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ECONOMYNEXT – Standard and Poor’s, a rating agency has downgraded the outlook on Sri Lanka’s ‘B’ rating to ‘negative’ from stable on tax cuts by the new administration but said the ability to pass laws in parliament will improve after elections.
But weak institutions and rising ethnic religious divides were risks.
“The negative outlook reflects our view that Sri Lanka’s fiscal trajectory over the next two to three years could deviate from a fiscal consolidation path,” the rating agency said.
“The sizable deficits will add to Sri Lanka’s already-large debt stock at a faster pace.”
“While political risks have not lifted completely, a government with a clear mandate following the parliamentary elections that are likely to be held in the first half of 2020 could improve investor sentiment and boost growth, in our view.
However the country’s institutions were weak and there were rising ethnic and religious divides.
Sri Lanka’s “institutional settings will remain a credit weakness due to concerns over the sustainability of public finances, centralized policy decision-making and uncertain checks and balances between institutions,” the rating agency said.
“Perceived widening divisions in civil society in recent years, particularly along ethnic and religious lines also increase the risk to political stability, in our view.”
Standard and Poor’s said Sri Lanka had the ability to repay near term debt.
The full statement is reproduced below:
• We believe that the tax cuts introduced by Sri Lanka’s Cabinet risk undermining fiscal and debt sustainability, even if they boost near-term growth.
• Policy uncertainty will remain elevated ahead of the parliamentary elections. Following the elections, a government with a new mandate could improve legislative efficiency, in our view.
• We are revising our outlook on Sri Lanka to negative from stable, as risks from a deteriorating fiscal position increase. We are affirming our ‘B/B’ sovereign credit ratings on Sri Lanka.
• The negative outlook reflects our view that a larger-than-expected fiscal deficit will increase the government’s financing needs and concerns over debt sustainability.
SINGAPORE (S&P Global Ratings) Jan. 14, 2020–S&P Global Ratings today revised its outlook on the Sri Lanka sovereign credit rating to negative from stable. We affirmed our ‘B’ long-term and ‘B’ short-term foreign and local currency credit ratings on Sri Lanka. The transfer and convertibility assessment is affirmed at B.
The negative outlook reflects our view that Sri Lanka’s fiscal trajectory over the next two to three years could deviate from a fiscal consolidation path. The sizable deficits will add to Sri Lanka’s already-large debt stock at a faster pace.
We could lower our ratings over the next 12 months if we believe that the fiscal position could deteriorate further from our current forecast, either due to policy changes or growth underperforming expectations. This will further weaken fiscal sustainability and increase the risks of sudden shifts in investor sentiment or changes in global credit conditions.
We could revise the outlook to stable if we see credible improvements in the fiscal and debt metrics on a sustained basis.
Our ratings on Sri Lanka reflect the country’s macroeconomic imbalances, namely weak external profile, sizeable fiscal deficits, and extremely high government indebtedness. Counterbalancing these factors are higher growth prospects. While political risks have not lifted completely, a government with a clear mandate following the parliamentary elections that are likely to be held in the first half of 2020 could improve investor sentiment and boost growth, in our view.
Institutional and economic profile: Growth prospects have improved while political uncertainty will likely ease following parliamentary elections
• Economic growth is likely to improve from its current cyclical weak patch, driven by recovering tourist arrival as well as stronger consumption and investment spending.
• Parliamentary elections could help alleviate uncertainty associated with the persistent factionalism within the current parliament.
Sri Lanka’s economy has been consistently growing below potential in recent years due to a confluence of exogenous shocks and intractable political difficulties. After a brisk uptick in the first quarter of 2019, economic growth was again derailed after the Easter Sunday attacks. Meanwhile, persistent fiscal deficits, a large debt stock, and rising interest servicing cost eroded policy buffers and reduced fiscal capacity to support a slowing economy. We forecast growth in 2019 will slow to 2.7%, the lowest rate in decades.
Barring further unforeseeable exogenous shocks, we expect growth to pick up appreciably to 4% in 2020. This will be supported by several factors. Chiefly, the fiscal stimulus implemented by the interim Cabinet–including steep cuts to the value-added tax (VAT) rate and the elimination of several tax items–is expected to boost private consumption and investment activity.
