By A Special Correspondent Courtesy The Island

The Fitch Rating Agency has downgraded Sri Lanka’s international sovereign rating from BB- to B+ and outlook negative. The rating agency concluded that refinancing risks for the maturing debt is on the rise in the wake of weaker government budget and falling foreign exchange reserves .The rating agency also downgraded local currency bonds as well as country ceiling to B+ from BB-. This is a clear indication that the country is heading towards a virtual economic collapse.

The reasons are obvious.

The new government increased public sector salaries by Rs. 10,000 per mensum, pension allowance by Rs.1,000, reduced motor vehicle duties, and removed custom based taxes on essential food items and administered fuel prices including LPG prices and public transport fares to provide relief to the consumers. This raised Government current expenditure to a record high of RS. 1,929 billion.

Export income registered around a 10 percent reduction in agricultural exports, around 1 percent reduction in textile and apparel exports, and a 12 percent reduction in rubber based industrial exports.

The suspension of Foreign Direct Investment Projects such as the Port City created uncertainties with regard to the investment climate in the country. Foreign Direct Investments declined to around USD 500 Million in 2015.

Foreign holdings of Treasury bills and bonds declined from over USD 3,500 Million to USD 2,100 Million during the same period.

The Stock Market lost 1,385 points in the All Share Price Index. Equity sales by foreign shareholders exceeded purchases from June through December of 2015 leading to a net outflow of LKR 9,576 Million. Consequently, the net outflows amounted to LKR 5,371 Million in 2015 as against a net inflow of LKR 21,217 Mln. in 2014.

Despite such weakening in financial conditions, the Central Bank engaged in defensive actions on exchange rate management by injecting foreign exchange to the market throughout the 12 months ending 2015 resulting in a net outflow of USD 3,250 Mn. Consequently official international reserves declined to a level of USD 7,304 Mn. in 2015 from USD 8.2 bn in 2014.

Unsuccessful reserve injections did not help to defend the Exchange Rate which increased to LKR 144.01/USD in 2015. The exchange rate had remained stable at an average of LKR 130.56/USD throughout 2014. Official reserves have further eroded to USD 6.3 Bn. in January, 2016.

Sri Lanka being an oil import dependent economy, benefited from falling oil prices from over USD 90/bbl in January 2015 to around USD 30/bbl in December 2015 bringing down fuel import costs to USD 2,797 Mn in 2015 from USD 4,597 Mn in 2014. Tourism revenue increased from US$ 2,431 Mn. in 2014 to US$ 2,863 Mn. in 2015. In spite of a slowdown in inflows, worker remittances were still a buffer to the Island nation raising USD 6,980 Mn. in 2015 in comparison to USD 7,018 Mn. in 2014.

Favorable rainfall throughout the year helped use hydro power capacity to the maximum and the low cost 900MW coal power generation capacity, reduced reliance on fuel based power generation. Rains also blessed the cultivation of rice – the country’s main staple food during both Yala and Maha seasons in 2015 reducing import requirement of rice. However, depressed producer prices for tea and rubber throughout the year and reduced export earnings and adversely affected the plantation economy.

Despite all such fortunes, the economy seems to have slowed down with a GDP growth below 5 percent in 2015. The weakening economic outlook is visible in the reduced profits of Sri Lanka Telecom. Inflation and the international reserve outlook is worrying. The unemployment rate has increased from 4.3 percent in 2014 to 5 percent by the 3rd quarter of 2015.

Meanwhile, the Rupee remains vulnerable to further pressures in the coming months since global investors continue to relocate assets out of emerging markets.

The Deputy Governor of the Central Bank, Dr. Nandalal Weerasinghe has told The Island Financial Review that monetary supply (M2b) has increased by 17.8 percent in 2015 in comparison to 13.4 percent in 2014.

Private sector credit has surged by 25.1 percent in comparison to 8 percent in 2014. This fueled the import of motor vehicles, consumer durables and food items consuming over and above the savings on oil imports during 2015.

