A Probability or an Inevitable Certainty?

Downgrade and Foreign Exchange Controls

| by Arujuna Sivananthan

( February 20, London, Sri Lanka Guardian) With rating agencies being criticised for inertia, the contravening of terms of the IMF’s standby facility by Sri Lanka’s policy makers, and, their failure to consolidate both fiscal and current account deficits; the trajectory of its foreign currency credit rating remains uncertain.

Rating agencies were blamed for not being forward looking in their assessment during the sub-prime and Eurozone debt crisis. Remedial steps have now been taken and their future ratings actions are likely to be anticipatory.

On the face of it some of Sri Lanka’s macroeconomic data is positive. Its inflation rate and nominal GDP growth are good. However, a reduction in the former was achieved through several changes in the basket of goods and services measuring it to reflect ‘shifting’ consumption patterns. GDP growth has been buoyant driven by post-war infrastructure development, which was financed through external borrowing.

Nevertheless, not all reasons cited for the positive ratings action by rating agencies in July 2011 are present. Despite, the Central Bank (CB) relenting on its policy of soft-pegging the Rupee to the US dollar (USD) there has been no reform of its state owned utilities. State monopolies such as the Ceylon Electricity Board and Ceylon Petroleum Corporation were last projected to lose not less than 400 million and 700 million USD respectively in 2011. Recent price rises in electricity and distillates may not be sufficient to mitigate losses in 2012.

Fiscal consolidation is not visible. The budget deficit will remain high in 2011 at 8 percent of Gross Domestic Product (GDP) and little changed from 2010. Sri Lanka’s public debt to GDP ratio will also remain unchanged at 82 percent of GDP, well above its single-B and double-B rated peer group of 41 and 40 percent respectively. Any reduction in both will be difficult to achieve while defence spending continues to account for 20 percent of government disbursements and post record highs each year.

There is a material deterioration in Sri Lanka’s external position. Its Current account deficit will be 20 percent of GDP in 2011 and will increase in 2012. Geopolitical developments in the Middle-East have already taken their toll on its balance of payments and will continue to do so. Migrant worker remittances from the region are Sri Lanka’s largest source of foreign exchange (forex). It is also the biggest market for Sri Lankan tea exports accounting for over 55 percent of sales; Iran, Iraq, Syria and Libya being large buyers. Both these sources have been adversely affected. Also, crude oil prices have surged on average 30 percent higher. With crude accounting for 25 percent of Sri Lanka’s imports, its balance of payments is being squeezed from both ends.

Foreign Direct Investment (FDI) year on year has consistently been below budget for various reasons including poor infrastructure, a highly unionised labour force, lack of transparency and the recently passed expropriation law.

Sri Lanka’s external indebtedness is approximately 40 percent of GDP; also well above its single-B and double-B rated peers. And, its external reserves at USD 5.3 billion now stand at less than 3 times average monthly imports; a level suggestive of a balance of payments crisis.

Fitch in a report published in December cites India and Sri Lanka as the only Fitch-rated emerging Asian countries to run deficits on their basic balance, i.e. inability to fund imports through exports and net FDI.

Moody’s states that “a deepening current account deficit and lower-than-expected foreign exchange reserve level projected for the end of 2011 suggests that external vulnerability event risk has not yet receded to a low level” and sees Sri Lanka’s financial weaknesses as a key rating constraint.

What is apparent is that, unless we see a dramatic turnaround in Sri Lanka’s metrics, its foreign currency ratings will be capped at their present level. Also obvious is that rating agencies have given its policy makers the benefit of the doubt despite lagging well behind their cohort on key metrics. How long they will do so without credible action to remedy prevailing imbalances is not clear. However, sooner or later they will address this discrepancy and the resultant consequences for Sri Lanka in capital markets will be harsh. Investors will demand higher yields and limit the extent to which it can borrow; not just on the nominal amount but also duration.

Perhaps, it was the risk of a negative rating action and the dissipation of its forex reserves which stopped the CB from defending the rupee. But, it is only the first of many steps which Sri Lanka’s policy makers must take to redress the various imbalances. And, if they do not, then Standard and Poor’s may be right in concluding that in their opinion “the government tends to be interventionist and may, in a severe downside scenario, use restrictions on access to foreign exchange needed for debt servicing as a policy tool”.

That is, to impose controls on access to foreign exchange!

There is another and not altogether unlikely set of events which will also bring us to this terminus. It begins with a pre-emptive strike on Iran by Israel. The economic forces it will unleash on small open economies like Sri Lanka are such that they cannot be fathomed.