Nov 21, 2019 (LBO) – Sri Lanka's presidential election significantly increases policy uncertainty and could prompt loosening that exacerbates fiscal weaknesses and a rollback of reforms, Fitch Ratings says.
However, whether these risks materialise remains to be seen as a clear policy direction may only start to emerge after parliamentary elections.
Gotabaya Rajapaksa of the Sri Lanka Podujana Peramuna (SLPP) defeated Sajith Premadasa of the ruling United National Party (UNP) in Saturday's election.
He is a former defence secretary and the brother of SLPP leader and ex-president Mahinda Rajapaksa.
Mahinda Rajapaksa has been named prime minister following the resignation of the UNP's Ranil Wickremesinghe, and an interim cabinet is likely to be appointed.
The policy environment in Sri Lanka (B/Stable) had improved following the resolution of the 2018 political crisis, supporting the resumption of fiscal and economic reforms and of Sri Lanka's IMF programme.
"However, political tensions could resurface ahead of elections to parliament, where the UNP is the largest party," Fitch Ratings said.
"These are expected early next year. The new president's constitutional reform plans could resurrect controversial proposals to enhance the executive's powers.
"
Gotabaya Rajapaksa's economic manifesto targets average growth of 6.5% or higher, compared with 3.2% in 2018 and a Fitch-forecast 2.8% in 2019, by promoting commodity and apparel exports, construction and tourism.
"Strengthening growth and exports would be credit positive, but we think there is a risk of a more expansionary fiscal stance after the parliamentary elections," the agency said.
Under Mahinda Rajapaska's presidency from 2005-2015, an aggressive infrastructure drive pushed up government debt. Gotabaya Rajapaksa's manifesto targets a budget deficit below 4% of GDP and inflation below 5%.
"Although detailed economic plans are yet to be announced, we think achieving ambitious growth targets could entail stimulus measures that erode fiscal headroom, which is limited by high public debt (about 83% of GDP).
This could undermine policy credibility, investor confidence, and potentially complicate relations with the IMF."
The new president's manifesto suggests that the undermining of monetary policy credibility that was a feature of Mahinda Rajapaska's presidency will not recur.
An important measure of this commitment will be the status of a planned amendment to the Monetary Law Act, which would establish price stability as the central bank's primary objective and support the shift towards flexible inflation targeting.
Gotabaya Rajapaksa's commitments on social spending and public-sector wages and pensions could jeopardise deficit reduction unless government revenue (which is low at just over 13% of GDP) increases.
His manifesto includes plans to replace the Inland Revenue Act, a lynchpin of fiscal reforms under the IMF programme, to unify VAT (currently 15%) and the Nation-Building Tax (2%) with a single VAT rate of 8% and cap personal income tax rates at 15%.
If these lead to revenue losses, they could put Sri Lanka's medium-term fiscal consolidation plan at risk.
"A 4% deficit may therefore prove challenging. We forecast the deficit to stabilise at about 5% of GDP in 2020-2021, as GDP growth recovers from the April bombings in Colombo," Fitch Ratings said.
Contingent liabilities from major state-owned enterprises (SOEs) pose risks to debt sustainability.
Gotabaya Rajapaksa's manifesto says that SOEs will not be 'a burden to the exchequer' but SOE reform has been difficult to achieve. A high share of foreign-currency debt could also pressure debt sustainability if investor confidence deteriorated and the rupee fell sharply.
The market reaction to the election has been mildly positive. The Sri Lankan currency has appreciated by about 0.5% against the dollar and the Colombo stock index rose by about 2%.
"A row-back on reforms could have implications for Sri Lanka's IMF programme, which has been extended to June 2020."
The sixth review was completed in September and, coupled with USD4.4 billion of sovereign bond issuance this year, has eased near-term external pressures. But external debt repayments are substantial at USD19 billion in 2020-2023 (against reserves of USD7.
8 billion).