The IMF staff-level agreement with Sri Lanka on a USD2.9 billion programme, confirmed on 1 September, appears to signal a sharp change in policy settings to achieve macroeconomic stability, including through large fiscal adjustment, greater exchange-rate flexibility and more central bank autonomy, says Fitch Ratings.
This should facilitate negotiations with official and private creditors, but the timing of any debt restructuring agreement remains uncertain. The Extended Fund Facility will not be approved by the IMF’s Executive Board until the government has implemented several agreed prior actions (not publicly specified), financing assurances have been received from official creditors, and good faith efforts have been made to reach an agreement with private creditors. The IMF has assessed Sri Lanka’s debt burden as unsustainable, so the outcome of negotiations with creditors should involve debt relief. Tax reform will be an important element of the agreed programme.
In line with this, the interim 2022 budget unveiled by the new government on 30 August laid out plans to raise the standard rate of VAT to 15% from 12% from 1 September and proposed compulsory tax registration for all residents aged over 18 years.
The revised budget deficit for 2022 is projected at 9.8% of GDP, up from 8.8% of GDP in the original 2022 budget. We believe the government has some room to reduce CAPEX, but its non-discretionary expenditure is large. Interest payments and wages were equivalent to 1.3x government revenue in 2021.
“We expect additional revenue raising to be the main driver of fiscal consolidation, but the budget signalled there will be a reallocation of expenditure towards social spending to cushion the effects of the economic crisis. Political instability will pose risks to the implementation of reforms and the distribution of IMF funding, even if a debt restructuring is agreed.”
Fitch rates Sri Lanka’s Long-Term Foreign-Currency (LTFC) Issuer Default Rating (IDR) at ‘RD’ (Restricted Default). The Long-Term Local-Currency IDR is ‘CCC’, and is Under Criteria Observation following our introduction of +/- modifiers in the ‘CCC’ category.
A default on local-currency debt could have adverse effects on Sri Lanka’s banking sector that would erode the net benefits of such a restructuring.
Nonetheless, the ‘CCC’ rating reflects a high risk that local-currency debt will be included in debt restructuring, as the stock and interest costs are large, and omitting it could increase the restructuring burden on holders of foreign-currency debt.
Fitch may move Sri Lanka’s LTFC IDR out of ‘RD’ upon the sovereign’s completion of a commercial debt restructuring that we judge to have normalised the relationship with the international financial community.
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