In the last days of November 2020 during a second coronavirus wave, Fitch Ratings downgraded Sri Lanka’s country rating to CCC, down from B-. This was days after the government announced its budget for 2021 and plans for a post-COVID revival of the economy ravaged by the pandemic. The rating agency was not impressed.
“In our view,” it said in a statement, “the budget lacks a credible fiscal consolidation strategy and provides only limited details on the potential revenue impact of some of the measures announced, raising uncertainty about the government’s planned reduction in government debt and budget deficit.
” The government plans to widen the deficit to nearly 9% of GDP in 2021, up from nearly 8% estimated for the previous year. The rating downgrade dampens prospects of raising much-needed debt capital from international capital markets to finance debt repayments and large infrastructure and also impacts the country’s banking sector and their relationships with global correspondent banks.
Banks continue to operate in a challenging environment with non-performing loans increasing to 5.4% by the end of June 2020, up from 4.7% six months earlier. “Underlying asset-quality stress could continue to build, despite the regulatory relief in the form of a moratorium for affected customers that has to a large extent halted the recognition of credit impairment. Sri Lankan banks could also face increased challenges in foreign currency funding stemming from the deteriorating sovereign credit profile,” Fitch said.
Fitch forecasts Sri Lanka’s GDP to contract by 6.7% in 2020 and recover to 4.9% in 2021, partly driven by the low-base effect. The government projects revenue growth of 28% in 2021 but Fitch calls it ‘highly ambitious’ due to the numerous tax cuts and incentives offered and the absence of any major revenue-raising measures. The budget proposed to increase public investments to 6.1% of GDP in 2021, up from 2.6% in 2020.
The country’s Central Bank was quick to respond and defended its ability to meet heavy foreign debt repayment obligations over the next few years.
“As the relative share of outstanding foreign debt has already fallen to 44%, projecting a rise in foreign debt servicing obligations in the period ahead cannot be corroborated with facts,” the Central Bank said in a statement objecting to the downgrade. “Based on such unfounded assumptions, Fitch Ratings project a government debt to GDP ratio of 100% in 2020, and 116% by 2024, while grossly overestimating the budget deficit at around 11.5%.”
Fitch Ratings’ Sri Lanka Country Manager Maninda Wickramasinghe believes otherwise. “We need to realise there is a fundamental problem when the rating is downgraded four times in four years,” he says in this interview with Echelon magazine where he discusses Sri Lanka’s challenges and prospects in the wake of the recent downgrade, and alternatives to international capital markets and the next for Sri Lanka.
What is the outlook for both the local and global capital markets in the context of our sovereign bonds? And the ability of corporates to raise capital in the year ahead?
The downgrade makes conditions unfavourable for the government to raise capital in international bond markets. Local banks may start to feel the impact first, in the form of restrictions from their correspondent banks globally when negotiating trade facilities and long term, or enhanced, credit lines. Sri Lanka have an opportunity to appeal to the Diaspora to invest their forex savings locally.
There are some options available if the operating environment becomes difficult. We need to resolve to build enough foreign reserves to meet repayments of external debt amounting to about $4.5 billion maturing over the next 12-13 months. With the international bond market being an unattractive option, we can renegotiate bilateral loans, by negotiating deferred repayments or extend payback periods. We also need to look at how we can rebalance the external trading account. Import substitution and restricting imports alone is not going to help us.
We need to grow our export markets because it is a sustainable way to build reserves, but this requires attracting FDI and global talent and acquiring technology to develop our competitive advantages. Over the years, Sri Lanka has restricted imports of certain goods while importing goods than can be produced here while exports have declined for decades.
We need a solid industrial base, and if we lack the capacity for large scale manufacturing, we need to then specialise in niche markets. It is vital to focus on our competitive advantages right now. I believe the government is focusing on this area and even introduced several incentives to attract private investments. The government is also making a push to develop the necessary infrastructure.
We need to encourage international capital to find its way here because Sri Lanka does not have the resources to develop. We need to approach investments in the Colombo Port and Hambantota industrial zone with a sense of urgency and be more strategic.
For instance, we only have one functional terminal at the extended deep water port in Colombo, which has a built-in capacity for three. India continues to make a strong push to develop its ports so we cannot afford to delay. We also need to look at how we can make the Mattala Airport more sustainable and make it an international destination. The country has nine domestic airports, but they need upgrading to attract high-end tourists to up our tourism offering and boost our external sector balances.
We need to pick and choose where to deploy strategic investments and develop those quickly. Therein lies our opportunity, and the government need not take on the entire burden. Sri Lanka does not have room to borrow so needs to explore alternate models such as private-public partnerships.
