Courtesy Adaderana

Greater clarity over economic policy matters more for the credit than the party composition of Sri Lanka’s next government, says Fitch Ratings. Improved economic policy credibility and coherence would strengthen Sri Lanka’s resilience to growing investor uncertainty towards emerging Asia. The establishment of a new government with a clear electoral mandate following parliamentary elections on 17 August, should mitigate some political uncertainty, though the direction of economic policy and the stability of the likely coalition remain unclear.

Early election results indicate that the governing UNP is likely to emerge as the largest party in Sri Lanka’s parliament, defeating former President Mahinda Rajapaksa’s bid to return to power as prime minister. The broadly peaceful election campaign, which follows the orderly transition of the presidency in January 2015, will further reinforce the perceptions of Sri Lanka as a functioning democracy with relatively strong institutional capacity – in line with its ‘BB-’ rating.

The new administration inaugurated in January under President Maithripala Sirisena has made some progress in addressing perceived governance shortcomings, in particular by adopting a constitutional amendment limiting presidential powers and launching anti-corruption investigations. However, there has been no corresponding strengthening in economic management. A populist budget was introduced in February that raised public sector wages and reduced publicly administered prices. The government has also disclosed that the 2014 budget deficit was around 1pp higher than previously thought, owing to revenue shortfalls. This indicates that fiscal consolidation has stalled. Sri Lanka has the fourth-highest share of government debt – 72% of GDP – of any country in the ‘BB’ range, after Portugal. Hungary and Croatia.

Monetary policy has also been accommodative, allowing credit growth to accelerate sharply to 17.6% yoy in May 2015, from almost 0% in 3Q14. This has fuelled a 45% yoy rise in consumer goods imports in the first five months of the year at a time when exports were unchanged owing to stagnant agriculture and textiles. A rise in tourism receipts and remittances has acted as a buffer, although the trade deficit widened to USD3.4bn in May, up from USD3.1bn in May 2014. The current account deficit had narrowed to 2.7% of GDP in 2014 from 7.8% in 2011, but should widen back to 3.0% this year.

Gross foreign reserves had dropped sharply to USD6.8bn by end-May 2015 from USD7.5bn a month earlier, further highlighting pressures on external balances. The authorities indicated that reserves had been bolstered back up to USD7.5bn by end-June through a USD650m sovereign dollar debt issue and USD338m Sri Lanka Development Bond, though the latest data for end-July show reserves had fallen back down to USD6.9bn. External liquidity has been buffered by a USD1.1bn swap facility with the Reserve Bank of India in July. These factors have buffered external liquidity recently, though it is not a sustainable way of improving the stability of the external accounts.