Govt. grapples with debt crunch
*Standard & Poor’s notes political uncertainty and lack of commitment to fiscal reform March 12, 2016, 8:48 pm
*India emerges as the single most important financial backer of govt.
*China flayed again by CBK and a deputy minister
Despite what appeared to be a concerted effort to deflect public attention with various sideshows like Minister Sarath Fonseka’s maiden speech in parliament, and the arrest of Ven. Uduwe Dhammaloka on charges of illegally keeping an elephant, the economy remained the main focus last week with the opposition even hinting at a likelihood of a sovereign default as the 1.1 billion USD currency swap with India came due. The Financial media reported last Friday that India had agreed to provide another 700 million USD currency swap arrangement until the expected IMF bailout package materialized. That would be the third occasion in which India provided short term external financing for Sri Lanka in the past 12 months.
Sri Lanka entered into currency swap arrangements with India in March 2015 for USD 400 million, and in July 2015 for 1.1 billion USD. This 700 million USD arrangement would be the third such occasion in a matter of 12 months. Sri Lanka has never been this dependent on India at any time in the past. This dependency probably explains the government’s antics over the proposed ETCA with India. Any hopes of the government being able to raise money on the open market were dashed when Fitch ratings downgraded Sri Lanka’s credit rating and pushed us into the negative outlook category. Even before we were thus downgraded, it was prohibitively expensive to raise money on the open market. The 650 million USD sovereign bond issue in May 2015 had been made at over 6% interest and the 1,500 million USD sovereign bond issue in October 2015 was at a near 7% interest.
The body blow from Fitch
One matter that weighed heavily on the decision by Fitch to downgrade Sri Lanka was the fact that they had estimated that external debt servicing amounting to around four billion USD was becoming due in 2016 in a situation where foreign exchange reserves were around 6.3 billion. It is interesting to note that of this four billion USD in repayments that was becoming due this year, 1,416 million USD or over 35% of the total were loans that the present government had taken in just the past year! Firstly, there was the 316 million USD 13-month Sri Lanka Development Bonds issued in May 2015 and the 1.1 billion USD currency swap arrangement with India for six months which fell due this year. The share of the repayments due in 2016 attributed to all previous governments put together was thus just over 2.5 million USD.
It is not surprising that we were downgraded given the reckless record of short term borrowing during the past year. While borrowings were thus increasing, Fitch also noted the haemorrhaging of foreign money from the Sri Lankan bond market. They made specific mention of the withdrawal of nearly two billion USD held by foreigners in rupee denominated government securities in 2015 which in turn led to a decline in government reserves. Fitch forecast that foreign-exchange reserve coverage of current external payments would decline to 2.9 months in 2016 from an estimated 3.4 months in 2015. They also noted that the foreign-currency debt had risen to 46% from something like 42% at the end of 2014. What this meant was that Sri Lanka’s woes would be amplified if the rupee depreciated any further.
The task of credit rating agencies is to evaluate the creditworthiness of countries so that other parties can make informed decisions when making transactions with such countries. Those who have low credit ratings may find that the market is willing to lend money to them only at higher interest rates to compensate for the increased risk. A sovereign rating measures the risk of a government defaulting on its obligations in either local or foreign currency. In making an assessment ratings agencies take into account factors such as political stability of the country, fiscal management, the existing debt burden etc. Among the political factors taken into account are stability and legitimacy of political institutions, popular participation in political processes, orderliness of leadership successions. Sri Lanka would no doubt score highly on all the political criteria.
One of the key factors taken into account on the economic front by ratings agencies is transparency in economic policy decisions and objectives. Sri Lanka will begin slipping on such criteria especially after the change of government last year. From the time the government changed last year, the sentence we see most often in documents released by trade chambers and economic analyses in the financial media is ‘a lack of policy clarity’. This despite the fact that the prime minister has explained what his economic policy is several times in parliament. One gets the impression that this oft used phrase ‘lack of policy clarity’ is being used as an euphemism for the lack of confidence in the economic management of the present government. The fact that so many local bodies and analysts have been speaking of ‘a lack of policy clarity’ would no doubt have had an impact on the assessments made by the ratings agencies as well.
Among the other economic criteria taken into account by the ratings agencies are the rates of economic growth, government revenue and expenditure, debt as a percentage of GDP, and the share of revenue devoted to repayment of interest etc. Ratings agencies are far from squeaky clean and there are various complaints about sharp practices engaged in by some. For example, they would make an automatic downgrade of an issue of securities if those agencies were not hired to rate them. This would be on the excuse that they have had to make decisions on publicly available material. If the issuer requests the rating, then it provides information to the rating agency and pays the fees. So then you may get a good rating because all the necessary information is provided.
