COLOMBO – The successful formation of a government under the new president, Ranil Wickremesinghe, is an important precondition for resolving Sri Lanka’s debt default, but many challenges remain as the country seeks financing support from the International Monetary Fund (IMF) and debt restructuring from private and official bilateral creditors, Fitch Ratings said on Thursday (28).

In an article released on its Fitch Wire credit market commentary page, the rating agency
noted that the new president had been confirmed by a large majority, including some opposition members, in Parliament, giving some hope that it will have sufficient support to negotiate and carry out difficult reforms as part of efforts to restore macroeconomic stability and debt sustainability.

“Such reforms could unlock funding support from the IMF, which we view as important for Sri Lanka’s emergence from default,” Fitch said, but cautioned that though the government’s parliamentary position appears strong, public support for it is weaker. It warned that the domination of both Parliament and government by politicians from the Sri Lanka Podujana Peramuna (SLPP) alliance, which is closely affiliated with the Rajapaksa family, was likely to increase the risk of further destabilizing protests, if economic conditions do not improve and/or reforms generate public opposition.

President Wickremesinghe was prime minister in the previous administration under President Gotabaya Rajapaksa, who was brought down by protests.

Fitch said it expects any reform package agreed with the IMF by the government to include elements such as higher taxes, expenditure rationalization and a commitment to a greater degree of exchange-rate flexibility, but warned of a significant risk of such reforms causing public opposition that might impede their implementation.

In the absence of an IMF deal, the rating agency said it expects Sri Lanka to face a very strained external position in the near term, noting that the country has little foreign exchange to pay even for essential imports such as fuel, food and medicines, with official reserve assets at just US$1.9 billion (just over one month of imports) as of end-June.

In a statement on June 30, the IMF noted that it assessed Sri Lanka’s public debt as unsustainable, and confirmed that it would require adequate financing assurances from the country’s creditors that debt sustainability would be restored.

IMF also noted that debt negotiations could be complicated by debt owed to China, amounting to US$ 5 billion at end-2020, including bilateral official lending and loans from the China Development Bank and Export-Import Bank of China, accounting for around 13% of Sri Lanka’s external debt.

Nothing that China has traditionally preferred to offer relief for large loans through deferrals such as maturity extensions, payment rescheduling or grace periods, rather than through write-downs, Fitch cautioned this approach could increase challenges for Sri Lanka to successfully negotiate debt restructuring with other creditors, including private creditors, that delivers the debt sustainability sought by the IMF.

Fitch has rated Sri Lanka’s Long-Term Foreign-Currency (LTFC) Issuer Default Rating (IDR) at ‘RD’ (Restricted Default), with the Long-Term Local-Currency IDR at ‘CCC’, and Under Criteria Observation following its introduction of +/- modifiers in the ‘CCC’ category.

A default on local-currency debt, Fitch warned, could erode local banks’ capital positions, possibly leading to government capital injections into the banking sector that would erode the net benefits of such a restructuring, noting, “When we affirmed the Long-Term Local-Currency IDR in May we assumed that the government would continue to service local-currency debt. 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 also said it may move Sri Lanka’s LTFC IDR out of ‘RD’ upon the sovereign’s completion of a commercial debt restructuring that it judges to have normalized the relationship with the international financial community.

-ENCL