Fitch now says responsibility for SL external debt negotiations

  • Warns that political instability will pose risks to the implementation of reforms and the distribution of IMF financing, even if debt restructuring is agreed

Fitch Ratings said yesterday that the IMF’s staff-level agreement with Sri Lanka on a $2.9 billion program, confirmed on September 1, appears to signal a sea change in political parameters in order to achieve stability. macro-economic, notably through a significant fiscal adjustment, an increase in exchange rates, rate flexibility and more central bank autonomy.

“This should facilitate negotiations with public and private creditors, but the timing of any debt restructuring agreement remains uncertain,” Fitch said.

He said the Extended Financing Facility will not be approved by the IMF’s Executive Board until the government implements a number of agreed prior actions (not publicly specified), assurances of financing will have been received from official creditors and that good faith efforts will have been made to reach agreement with private creditors.

The IMF has assessed Sri Lanka’s debt burden as unsustainable, so the outcome of negotiations with creditors should involve debt relief. Tax reform will be an important part of the agreed program. Personal income tax will be made more progressive and corporate tax and VAT will be expanded, with the objective of achieving a primary budget surplus of 2.3% of GDP by 2025, compared to a deficit of 5.7% in 2021.

With this in mind, the 2022 interim budget unveiled by the new government on August 30 provided for an increase in the standard VAT rate to 15% from 12% from September 1, and proposed compulsory tax registration for all residents aged over 18 years old.

The budget aimed to increase government revenue/GDP from 8.2% in 2021 to 15% by 2025, and reduce government debt/GDP from around 110% at end-2021 to a maximum of 100% over the medium term. The revised budget deficit for 2022 is projected at 9.8% of GDP, compared to 8.8% of GDP in the initial 2022 budget.

“We think the government has some leeway to reduce capital spending, but its non-discretionary spending is significant,” Fitch said. Interest payments and wages were equivalent to 1.3x government revenue in 2021.

Fitch also said it expects additional revenue collection to be the main driver of fiscal consolidation, but the budget signaled there will be a reallocation of spending towards social spending to cushion the effects. of the economic crisis.

“Political instability will pose risks to the implementation of reforms and the distribution of IMF financing, even if debt restructuring is agreed. Additional social spending may not be enough to stave off public opposition, especially as public support for the government appears weak, by our assessment, and the recovery of economic growth in 2023-24 will be limited by the strong fiscal consolidation,” Fitch said.

Fitch rates Sri Lanka’s Long-Term Foreign Currency (LTFC) Issuer Default Rating (IDR) at ‘RD’ (Restricted Default). The long-term local currency IDR is “CCC” and is subject to criteria due to the introduction of +/- modifiers in the “CCC” category. A default on local currency debt could have adverse effects on the Sri Lankan banking sector that would erode the net benefits of such restructuring.

When Fitch confirmed the long-term IDR in local currency in May, it assumed that the government would continue to service the debt in local currency. Nevertheless, the “CCC” rating reflects a high risk of local currency debt being included in the debt restructuring, as equity and interest costs are significant, and its omission could increase the restructuring burden for holders. foreign currency debt.

In late August, the Central Bank Governor asserted that Sri Lanka would not restructure domestic debt, but that was partly in response to comments from President Wickremesinghe that appeared to suggest this policy option was being considered.

Fitch could move Sri Lanka’s IDR LTFC out of the “DR” once the sovereign completes a commercial debt restructuring that it believes has normalized relations with the international financial community.

Shirlene J. Manley