We need to attract more FDI. The Colombo Port City and Hambantota Special Economic Zone should be priorities so that foreign capital can flow in and generate opportunities for the private sector. Fast-tracking these two projects is an immediate requirement. Much of the supporting infrastructure is in place. We need to move on!
The proposed new laws that will govern commercial activity in the International Financial Centre at the Colombo Port City aims to create a business and investor-friendly environment by putting in place an efficient administration and a credible legal system. It will serve as a benchmark for the rest of the country where many archaic laws and practices need overhauling to attract capital.
How effective will the current import restrictions be in the long-run?
We cannot ban imports completely, and there is a balance that needs to be maintained because you need to drive your exports to other countries, so good relations matter.
However, we need to manage our external trade flows, and tariff adjustments are the best way to do this. Countries in Asia from Japan to South Korea, Taiwan, Thailand, and Malaysia, have done import substitution, but they grew their exports. They built new export markets by incentivising FDIs and technology transfers.
Sri Lanka also needs a strategy about gaining access to large markets in the South Asian region such as India next door. We have a trade agreement with India, so why are not we exploiting it?
We should not slap import restrictions and tariffs across the board but be strategic about it. For instance, are we importing goods that can be produced at low cost here? During an economic crisis, we need to manage foreign exchange outflows strategically. So, it is valid to question the logic of importing goods that can be locally produced.
We need to build competitive advantages so local businesses can scale operations and look for new export markets. The problem with Sri Lanka, and for a long time now, is that we do not have enough import substitution, but restrict imports to protect a few large suppliers monopolising the domestic market.
Sri Lanka also needs a strategy about gaining access to large markets in the South Asian region such as India next door. We need to create opportunities for entrepreneurs to get access to credit, scale their businesses and then make inroads in these large export markets. We have a trade agreement with India, so why are not we exploiting it?
Can you explain to us the underlying factors behind the recent credit rating downgrade?
Sri Lanka has been downgraded four times from BB- in 2016 to CCC in November 2020. We hear many arguments against the rationale of the rating downgrades, but what is not recognised is that fact that Sri Lanka has been in a downward spiral and that it is not paying attention to something. Things have been allowed to deteriorate.
The economy has had unfortunate setbacks from the 2019 Easter attacks and then came the Coronavirus pandemic. But this is what risk management is all about. As a country, we have accumulated risks as we go along, but do little to manage risks, so when a crisis hits, the recovery is painful and prolonged because the government has limited resources to stimulate the economy and often painful adjustments are needed. While we have little control over external risks, we have perpetuated our own policy mistakes over the last seven decades since independence and we are running a huge deficit that is financed by debt.
One thing that we have to be mindful of is our budget deficit, and now it is estimated that it will be above 10%. So, the important thing is we have to understand that 2020 is an unusual year with the pandemic and three-month lockdown. The country had to find the money for a stimulus package and there was a sharp drop in revenue on the other hand.
While the government has expressed a willingness to contain the external debt position in the medium term, we need to set our course on a growth trajectory that can sustain itself, but the huge deficits we run are not conducive for that. There are two fundamental problems with the budget that continue to drain the Treasury; one is the oversized public service, and the second is are underperforming state-owned enterprises. There are state enterprises that are profitable and managed like private companies, so these can be good models to adapt for reforming the rest.
When you set off on a growth trajectory, two areas to look at is macroeconomic stability and policy consistency that makes it sustainable. Managing the exchange rate and interest rates in a balanced way is important so that credit growth can lead to a revival of the economy without inflation running out of control.
There are limitations to how much we can borrow, I believe our debt repayments amount to something like $23 billion by 2025, so we may be in a situation where we find ourselves sliding further down if the pandemic persists
But a government running a high deficit will find it difficult to do that. The country also needs to seriously consider reversing this trend of downgrades. We must recognise that we cannot operate in isolation. As a middle-income country, Sri Lanka does not have access to grants and cheap credit, so there is no option but raise funds to bridge the deficit from the international capital market.
There are limitations to how much we can borrow, I believe our debt repayments amount to something like $23 billion by 2025, so we may be in a situation where we find ourselves sliding further down if the pandemic persists and we do not have much space to provide a meaningful stimulus. We need to make use of the opportunity to build the foreign exchange reserves and also push for the important macroeconomic reforms that can divert the country away from the cycle of debt.
A recent Fitch report says that the Sri Lankan banking sector has substantial fundamental credit risk, which is tied to the sovereign rating, but it also says that there is an indication that there’s low vulnerability to potential systemic risk, what does this mean for the banking sector?
It has been a tough two years for the banking sector starting with 2019 Easter attacks when the tourism industry collapsed, and banks took a hit due to rising non-performing loans as hotels and other related businesses could not service their loans.
