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Credendo downgrades SL from 5/7 to 6/7

23 Jul 2021

 
  • Points at ‘gloomy’ public finances, external debt repayment stressSri Lanka may ‘eventually call
  • IMF’ to the rescue
  • Indicates increasing risk of sovereign debt default
  By Imsha Iqbal  Credendo, the European credit insurance group, has downgraded Sri Lanka from 5/7 to 6/7 for medium to long-term political risk driven by gloomy public finances, the sharp deterioration of external and public debt ratios, and expected external debt repayment stress amid eroding liquidity. Explaining the rationale behind the downgrade, Credendo stated that Sri Lanka’s economic outlook remains uncertain, and added that in its April forecasts, the IMF expected a 4% real GDP growth rebound in 2021 after a 3.6% contraction in 2020.  “However, this might be revised down due to the sharper Covid-19 wave since spring and given the slow vaccination rollout. The protracted impact of the pandemic will continue to weigh on exports and recovery in the important tourism sector, which might also suffer from the recent environmental disaster caused by the sinking of an oil cargo ship. Also taking into account weak capital inflows and large scheduled sovereign bond repayments, external liquidity is likely to remain under strain beyond 2021,” it stated. It further noted that in the coming years, their level is projected to stay below the forecast external debt service (estimated to be close to $ 30 billion in 2021-2025). Therefore, the authorities could use extra tools to support foreign exchange reserves, such as further tightening import restrictions, and might even impose capital controls and eventually call the IMF to the rescue. While local banks are temporarily financing the fiscal deficit and assuming that any arrears would probably be first domestic, it is not ruled out that the Government might eventually have to come to the IMF as a last resort, it added.  However, this scenario is unlikely to materialise in the very near future. Indeed, last year the authorities’ request for emergency financial support from the IMF to help fight the pandemic was dropped due to disagreement about the requested policy commitments. According to Credendo, in the short term and without market access, Sri Lanka will essentially rely on bilateral financing support, first from China (via new loans and a three-year currency swap line of an equivalent of $ 1.5 billion agreed last March) and then India, and use its foreign exchange reserves to honour its external debt obligations and finance the current account deficit (expected to widen to 2.3% of GDP this year before gradually narrowing). By opting for debt accumulation instead of fiscal consolidation, there is a risk that public finances could worsen (with an external share potentially exceeding the domestic one), the debt spiral could continue, and financial dependence on China could increase. In 2019, about 10% of external public debt was owed to China and this share is undoubtedly going to rise.  “Opting to use gross foreign exchange reserves is also a risky strategy. Last year, reserves dropped by 21.4%, and by a further 15% in January-April 2021. They cover around two months of imports (i.e. a record low since 2008), and barely around half of the short-term external debt. The extra loan of $ 500 million granted by China in March improved the liquidity situation in the short term. However, the situation remains precarious taking into account that Sri Lanka lacks access to financial capital markets.”


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