Sri Lanka’s overall budget deficit of LKR 520.5Bn for the first four months of 2021 has overtaken revenues of LKR 481.7Bn, following tax cuts in Dec 2019 compounded by a Coronavirus pandemic, says First Capital FI Report released last week.
Government’s dissaving nature increased as a result of the Covid-19 pandemic, worsening the pre-existing weaknesses in government finances. Amidst the continued high infrastructure spending we expect the fiscal deficit to surge above 10% for 2021 similar to 2020. Covid-19 has exacerbated existing weaknesses in government finances, with the general government’s borrowing requirement skyrocketing during 2021.
“We expect Sri Lanka’s foreign reserve to drop USD 3 billion in July 2021 after repaying USD 1 billion sovereign bond but recover somewhat following IMF funding and SWAPs to USD 3.5 billion by December 2021.“
Funding from multilateral/bilateral partners may not be sufficient to cover external financing needs over the next 12 months. As of May 2021, foreign reserves not enough to cover maturities over the next 12 months, it would bring down to a dangerously low-level impairing debt servicing ability. Monitoring the environment, Moody’s on July 19 placed Sri Lanka’s “Caa1” foreign currency long-term issuer and senior unsecured debt ratings under review for downgrade.
Increased budget deficit and uncertainty in all other indicators (Foreign Reserves, Inflation and exchange rate) may significantly deteriorate macro-economic conditions and increase pressure on interest rates. We expect the Government Sector Yield curve to move towards our upper bands towards the end of the year. The uptrend would be gradual considering the continued quantitative easing strategy.
Weaker external profile due to a high share of dollar-denominated debt exposures has continued to increase the uncertainty over access to official creditors resulting in inadequate foreign currency inflows. The situation has forced the government to shift its risk sentiment into more short-term higher risk SWAP deals.
The report says that over the near term, inflation and potential monetary policy normalization will play a more important role in shaping the interest rate trajectory.
With gradual progress in vaccination and inflation picking up, talks of policy normalization may intensify. We believe bond yields have already started to pick up and expect it to move higher over upcoming months.
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