Sri Lanka’s economic trajectory has recently witnessed some noteworthy developments, according to Fitch Ratings’ recent evaluation which provides a multifaceted perspective on where the nation stands, what drives its current economic narrative, and the areas needing immediate attention. In a September 2023 statement, Fitch said Sri Lanka finds itself at a pivotal juncture. While Fitch Ratings’ assessment underscores certain positive strides, it simultaneously highlights areas requiring focused, strategic interventions. The road ahead is intricate, demanding a harmonized blend of national initiatives to drive through long-needed structural reforms.
Resilience with Caveats
In a significant move, Fitch upgraded Sri Lanka’s LongTerm Local-Currency Issuer Default Rating (IDR) from ‘RD’ to ‘CCC-‘, a sign of moderate stability. This upgrade primarily recognizes the conclusion of Sri Lanka’s domestic debt optimization, an initiative where the Central Bank of Sri Lanka traded treasury bills for new bonds and bills. Such measures could lower Sri Lanka’s financing needs, aligning with the IMF’s Extended Fund Facility recommendations. Still, the local optimism is counterbalanced by the affirming of the Long-Term Foreign-Currency IDR at ‘RD’, signalling continued challenges on the foreign currency front.
A Looming Shadow
While Sri Lanka has initiated efforts to restructure its debt, the country’s governmental debt continues to be a significant concern. According to IMF forecasts, the debt-to-GDP ratio, which stood at a worrying 128% in 2022, is only expected to decrease marginally, hovering just above 100% by 2028. These figures accentuate the pressing need for comprehensive economic strategies to effectively manage and reduce this debt burden.
In anticipation of decreased government financing requirements after the local-currency debt exchange, there remains a vital emphasis on restructuring external debt. In a bid to bolster revenue streams, the government has taken assertive fiscal steps since May 2022. This includes raising corporate income taxes, increasing VAT rates, and implementing higher fuel excise taxes. These initiatives seem to be paying off, as evidenced by a notable 43% surge in revenue during the first half of 2023. As part of ongoing fiscal reforms, upcoming measures include the phasing out of certain VAT exemptions and the launch of property taxes.
Silver Lining
Sri Lanka’s foreign exchange reserves have showcased a promising increase, soaring to $3.6 billion in August 2023 – an impressive leap from its position at the close of 2022. This significant rise, attributed in part to disbursements from the IMF and a pause in external debt payments, is a vital sign of the nation’s improving fiscal position. However, the lack of strong access to global capital markets means Sri Lanka continues to rely heavily on formal financial channels. While recent GDP numbers suggest a lessening of economic contraction and forecasts indicate potential growth in the coming years, the path to economic recovery remains fraught with challenges.
On the banking front, there’s a glimmer of hope. Banks have benefitted from the decision to keep their treasury securities holdings separate from the country’s efforts at domestic debt optimization. Coupled with their minimal involvement with defaulted sovereign bonds and a commendable provision coverage ratio, they find themselves in a relatively secure position. Still, the unresolved issue of outstanding foreign-currency commitments, with the nation’s debts still in arrears, demands immediate attention.
Furthermore, the International Monetary Fund, during its 17th mission to Sri Lanka in September, emphasized the nation’s progress. The IMF’s statement highlighted a collective consensus on the imperative of maintaining the pace of reforms, signalling a potentially transformative phase for the country’s economy.
Gains on the Horizon
Despite facing significant obstacles, Sri Lanka has demonstrated remarkable resilience and progress, as highlighted by the IMF. The country’s dedication to vital reforms is now bearing fruit. A prime example is the drastic reduction in inflation from a staggering 70% in September 2022 to just under 2% a year later, underscoring the effectiveness of Sri Lanka’s economic measures. Furthermore, in a relatively short span, the nation’s gross international reserves swelled by $1.5 billion. This economic upturn has also positively impacted the consistent availability of essential commodities.
Yet, the journey to full economic recovery remains challenging. Recent real GDP data, along with other economic markers, depict a multifaceted picture. Notably, the real GDP saw a contraction of 3.1% in the most recent quarter, accompanied by a noticeable slowdown in the growth of reserves.
Revenue generation remains a concern. Despite improvements throughout the year, projections hint at a potential 15% revenue shortfall by the end of the year, influenced by various economic elements. The IMF cautions that without corrective measures, this could place substantial fiscal pressure on the country, jeopardizing essential public services and potentially diverting Sri Lanka from its debt sustainability goals. The IMF emphasizes the urgent need to fortify tax administration, eradicate tax exemptions, and vigorously counter tax evasion.
Structural Reforms: A Beacon of Hope
Despite facing numerous challenges, the Sri Lankan government has actively pursued structural reforms. Noteworthy among these is the introduction of significant legislation, including the new Central Bank Act and the Anti-Corruption Act. When effectively executed, these can significantly strengthen governance. The government’s intent is further evident in its initiatives to revamp the welfare system and improve banking frameworks, highlighting its commitment to broad-based reforms.
The recent IMF report emphasizes the progress Sri Lanka has made in its journey towards debt sustainability, notably through its efforts in domestic debt restructuring. While the success of these efforts is still under review by the Executive Board, the IMF remains hopeful about Sri Lanka’s adherence to the programme’s debt objectives.
The IMF and Fitch both allude to Sri Lanka being at a crucial crossroads. The nation has a clear opportunity for economic revival. Both Fitch Ratings and the IMF acknowledge this potential, emphasizing the need for consistent reforms, fiscal responsibility, and global partnerships to help Sri Lanka harness its full economic promise.