Are we avoiding Lebanon or IMF?
By Ishara Gamage
It was only a few days ago that the arrival and appointment of Basil Rajapaksa as the Finance Minister was announced to the public. Within days of him taking office as the Finance Minister a breakthrough story emerged of his possible consultation with the International Monetary Fund (IMF) to manage the debt crisis confronting Sri Lanka.
The story referenced a credible source in the form of former Minister Lakshman Yapa Abeywardena , a close associate of the newly appointed Finance Minister and caught the eye of many with more than a sigh of relief. The intended move reflected, many thought, not only a change of mindset within the corridors of power, but also a recognition that inaction was out of the question as it will inevitably lead to Lebanon, now gripped by unrelenting pressures on its citizenry making daily living simply dismal.
On 19 July 2021, not even a week after the appointment of the new Finance Minister came the announcement by Moody’s, the global Rating Agency, which it will review its rating of Sri Lanka currently standing at Caa for a possible downgrade. As usual GoSL has responded in a tone not dissimilar to previous such announcements with an outpouring of scorn at the Rating Agent, no more than a messenger but a professional and a knowledgeable party that has first hand experience of matters relating to sovereign credit and bonds.
What exactly did Moody’s say? Was it speculative, derogatory and without foundation? Should GoSL give some thought to its point of view or simply resort to its usual knee-jerk pre-fab response? Here is what Moody’s said in its 19th July statement.
Referring to it as its RATIONALE FOR INITIATING THE REVIEW FOR DOWNGRADE, it pointed out the following in terms of Sri Lanka -
• Low and declining foreign exchange reserves
• Limited and narrowing set of external financing options
• Large share of Government revenue taken up by interest payments
• Increasing fragility of the situation continued worsening of credit metrics and no decisive actions, notwithstanding the Government’s repeated commitment to repay its debt, for a credible and durable financing strategy.
In terms of numbers, Moody’s points to some simple fundamentals often quoted but equally often ignored or denied. It forecasts coverage of external debt repayments by foreign exchange reserves to continue falling from already low levels.
As of the end of June 2021, Sri Lanka’s foreign exchange reserves (which in Moody’s definition exclude gold and Special Drawing Rights) amounted to circa US$3.6 billion, down 30% since the start of the year and insufficient to cover the Government’s annual external debt repayments alone of around US$4-5 billion over the next 4-5 years. Considering plausible projections for the balance of payments, the country’s foreign exchange reserves will fall further over the next 2-3 years unless Sri Lanka manages to raise sufficient capital inflows. Sri Lanka is already barred from raising funds to a favourable percentage in the international capital market in the face of poor credit rating.
Moody’s then referred to a number of measures that the Government of Sri Lanka (GoSL) can and will take to secure foreign exchange. These include measures to curtail capital outflows such as import restrictions plus project related multilateral inflows, bilateral assistance and State-owned asset sales. Moody’s assessment is that such action can only shore up reserves, are temporary, marginal and comes at a cost. The current account, Moody’s say is likely to remain stable at around 1-2% of Gross Domestic Product (GDP) until the Tourism Sector becomes fully operational with the Port City yielding Foreign Direct Investments (FDI) only in the longer term while privatisations are unlikely to gather momentum in the short term.
By contrast, Moody’s does not assume that the Government will enter into programme-based financing facilities with multilateral development partners at this stage, which significantly narrows external financing options. Furthermore, while the Government has historically relied on international market access to finance its fiscal deficits and external repayment needs, borrowing costs remain prohibitive. Moody’s point out that Sri Lanka’s Government bond spreads are now priced, in terms of US Treasuries, at more than 3 times the rate before the onset of the pandemic.
The seemingly structural fiscal weaknesses of Sri Lanka complicate its policy choices. Moody’s expects Sri Lanka’s economy to grow by around 3.5% this year, considering less stringent pandemic-containment measures compared to last year. Economic growth is likely to accelerate further next year on base effects and the reopening of borders, providing some boost to Government revenue. However, even with some revenue increases, Moody’s estimates that the Government’s fiscal deficit will remain wide at around 9.5-10% of GDP this year and average 8.5% over the next two years. In turn, the Government’s debt burden will likely rise further to around 110% of GDP over 2022-23, from around 100% at the end of 2020 and around 87% in 2019.
Extremely weak debt affordability magnifies debt repayment risks. Interest payments exceeded 70% of Government revenue in 2020 and will likely remain around 60-70% over the next few years – highest across other countries rated by Moody’s – even as revenue rebounds from very low levels. Indeed, Government revenue is likely to remain around 10% of GDP over the next few years, unless the Government’s efforts to enhance tax administration and impose special taxes can sisably and durably expand its revenue base.
While domestic resources have been sufficient so far to finance the Government’s wider deficit in local currency, limited fiscal resources impose difficult policy choices to rationalise social spending and development expenditure, if interest payments continue to be prioritised.
Moody’s maintain weak credit metrics together with falling reserves is likely to precipitate a crisis of confidence, involving a negative spiral of a rapidly depreciating exchange rate, rising inflation, higher domestic interest rates, higher debt payments in local currency terms, and a weaker domestic economy. In this scenario, default risk would increase sharply. Conversely, the recent track record of Sri Lanka in securing some financing options, from foreign and domestic investors, may keep such a negative spiral at bay for some time.
Thus, the rating review will focus on assessing whether Sri Lanka is able to use a period of time provided by its current foreign exchange reserves and bilateral arrangements to implement measures that widen and increase its financing sources for the medium term, and thereby avoid default for the foreseeable future.
In a response headlined ‘ill-timed, ill-judged and hence unacceptable’ GoSL replied to the Moody’s downgrade notice not only pointing out the double-fault of Moody’s undertaking downgrades at the time of repayment but also unnecessarily spooking Investors in the face of GoSL efforts to ensure availability of funds for full payment on due date. While the aggrieved nature of the GoSL response is perhaps understandable, the absence of any reference to the central point made by Moody’s i.e. the lack of a credible longer-term financial strategy excluding patches here and there is telling and needs clear articulation.
Important also is to note that Moody’s does not seem to judge the earlier story of a change in mind with ‘Sri Lanka going to the IMF’ as having any strength and have simply ignored it while the GoSL response also makes no reference to it. More to the point GoSL response avoids any critic of the analysis and logic provided by Moody’s in their downgrade notice except the aim for a Budget Deficit amounting to 4.5% of GDP by 2025 versus double that level forecast by Moody’s up to 2023.
Irrespective of whether or not Moody’s downgrade, the financial status of Sri Lanka continues to deteriorate. The shortage of $ is likely to escalate as we approach the US$1 billion late July 2021 repayment date with the reserves also likely to fall to hitherto low levels of say US$ 2 to 1.5 billion level by year end 2021 considering the impact of other so far confirmed smaller inflows (Such as IMF US$ 780 million worth SDR allocation and Bangladesh US$ 200 M swap arrangement) and over US$ 2.3 billion outflows during the remainder of 2021.
Thus, a repayment crisis in early 2022 is visible now unless matters are strictly managed going forward. Government strategy of short-term adjustments i.e. Plan A may pay-off but there is little certainty of such an outcome. Thus, analysts say a full professionally evaluated Plan B with the IMF as the back-stop becomes necessary in managing the finances of the country in order to avoid a Lebanon situation. Sri Lanka awaits a clarification from the newly appointed Minister of Finance.
(The writer is a senior staff journalist with nearly two decades of financial journalism experience. He can be reached at [email protected])