The political turmoil triggered in Sri Lanka following the abrupt replacement of the Prime Minister and the Cabinet by the President a month ago has given rise to a constitutional crisis harming an already battered economy. Even before the political catastrophe, the economy was in bad shape on all fronts. The economic growth slowed down to a mere 3.5 percent a year. The budget deficit was high at 5.5 percent of the GDP. The worst has been the foreign exchange situation impaired by rising imports, bulging external debt commitments, decelerating worker remittances and capital outflows. These negative effects could not be offset by the rise in exports and tourist earnings, and hence, the country continues to resort to foreign borrowings to finance the balance of payments deficit posing severe debt service risks.
In the wake of the political turmoil and weak external finances, the rupee hit a record low of Rs. 182.27 per US dollar on Wednesday. The delay in the loan tranche with the IMF and the country’s credit rate downgrade due to political uncertainties fuel external payments imbalance.
Moody’s downgrades Sri Lanka’s Ratings
The global rating agency, Moody’s Investors Service (“Moody’s”) has recently downgraded Sri Lanka’s foreign sovereign debt from B1 to B2. This was done in view of the tightening in external and domestic financing conditions and foreign reserve inadequacy, exacerbated by the recent political crisis. Moody’s also projects a slower pace of fiscal consolidation than assumed previously due to disruption in budgetary management in the backdrop of the political turmoil.
Foreign lenders depend heavily on credit rating agencies in assessing the creditworthiness of potential borrowers. The lower the credit rating assigned to a particular country, the higher the risk premium involved and interest rates to be quoted. Moody’s downgrade has adverse implications for Sri Lanka’s foreign finance which is already in poor state providing itself the basis for the downgrade. The rating cut will add pressure to the government in its effort to seek foreign borrowings. The government will not only have difficulties in raising more funds but it will also have to bear high interest costs for new loans to cover the risk premium as reflected in the rating downgrade.
This forms a vicious circle – poor external finances lead to a rating downgrade which in turn, tightens foreign exchange availability thus, worsening the already-hit external finances. Empirical studies conducted in several countries suggest that there is highly significant positive effect on dollar bond rates when emerging markets’ sovereign bonds are rated low. By contrast, higher credit rating announcements do not have a significant impact on dollar bond rates. Hence, announcements of rating agencies are alleged to be pro-cyclical, meaning ratings are stricter during an economic downturn, compared with an expansion. Sri Lanka which is having a higher rollover rate of debt and limited channels of capital inflows are more prone to pro-cyclical rating announcements. The country will have to pay higher interest rates for its new sovereign bonds following the rating downgrade.
Refuting Moody’s downgrading, the Central Bank claims that Sri Lanka’s current gross external reserves which stood at $ 7.2 billion is sufficient to meet foreign debt obligations, and as a further precautionary measure the Bank has initiated negotiations with the central banks of friendly nations to obtain sizable foreign currency swap facilities.
Macro-financial risks of accumulated debt
The government’s outstanding external debt including government guaranteed loans is at around $ 33 billion. The external debt usually refers to the foreign debt component of the public debt. But the external debt of the country should also include the foreign debt raised by deposit-taking financial institutions and other entities in the private sector, as the repayments and interest payments pertaining to such loans have to be met by using the country’s foreign reserves, irrespective of the type of borrower. When such borrowings are included, the country’s total external debt is around $ 44 billion which is equivalent to as much as 59 percent of GDP.
Net foreign exchange outflow of $ 5.3 billion is projected for loan repayments and interest payments within the next 12 months, as against the official foreign reserve stock of $ 7.2 billion. Given the insufficient export earnings to meet the rising import payments, fresh foreign borrowings are essential to settle the maturing foreign loans.
Sri Lanka has failed to achieve export-led growth despite the economy being liberalized four decades ago. GDP growth in recent years has been driven by the non-tradable sector dominated by locally rendered services – construction, transport, domestic trade and banking. The successive governmen’ts debt-funded infrastructure projects since the cessation of the war in 2009 boosted construction activities and GDP growth. The resulting accumulated debt has posed tremendous macro-financial risks. As shown in the following Chart, there is heavy bulging of debt commitments in the next four years causing enormous debt risks for the economy.
According to the Central Bank, further foreign loans are to be obtained to secure Sri Lanka’s unblemished track record of debt servicing. The issuance of Sri Lanka Development Bonds (SLDBs) of around US $ 750 million to US $ 1 billion during the remainder of the year and in early 2019 is said to be at an advanced stage of completion. In addition, the US $ 500 million enhancement, in February 2019, to the syndicated loan obtained from CDB is also on track. Thus, it is expected to raise more than $ 2 billion by February 2019 mainly through foreign borrowings. The Central Bank states that it would more than cover all the international sovereign bond payments due in 2019. The buffer fund built from proceeds of the divestment of Hambantota port and the syndicated loan of China Development Bank (CDB) will also be utilized to meet debt obligations. In addition, the buffer can be further built up through USD 600 million expected as disbursements from bilateral and multilateral agencies during next year. This kind of roll-over debt, however, is unhealthy from the viewpoint of balance of payments sustainability.
Heavy pressure on the exchange rate
The rupee was already under severe attack in the last three months even before the political turmoil, due to capital outflows, import surge, heavy debt service payments and strengthening of the US dollar in international money markets. The rupee depreciated by 12 percent against the dollar during the last 3 months. Further depreciation could be anticipated in view of the bleak balance of payments outlook, capital outflows and political uncertainty. This will further enhance the pressures on both the government budget and external finances. The rating downgrade by Moody’s makes it more difficult for the government to borrow from capital markets, as mentioned earlier.
The weak external finances and the rapid rupee depreciation have compelled the Central Bank to tighten its monetary policy by raising its Policy Rates with effect from 14 November. Accordingly, the Monetary Board raised the Central Bank’s Standing Deposit Facility Rate (SDFR) by 75 basis points to 8.00 per cent and the Standing Lending Facility Rate (SLFR) by 50 basis points to 9.00 per cent, thereby narrowing the policy rate corridor to 100 basis points. These adjustments are also expected to narrow the spread between deposit and lending rates in the market.
Source: Central Bank of Sri Lanka
Economic outlook disturbing
In the background of the worsening political turmoil, the future outlook of the economy appears bleak. There is no decision yet whether to present the Budget for 2019 or alternatively, a Vote on Account. In the absence of a Budget, fiscal directions are not clear. The already announced goodies including tax concessions, price cuts and various other populist reliefs by the newly set up Government will misfire the fiscal targets aggravating external finance imbalances and inflationary pressures. The Central Bank will not be able to exercise its inflation-targeting monetary management as planned.
Export earnings are sufficient to finance only about half of imports. Hence, further borrowing from foreign capital markets is unavoidable not only to bridge the trade gap, but also to roll over the maturing debt. These factors lead to further deterioration of the rupee, and consequent increases in the rupee cost of debt service payments. The rupee depreciation will also be followed by multiple rounds of production cost escalations further weakening the country’s export competitiveness and external payments position.