Sri Lanka: Risk Assessment
Country Risk Rating
Business Climate Rating
- Diversified agricultural production (tea, rice, coconut, rubber)
- Strategically located at the center of trade routes between Asia and the Middle East
- Indian, Chinese and Japanese interests
- Strong growth in tourism
- Successes in education, health and poverty reduction
- Agricultural production vulnerable to climate disasters; dependence on tourism
- Low levels of public capital expenditure due to debt servicing burden
- Reliant on short-term external financing
- Lack of infrastructure
- Ethnic tensions between Sinhalese and Tamils
Tourism recovery will restore growth in 2020
Sri Lanka’s growth in 2019 was severely affected by the April attacks, which killed more than 250 people in the capital. Tourist arrivals declined by 41.6% in the second quarter of 2019, impacting the entire service sector (23% of GDP). Both private and public consumption have declined, as has an investment in fixed capital. This shock is a transitory one and will fade after one year, allowing growth to strengthen in 2020. Industrial production was also affected, but recovered more quickly, thanks in particular to construction activity. Agricultural production benefited from favorable weather conditions, and exports contributed positively to growth, benefiting from last year’s depreciation.
Credit creation slowed in the first half of 2019, due to the economic slowdown and investors’ weakened expectations. This moderation offset the rise in food prices, and inflation remained at the levels expected for 2019. The expected recovery in activity, reductions in the key policy rate and the cap on private bank rates will stimulate credit in 2020, without stoking inflation: food prices are expected to stabilize, and energy prices will trend downwards.
High public debt
In the first half of 2019, Sri Lankan public finances deteriorated further: the shock to tourism and the decline in imports reduced government revenues and aggravated deficits, leading to non-compliance with the targeted primary balance criterion. Nevertheless, the IMF renewed its confidence in the State, turned a blind eye to the failure to comply with the criterion, and extended its support to the country by one year. A new credit tranche of USD 164 million was granted in June 2019, bringing the total disbursement of the program to USD 1.31 billion (1.4% of GDP). The country is continuing its reform program, which includes the use of indirect taxes, the forthcoming creation of a public debt management agency and the introduction of a fiscal rule. Given the strong growth expected, the deficit is therefore expected to decline in 2020. Public debt is high, and weighs heavily on the State budget: interest payments accounted for 44% of 2019 revenues. Financing needs are high, debt is expensive and external dependence is considerable. Half of the debt is in foreign currencies and therefore exposed to the risk of depreciation. Over the 2020/2023 period, debt service will represent USD 19.3 billion, while foreign exchange reserves stood at USD 7.8 billion in November 2019, or 4.5 months of imports, currently an insufficient level.
The current account deficit narrowed thanks to an improvement in the trade balance: exports increased by 4.7% on clothing sales, while restrictions reduced imports by 16.1%. These improvements offset the reduction in tourism revenues and expatriate remittances. In 2020, the deficit will widen again: the recovery in tourism revenues will not be enough to offset an increase in imports due to growth and the easing of import restrictions.
The Rajapaksa clan returns to power
The presidential elections saw Gotabaya Rajapaksa emerge as the winner, with 52.25% of the votes. A former soldier, Mr. Rajapaksa is a popular figure because of his role in ending the civil war in 2009. His victory, on a platform of nationalism and security, is symptomatic of the ongoing ethnic tensions in Sri Lanka: the President had the support of the Sinhalese ethnic majority, but received few Tamil votes. The appointment of his brother, former President Mahinda Rajapaksa, who pursued a set of nationalists, centralizing and authoritarian policies between 2005 and 2015, raises fears that the achievements of the previous government in terms of corruption, separation of powers and press freedom will be reversed. The fight against terrorism is a top priority for the President, and security improvements are expected. Regarding economic policy, the President has promised large tax cuts, as well as increased subsidies for farmers. The country is on the path of structural reforms, but the risk of a widening deficit in 2020 remains and is hostage to the discretion of politicians: populist measures could be taken ahead of parliamentary elections in August 2020 in an effort to wrest the majority back from the opposition. Sri Lanka has moved up the World Bank’s Doing Business 2020 ranking, coming 99th.
Relations with China were greatly strengthened during Mahinda Rajapaksa’s two terms of office and may deepen again in the coming years. The struggle for influence between China and India remains significant, but Indian projects have stalled, while China has helped the Rajapaksa family avoid international investigations of war crimes committed in 2009 and holds about a quarter of the public debt. China is very involved in Sri Lanka’s development, and finances the Colombo Financial District, for example, providing USD 1.4 billion, the largest foreign investment in the country. This raises the question of dependence on this financing: when it becomes impossible to repay the loan taken out to finance the port of Hambantota, the government was forced to cede the port to China for 99 years.