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 IMF and debt restructuring from private and official bilateral creditors, says Fitch Ratings.

The new president was confirmed by a large majority in parliament, and his government has drawn in some opposition members. This gives 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 is viewed as important for Sri Lanka’s emergence from debt default.

The government’s parliamentary position appears strong, but public support for the government is weaker. President Wickremesinghe was prime minister in the previous administration under President Gotabaya Rajapaksa, who was brought down by protests. Parliament and the government also remain dominated by politicians from the Sri Lanka People’s Freedom Alliance, which is closely affiliated with the Rajapaksa family. This may increase the risk of further destabilising protests if economic conditions do not improve and/or reforms generate public opposition.

We expect any reform package agreed with the IMF by the government to include elements such as higher taxes, expenditure rationalisation and a commitment to a greater degree of exchange-rate flexibility. There is a significant risk that such reforms could cause public opposition that might impede their implementation. In the absence of an IMF deal, it is expected that Sri Lanka will face a very strained external position in the near term. The country has little foreign exchange to pay even for essential imports such as fuel, food and medicines, with official reserve assets at just USD1.9 billion (just over one month of imports) as of end-June.

The Fund noted that it assessed Sri Lanka’s public debt as unsustainable, and confirmed that it would require adequate financing assurances from Sri Lanka’s creditors that debt sustainability would be restored.

Debt negotiations could be complicated by debt owed to China. This amounted to USD5 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, according to the IMF. 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. However, 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 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 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, and when affirmed, the Long-Term Local-Currency IDR in May 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 may move Sri Lanka’s LTFC IDR out of ‘RD’ upon the sovereign’s completion of a commercial debt restructuring judged to have normalised the relationship with the international financial community.

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