Sri Lanka’s sovereign credit outlook has been downgraded to ‘stable’ from ‘positive’ with the fiscal and external sectors expected to remain under stress in the months ahead, Standard Chartered Bank said in a recent report, urging investors to pick up future bond issues rather than existing issues in the secondary market.
The bank has forecast the budget deficit to reach 7 percent of GDP this year, missing the 6.2 percent target for the year. On a positive note, it believes the country would record a balance of payments surplus of US$ 900 million this year.
"Sri Lanka’s BoP position came under stress in H2-2011 when FX reserves depleted by USD 2.7bn (30% lower than its peak in July 2011) and FX reserve coverage fell to 3.4 months of imports. This was due to its current-account deficit increasing to 7.6% of GDP in 2011 (2.9% in 2010) following strong import demand, pro-growth policies and high oil prices. Broad policy measures were introduced in February 2012 as the authorities tried to arrest the rapid credit growth, widening trade deficit and the pressure on FX reserves. The measures included the abolishment of the Sri Lankan rupee (LKR) trading band, the tightening of monetary and credit policy, the fuel and electricity price increase and the hike in petroleum tax," the bank said in a report titled ‘Asian Sovereign Credit Comparator’ released earlier this month.
"While the BoP continued to record a deficit of USD 215mn in Q1-2012, it was an improvement over the USD 1.1bn in Q4-2011. We expect a BoP surplus of USD 0.9bn for full-year 2012 (USD 1.06bn deficit in 2011) on the back of sustained remittance flows, higher tourism earnings and FDI inflows," Standard Chartered Bank said.
"Disbursement of the final USD 430mn tranche by the IMF, the potential sovereign bond issuance (USD 500-1,000mn) and IMF loans (USD 500mn) will further support the BoP improvement. Also, private-sector credit growth (especially import-related credit growth) is slowing due to the 18% cap on banks’ lending growth, two policy rate hikes in H1 and the LKR depreciation (17% YTD).
"Fiscal consolidation, which has been underway since 2009 on the back of tax reforms and spending restraint, saw slippages in 4M-2012. The deficit increased to LKR 285.8bn or 3.8% of GDP (from 2.7% of GDP in the same period in 2011). That said, the increase in petroleum tax, the introduction of a commodity levy and LKR depreciation will help partially bridge the deficit gap in H2. On the other hand, higher commodity prices will trim the losses of state-owned enterprises (losses of c.1.5% of GDP in 2011).
"We expect the fiscal deficit at 7.0% of GDP (target at 6.2% of GDP).
"On the external front, as of April 2012, Sri Lanka had c.USD 2.7bn of short-term debt (including USD 698mn of marketable debt) as against FX reserves of USD 5.8bn. The roll-over risk is mitigated to an extent by the planned sovereign bond issuance and the fact that the bulk of the debt was issued by multilaterals at concessional rates. Going forward, ongoing support from the IMF and policy consistency will be crucial to reducing external vulnerabilities.
"While we believe that the medium-term structural positives for Sri Lanka remain intact, stress on the fiscal and external fronts will continue over the near term. We therefore revise our credit outlook to Stable from Positive.
"Sri Lankan authorities have implemented a number of measures in recent months, that have helped stabilise FX reserves. However, they will need to stay the course in order to prevent stresses building up again on the fiscal and external fronts. While there have been some comparisons with the Vietnam situation, we are slightly more comfortable with Sri Lanka given the better availability and transparency of data and the IMF’s involvement.
"We think the SRILAN bonds should trade broadly flat to VIETNM, on a duration-adjusted basis, given the improving macro fundamentals in Vietnam. At current valuations, we are Neutral on the SRILAN complex. For those looking to get involved in Sri Lanka, we recommend waiting for the new bond issuance, which is likely to come at a concession to the secondary levels," Standard Chartered Bank said.