Sri Lanka Faces Growth and External Pressures, Says Moody's

Sri Lanka's economy faces slower growth and elevated external pressure in the year ahead, says Moody's Investors Service. Although the government will likely continue to make gradual progress in reducing its deficit, the debt burden will remain high. The absence of a new funding program is credit negative from the perspectives of external payments and growth.


Moody's views were contained in a just-released report, titled, "Sri Lanka -- The Post-IMF Backdrop: Downward Growth Pressures and Elevated External Pressures."


The special comment examines the credit implications of Sri Lanka's (B1/Positive) decision on 12 February to not seek a new funding program from the IMF, following the successful completion of a $2.6 billion Stand-by Arrangement in 2012.


The report also looks at key factors that will shape the credit outlook going forward; in particular, trends in growth and macro stability, the external payments position, and progress on fiscal consolidation.


The B1 rating on Sri Lanka takes into account the notable progress that the country has made over the last three years, since the civil war ended in May 2009. However, given the challenging macroeconomic backdrop, the report's conclusion is that a follow-up funding program would have augmented international reserves directly through borrowed IMF resources. Through enhanced policy certainty under an IMF funding program, investor confidence would likely have been bolstered. And in doing so, it would have provided additional support to the balance of payments and economic growth prospects.


Moody's believes the government will continue to reduce gradually its budget deficit, but the composition of deficit reduction will be key. Supplier cash arrears, weak structural revenue reform and contingent liabilities in the SOE sector are concerns. Moreover, high inflation and rapid credit growth are risks to macroeconomic stability.


While there was a modest accretion to foreign reserves in 2012, at $6.9billion currently, reserves are still not back to the peak of $8.1 billion in July 2011, when Sri Lanka's rating outlook was changed to positive.


Moody's External Vulnerability Indicator (EVI) - which gauges if foreign reserves are adequate to cover short-term external debt and long-term debt maturing over the next year in the event of sudden stop in external credit extension - is expected to remain high at 124% in 2013, from 132% in 2012. This level is appreciably above the 100% threshold of reserve coverage for external creditors. This is partly because higher commercial bank issuances, which are classified as banking sector external liabilities have contributed to outstanding short-term debt .


A new IMF funding program would have helped build up foreign reserves, even if the program size were a moderate $1-1.5 billion. In its absence, greater foreign exchange inflows could possibly come through commercial bank issuances in 2013. This would likely provide further cushion, but we will also be monitoring trends in foreign direct investment. In general, flows which do not add to external debt, namely FDI, would be more favorable for the sovereign credit profile.


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