Sri Lanka is the only twin-deficit country in Asia whose growth has not been affected by currency volatility.
Fitch Ratings sees the relative currency stability as due to a less open onshore capital account which provides insulation from volatile global capital flows, as well as an increasing ability to tap offshore global bond inflows. This strategy, however, is adding to the stock of gross and net external liabilities, and carries medium-term credit risks.
The authorities have successfully reduced annual inflation to around 6%-7% from a near-double-digit rate in late 2012. This has brought on monetary easing - with the policy rate being cut by 125bp since November 2012, to 8.5%. Monetary easing coupled with softer inflation should support robust GDP growth - which we project at 6% this year, and 6.6% in 2014.
In contrast, we see the growth rates of India and Indonesia - the other two major Asian emerging economies with twin deficits (and both rated 'BBB-') - as languishing at a sub-6% rate in both years.
But Sri Lanka's benign growth-inflation story does not improve the overall sovereign credit profile ('BB-'/Stable), for two key reasons.
"First, we expect the current account deficit to remain at 5.6% of GDP this year. This has improved by 1pp from a year ago, but is larger than at all the other Fitch-rated Asian emerging markets, except Mongolia (B+). It is also larger than the 'BB' median current account deficit of 2.7% of GDP. Moreover, we see a rising external debt service burden as limiting much further improvement in the current account position in the year ahead," says Fitch.
The second reason is that Sri Lanka has been unable to attract much by way of foreign direct investment (FDI) inflows following the end of its civil war, with net FDI averaging just 1.2% of GDP since 2009. This is low in comparison with most regional peers, and has fueled a reliance on debt-creating capital.
The country has therefore banked on the promise of higher future growth to successfully issue more foreign debt. This has kept the external debt burden at 57% of GDP, and which is much higher than all other Asian emerging markets, except Mongolia.
The government's decision to refrain from issuing Global Bonds this year does not fundamentally alter what remains a growth strategy reliant on external debt. This is because the state-owned banks are picking up the slack, and are expected to issue around US$1.5 billion-1.8 billion in US dollar Global Bonds - for on-lending to SOEs, SMEs, long-term infrastructure projects, and for purchasing Sri Lankan government bonds.
The shift in debt issuance strategy may limit a further run-up in the sovereign's direct (foreign) debt-burden. However, quasi- and contingent-sovereign risks will still rise, along with credit and FX risks brought on by on-lending to local counterparties who may lack access to foreign-currency receipts and assets.
In the year-to-date, Bank of Ceylon and the National Savings Bank (both 100%-state-owned) have raised around $1.3 billion in five-year US dollar bonds. DFCC Bank and National Development Bank are expected to follow suit, with smaller amounts.
The upshot of all this is that Sri Lanka's relative currency stability and robust growth has not been accompanied, as yet, by a structural improvement in the size of the current account deficit or composition of capital inflows. Meanwhile, the reliance on foreign debt continues even though the sovereign has scaled back its own external bond issuance programme.