the tax cuts,” it said in a statement.
Fitch acknowledges that the tax cut announcement has come during the early period of the new administration and that further policy announcements will follow, which could mitigate some fiscal issues. “However, we believe the initial evidence of a roll-back of the revenue-driven fiscal consolidation path is negative for the sovereign's creditworthiness.”
Fitch expects growth to pick up to 3.5 per cent in 2020 and 3.7 per cent in 2021, from 2.8 per cent in 2019. These forecasts reflect Fitch’s expectation of a boost to growth in the short-term from the tax cuts, higher agricultural output and an ongoing recovery in tourism following last April's terrorist bombings. Remittances are also likely to remain supportive of domestic demand.
Sri Lanka's external balance sheet is weak, with external debt obligations totalling approximately US$19 billion coming due between 2020-2023, compared with foreign-exchange reserves of around $7.5 billion as of end-November 2019. “We expect the current account deficit to widen to about 3 per cent of GDP in 2020 and 2021, from an estimated 2.2 per cent in 2019, as domestic demand strengthens,” it said.

Large interest payments as a share of revenue, at about 46 per cent (current peer median 10.2 per cent), a low revenue ratio and a very high public debt/revenue ratio of 643 per cent continue to highlight the weak structure of Sri Lanka's public finances. In addition, foreign-currency debt is nearly half of total government debt and leaves public finances vulnerable to renewed currency depreciation.