Credit ratings are not always accurate either. During the Asian financial crisis of 1997-98 and the global economic downturn of 2008-09, the top ratings agencies ended with egg on their faces. Asked to explain why they could not give Enron the US energy giant an accurate rating, the ratings agencies claimed they were duped by the company’s executives. Despite the question marks hanging over the way the ratings agencies operate, and indeed even the ratings they give, countries like Sri Lanka are completely at their mercy when it comes to reassuring the financial markets about our creditworthiness. Ratings agencies gather and process information about a country which is then used in the decision making processes among potential investors. A downgrade in the rating can have fatal consequences for a country wishing to borrow on the open market.
A self fulfilling prophesy
Moody’s, the first to issue a rating for Sri Lanka, downgraded us a notch but stopped short of saying that the outlook was negative. They gave us an outlook stable categorization. It was not that they did not notice what the other two ratings agencies noticed, but had interpreted things differently. Moody’s did notice the outflow of foreign money invested in Sri Lankan bonds and securities. They noticed that central bank intervention to shore up the rupee by selling dollars was depleting foreign exchange reserves.
However Moody’s appears to have stopped short of giving an outlook negative grading to Sri Lanka mainly in view of the fact that Sri Lanka had announced that it has approached the IMF for a bailout package and it was anticipated that under IMF guidance, Sri Lanka would collect more taxes and reduce the budget deficit and reduce debt. They also anticipated that an IMF package combined with project funding from the ADB at concessionary rates would provide some liquidity.
Even though Moody’s gave Sri Lanka an outlook stable grading, they did note that the very fact that Sri Lanka had approached institutions like the IMF showed that there was little scope for Sri Lanka to be able to meet its external financing needs from the open market. While there were 13 nations in the B1 category to which Moody’s had included Sri Lanka, they put Sri Lanka right at the top of the list of those countries in that category which had the highest probability of defaulting. Even a country like Ethiopia which was also in that same grade, would be only 30% as likely to default when compared to Sri Lanka.
Moody’s had in fact been sounding warnings since last year. In the wake of the Sirisena-Wickremesinghe government’s mini-budget early last year, it was obvious that Moody’s was not happy about the revenue measures that the government had announced. They warned that if the super gains tax is not collected properly, the budget deficit would increase and they expressed doubt at the ability of some private institutions slapped with punitive one off taxes to pay up. They warned that such taxes will dampen investments and have a negative impact on growth. They also warned that increasing the salaries of public servants who make up 15% of the workforce would boost consumption and have a negative impact on the balance of payments.
The grading given by a rating agency can be deadly because it has a tendency to become a self fulfilling prophesy. Once you are downgraded by one rating agency the markets panic and everybody including other ratings agencies run for cover. Standard and Poor’s was the last of the big three ratings agencies to issue their grading last week and they have basically followed the lead set by Fitch and downgraded us a notch and also given us an outlook negative categorization. In doing so S&P said that Sri Lanka’s external and fiscal performances have not met expectations. They mentioned the high government debt and interest payment burden and observed that remittances from foreign employment had gone down, and short-term capital outflows have eroded foreign exchange reserves. Even more lethally, S&P stated that they expect sizable and rising fiscal deficits to push borrowings even higher in 2016-2019 and that the authorities face significant challenges in effectively addressing the rising imbalance due to ‘institutional constraints’ and a ‘fragmented political landscape’.
They were in other words saying that the political authorities were riding a roller coaster that they could not stop and they expected this to be the norm till 2019. They also noted ‘an uncertain commitment’ and capacity for fiscal consolidation following the Aug. parliamentary elections and the 2016 budget. If Moody’s looked at it somewhat positively by saying that the involvement of the IMF would put things right, S&P seems to think that the present political set up is fundamentally incapable of correcting the situation.
The S&P statement also said that "The gaps we observe in Sri Lanka’s policymaking capacity partly reflect the political uncertainty associated with two elections within seven months. We believe this hinders responsiveness and predictability in policymaking and weighs particularly on business confidence, investment plans, and overall growth prospects." This particular statement seems to suggest that political stability has not followed from the two elections and that economic decision making is completely overshadowed by political considerations (which we Sri Lankans know is indeed the main problem confronting Sri Lanka). S&P even stated that "The negative outlook indicates that we could lower our rating on Sri Lanka in the next 12 months if we see no tangible signs of a substantial and sustained reversal of the weakening of external and fiscal credit metrics we currently project."
They did however strike a conciliatory note by adding "We may revise the outlook back to stable if Sri Lanka’s external and fiscal indicators improve significantly, or if we conclude that the strength of Sri Lanka’s institutions and governance practices is on a significant and sustained improving trend."
Chinese projects maligned again!