The tourism sector, which has boomed in recent years, is also likely to see a stronger recovery in the coming quarters. Following sharp declines in arrivals after the attacks, tourist numbers were down merely 4.5% year-on-year in December 2019, which typically marks the start of peak travel season. This will contribute to export performance, which has already benefited from the restoration of the European Union’s Generalized System of Preference Plus facility for the textiles and garments sector this year.
Finally, we believe that parliamentary elections, scheduled to be held in the coming months, could help improve government processes and legislative efficiency, and resolve to a large degree, political uncertainty in the country associated with deep-rooted factionalism within the government.
Persistent political infighting has hindered responsiveness and predictability in policymaking in recent years, and weighed particularly on business confidence, investment plans, and overall growth prospects, in our view.
Nevertheless, even with a new government at the helm, we believe Sri Lanka’s institutional settings will remain a credit weakness due to concerns over the sustainability of public finances, centralized policy decision-making and uncertain checks and balances between institutions.
Perceived widening divisions in civil society in recent years, particularly along ethnic and religious lines also increase the risk to political stability, in our view.
We estimate real per capita income to reach about US$4,200 in 2020 and real GDP growth to average 3.8% in 2019-2022. This translates to real GDP per capita growth of 3.0% on a 10-year weighted average basis. Although this growth rate is in line with peers at a similar income level, it is substantially below Sri Lanka’s growth potential.
Flexibility and performance profile: Fiscal position has deteriorated and risk on debt sustainability has increased
• Sri Lanka’s fiscal position deteriorated following the Easter Sunday attacks. Although a recovery is expected, we expect a widening of the fiscal deficit following the implementation of wide-ranging tax cuts.
• This will likely worsen the government’s heavy indebtedness and add to repayment burdens.
• The external profile remains weak given that the high share of dollar-denominated debt exposes the government to sudden shifts in risk sentiments.
Persistent deficits in Sri Lanka’s fiscal and external positions have been rating constraints. The heavy government debt limits its ability to accumulate policy buffers, which are crucial in times of stress. The government’s fiscal position has weakened over the past year as the Easter Sunday attacks stymied economic activity and reduced tourism earnings.
As a result, government revenue growth came in significantly below initial expectations of a sizeable increase due to the implementation of the Inland Revenue Act (IRA). At the same time, government expenditure also increased due to higher security-related and election spending.
We believe this one-off underperformance on both the revenue and expenditure fronts will now continue over the next few years if the wide-ranging tax cuts announced by the interim Cabinet are implemented without sufficient offsetting measures. The main components of the tax cuts–which involve lowering the VAT rate to 8% from 15% for most sectors, increasing the turnover threshold for VAT by four-fold, and removing the 2% National Building Tax–will likely reduce revenue earnings significantly, in our view.
This will be temporarily cushioned by the government’s intention to curtail expenditure, such as the purchase of vehicles, as well as sizable reduction in the capital expenditure.
We estimate that the overall impact of the tax measures will further widen the fiscal deficit by about 0.8%-1.0% of GDP in 2020, even after taking into account benefits from higher growth prospects. Beyond 2020, we believe it could be difficult for the government to sustain a fiscal consolidation path without new revenue measures. As a base case, we estimate the change in net general government debt to reach 6.7% of GDP on average over 2019-2022. While the risk of large increases in the fiscal deficit could be mitigated by a faster rate of growth, the pace of consolidation will slow.
The tax cuts could also jeopardize progress under the IMF Extended Fund Facility (EFF), which counts the IRA as a key achievement in improving the country’s fiscal settings.
A weaker fiscal position will add to the government’s extremely high debt stock. We do not expect the government to start paring down its debt stock at least until after 2020, depending on the new government’s budget and medium-term fiscal plans. We estimate net general government debt to reach 83.1% of GDP in 2020 while general government interest expenditure is expected to account for 46.1% of revenues. This is the third-highest ratio among the sovereigns we currently rate, trailing only Lebanon and Egypt.