Core inflation continued to rise reaching 4.6 percent in January 2016 from 0.8 percent recorded in February, 2014.

Commercial banks have raised the Average Weighted Prime Lending Rate (AWPR) to 8.35 percent this week. It was 8.11 percent a week ago and 6.40 percent a year ago. The Central Bank has already increased the Statutory Reserve Ratio to 7.5 percent in mid January, 2016 and the policy rate by 50 basis points in mid February 2016. Dr. Weerasinghe has indicated to The Island Financial Review that policy rates will increase further in March as certain risks to macro-economic stability continue.

Government Revenue is already lagging behind the 2016 Budget as several revenue proposals have been withdrawn, revised or suspended. The Government also removed the VAT on supermarkets and reduced income taxes.

The Fitch Rating Agency has stated that the 2016 Budget has done little to address government revenue concerns and predicted continued fiscal slippage over 2016 and 2017. It explained that Sri Lanka’s government debt has increased to more than 75 percent of GDP by end 2015 up from 71 percent at the end of 2014.

Although the government raised USD 650 Mn. in September 2015 and a further USD 1,500 Mn. in October 2015 through the issuance of Sovereign Bonds and a further USD 1.500 Mn. through bilateral SWAP arrangement with other Central banks in the Second half of 2015, Fitch does not view that this to be sustainable way to improve the stability of external finance.

Current expenditure on salaries and pension payments are likely to increase by a further LKR 50 billion in view of the recent salary circular to absorb allowances into the basic salary structure. Interest payments are likely to exceed budget limits as rating agencies have downgraded government bonds. Projected public investments are likely to suffer due to tight cash operations.

The budget deficit is likely to be 7.2 percent of GDP in 2015 exceeding the Parliamentary approved limit of 6 percent of GDP. The deficit in 2016 is likely to remain high on account of inadequate revenue to meet recurrent expenditure unless the Government raises VAT and income tax before April 2016.

As stated in the Sunday Times last week, the IMF has suggested that the Government increase the VAT rate from 11 percent to 15 percent, and extend it to retail and wholesale trade, remove many exemptions and reverse the income tax proposals in the 2016 budget.

The post conflict GDP growth in Sri Lanka has been around 7 percent per annum. The unemployment rate declined to 4 percent. Headline inflation had averaged 3.3 percent. The one year Treasury bill interest rate was 6.01 percent. The prime lending rate (AWPR) was 6.26 percent. The exchange rate remained stable at Rs.130/USD throughout 2014. Remittance inflows had reached USD 7 billion (USD 7,018 mn). Tourism income had reached USD 2,431 million. International Reserve Assets totaled USD 9.5 bn of which USD 8.2 bn was official reserve assets.

The downgrade debacle by Fitch is a reflection that Sri Lanka’s economy has failed under the Unity Government within one year. Instead of blaming the past any further, the government must at least now get its act together and focus on the economy. They must now admit that they have created an economic mess by granting unsustainable salary increases to an overblown public service and giving unsustainable price reductions on popular consumer items. They have used the country’s foreign exchange to meet import demand created by bad economic management. The Government has not used oil savings or revenue from tourism or even the borrowings of over USD 4 billion by issuing sovereign bonds and SWAP during 2015 for the strengthening of the economy.

The 2016 budget was a further disaster in this journey as virtually all proposals were withdrawn. Now we have the fertilizer fiasco where price controls reminiscent of pre-1977 policies have been brought back. This is similar to price controls introduced during 2015 on tea and hoppers! The country loosing its investment grade is a real blow to foreign investments. In fact, this downgrading is taking place against the backdrop of President’s visits to Germany and Austria, The PM’s participation in the World Economic Forum, the Finance Minister’s assurance of USD 1 billion from a well known Belgian investor, the pledging of USD 2 billion by the ADB President and an LKR 1 trillion loan from IMF as mentioned by the Finance Minister. All we have now is a sovereign grade showing a country carrying junk bonds.