Then came COVID-19 and NPLs just kept piling up. Credit growth was around 6% in 2019 and maybe even less in 2020 so the operating environment for banks was not that great. The good news is that there is renewed interest and demand for credit due to the low interest rate regime. The question now is whether we can set our growth plans in motion.
When you look at Sri Lanka’s credit cycles, it usually takes the banking sector 12-18 months to recover from a slowdown, provided the economy recovers and the bank can grow their balance sheets. However, if credit expansion remains subdued, loan impairments increase and banks have few growth opportunities, that’s when systemic risks build up. It is a vicious cycle but so far, we do not see those risks in the banking sector.
The regulator has taken measures to soften the impact on banks after a debt moratorium was announced to help struggling businesses during the lockdown period. For instance, accounting rules on collective impairments were relaxed and banks were allowed to reschedule their loan books so that loan-loss provisioning is not a big drag on earnings.
The question is how long can the banking sector continue under these conditions as stress builds up. Banks mostly lend on security such as property and buildings, but this leads to a problem. The entire banking system builds up risk because loan recoveries are challenging under these economic conditions and assets pledged as security cannot be liquidated easily. The downgrade of the sovereign rating also impacts the banking sector because it is tightly integrated with the economy.
Macroeconomic reforms are particularly complex and could even take time. Until then, what options do we have to contain the rating slide, and still find resources to finance growth?
One option is to prioritise the large-scale infrastructure projects and select the ones that can generate economic activity and create jobs and negotiate to offer an equity stake instead of borrowing. This ensures that a lender is not lending to the country but to the project.
Another option is to consider arbitrage opportunities because yields are better here compared to the benchmark 10-year Treasury bond, so you can raise capital to pay off some existing loans. The government can also negotiate a deferment or credit enhancement with bilateral lenders who are often friendly countries and maybe more than happy to help. Even in these trying times, there are developed countries with enough capital that has not moved for a year or yielded low returns, so we can use the opportunity of higher yields to negotiate better terms.
Move on to the corporate sector, what are their prospects when it comes to their ratings and being able to raise capital?
The cost structures right down will make dollar borrowings difficult. International capital markets will be expensive, and the local banks may have limited forex reserves to lend.
The country needs to attract more private investments so that
the government can clear its debt and clean its balance sheet, this is what is needed for a stable economy
On the positive side, rupee borrowings may be a viable option because interest rates are low, however, macroeconomic stability will be critical and the government will have to maintain a stable currency and stable rates, so we will have to wait and see how that pans out. Right now, conditions are favourable for corporates to borrow locally with interest rates at low levels and the government announcing various incentives, so the investment climate is good.
The government has proposed to develop a Biotech Park, so clearly, there is an effort to build up competitive advantages and can attract private capital for that. Technology is an exciting emerging industry for Sri Lanka which has the potential to attract FDI and local investments. In tourism, we have built substantial hotel room capacity over the years and we need to now fill them up by thinking out of the box and what travellers emerging from the pandemic will want to experience here.
The pandemic has forced businesses to open their eyes about where they can grow their businesses. Let us take the example of Hayleys. The company is reporting record profits because of rising export demand for activated carbon, rubber-based products, and value-added agriculture products. So, we need more companies that like this, that can think out of the box.
Any thoughts on the 2021 budget? Will it take us to where you think we need to go, towards an economic?
Budgets are more or less a policy statement about the intended direction of the economy. It may or may not achieve all the individual numbers, but it gives us a direction.
While the coconut industry is still very much a traditional industry, there are a few companies that export value-added products such as desiccated coconut and virgin coconut oil which enjoys huge demand. This is the kind of success we need to replicate in other industries. When you do value addition and are able to command good margins, you are in a position to pay better wages.
The tea industry operates a model that has not changed for centuries and struggles to meet worker pay demands. We need to infuse capital and take the industry to a whole new level by focusing on value-added consumer products. The government needs to reconsider its status as owners of the tea plantation lands and give the private sector enough leeway to make viable business decisions that generate better returns, better wages, and improve living standards of the plantations communities. This is true for any industry.
The state does not have the resources to develop industries by itself and needs to get the private sector involved. Take the example of the rubber industry which is more recent than tea. We have private businesses that have built thriving export businesses, around value-added rubber-based products such as protective gloves and tyres that enjoy global recognition. Can tea replicate this success?
So, a lot more needs to be done to change those traditional industries and businesses into globally competitive ones. All the government needs to do is provide the infrastructure and the enabling financial and legal systems. The country needs to attract more private investments so that the government can clear its debt and clean its balance sheet, this is what is needed for a stable economy.