The government seemed to be intent on scoring own goals. If Moody’s thought that ADB project funding and IMF package would inject some badly needed liquidity into the economy, a section of the government seemed to be thinking on similar lines which is why Minister Malik Samarawickrema was engaged in a concerted effort to get the Chinese funded projects including the Port City going again. But last week, the Deputy Minister of Power and Energy Ajith P.Perera once again launched into a tirade against Chinese projects reminiscent of the early days of ‘yahapalana’ euphoria. The cause for the latest tirade by the deputy minister was the shutdown of the coal power plant following a lightning strike on a transmission line two weeks ago.
He said that the Norochcholai power plant has been built with substandard and outdated material and is below international standards but that the authorities are unable to claim any damages as the previous regime agreed to use the material specified in the agreement which are sub-standard. Perera had even lamented that while in China a contractor can be jailed for a similar offence, there are no such laws in our country.
He had observed that the Norochcholai power plant has had a record number of breakdowns since operations launched in 2011. He had further said that to compensate for failures of Norochcholai, three coal power plants are to be built in Sampur. The first would be an Indian funded power plant generating 500 mega watts. Another two power plants generating 600 and 1,200 mega watts will be built within the next two years with Japanese funding.
When the Deputy Minister of Power and Renewable Energy speaks in such terms about a Chinese funded project, how is that supposed to act as an incentive for the Chinese to re-commence operations in this country? One question that we have to ask ourselves is whether the allegations made by Minister Perera against the Chinese contractors are even true.
A knowledgeable expert (who wishes to remain anonymous) contacted by the present writer said that the public should be aware of the following points in relation to the Norochcholai power plant.
1. It was not only the Norochcholai coal power plant that went out of operation (trip off) due to a lightning strike on a transmission line. All other power plants of the CEB including hydro power plants, the Kelanitissa thermal power plant, the Kerawalapitiya combined cycle power plant and the barge mounted power plant at the Colombo port, had tripped off instantly causing an island wide power failure.
2. The technical specifications of the plant, machinery and equipment and and scope of the project all were decided by the General Manager and Senior Engineers of the CEB with the assistance of the Foreign Consultant M/S Electrowatt of Switzerland, retained by the CEB during the tenure of Chandrika Kumaratunga. The agreement specifying all technical standards of the project had been signed on 30.8.2005 by President Chandrika Kumaratunga during her state visit to China.
3. The China Machinery and Equipment Company (CMEC) has been selected to undertake the engineering, procurement and construction of the Norochcholai plant by the Cabinet of Ministers headed by President Chandrika Kumaratunga on 8.4.2005. This company was recommended by the Chinese Government as the contractor for this project.
4. The manufacturing process of the plants, machinery, turbines, boilers and generators etc were inspected by the senior engineers of the CEB at the factory site having gone to China at the expense of the Chinese con tractor.
5. The supervision of the entire project was by the senior engineers of the CEB including the Director of the Project with the Assistance of the Swiss foreign consultant.
6. The inspection of the plant and machinery prior to shipping was done at the Chinese port by CEB engineers having gone to China at the expense of the contractor and shipments of those items were allowed by the senior engineers of the CEB having satisfied themselves that this equipment and machinery was of good quality, and meets the technical standards and technical specifications stated in the agreement .
7. All payments for the construction were released by the Chinese Exim Bank out of the loan directly to the contractor based on the payment recommendations made by CEB Board - the General Manager of CEB, the Project Director of the CEB, the Finance Manager of the CEB and the Consultant M/S Electrowatt who have certified the quality, quantity and fulfilment of the requirements of the agreement by the contractor.
8. President Mahinda Rajapaksa, the Presidential Secretariat, the Treasury and the Minister and officials of the Power and Energy Ministry had not been involved in these transactions and all those activities were carried out by the CEB and CMEC independently.
9. The same contractor CMEC has now been awarded a contract by the Ministry and the CEB during the tenure of the present government for procurement of spare-parts and for the installations of cranes and other equipment in the newly constructed coal yard at Norochcholai adjoining to the existing coal yard.
No government is going to set up a power plant without the CEB engineers being involved in the process. If CEB engineers certify something as up to standard, no politician can say anything to the contrary. If however the CEB engineers come out and say that the political authorities had approved the contract contrary to their recommendations, then it would be a different story. One can only wonder which is worse, Deputy Minister Ajith P.Perera’s comments on Norochcolai or former President Chandrika Kumaratunbga’s comment about the Chinese built Nelum Pokuna which she likened to a ‘kakkussi pochchiya’ or toilet bowl! This was a gift from China and the architecture was based on the 12th century Nelum Pokuna in Polonnaruwa. When the ratings agencies see China, the world’s financier being publicly maligned by irresponsible politicians in this manner, we may end up with another downgrading.
Last Updated Mar 24 2017 | 09:21 pm