Top credit-rating agency, Moody’s Investors Service last week released the following Issuer Comment titled ‘Sri Lanka’s election outcome improves the government’s ability to pass credit-positive reforms’ authored by Senior Vice President Atsi Sheth and Associate Analyst Shirin Mohammadi.
Last Friday, a coalition government led by the United National Party (UNP) took office in Sri Lanka (B1 stable), following 17 August parliamentary elections in which the UNP more than doubled its seats in parliament to 106 of 225 total seats. The UNP-led coalition will include the Sri Lanka People’s Freedom Party, the second-largest political party in parliament, of which former President Mahinda Rajapaksa is a member.
The establishment of a coalition government with more than a two thirds parliamentary majority is credit positive for Sri Lanka because the government can now more easily enact policies that revive growth and address its large fiscal burden. This would address flagging business confidence and slowing foreign investment flows of the past six months.
Before the elections, the UNP and its allies controlled 26% of the seats in parliament. A UNP-led government led by Prime Minister Ranil Wikremesinghe was appointed in January by President Maithripala Sirisena, who in January 2015 unseated Mr. Rajapaksa, who had been in office since 2005. However, the UNP’s lack of a parliamentary majority slowed policymaking and resulted in a political environment characterized by fractious rhetoric between rival political factions. In an environment of slowing global growth, political gridlock in the first half of this year dampened business confidence, leading to a reversal of capital flows. Had these conditions persisted, they would likely have slowed domestic investment growth as well.
As the exhibit below shows, net portfolio investment into Sri Lanka declined in the first quarter of this year, partly reflecting market pessimism about the direction of policymaking and its effect on Sri Lanka’s macroeconomic prospects. As a small economy with a current account deficit, a continued decline in capital inflows would have hurt Sri Lanka’s balance of payments position with the potential to negatively affect domestic growth as well.
Continued growth is crucial in addressing Sri Lanka’s high government debt burden, which at 76% of GDP is higher than similarly rated peers. The government in February announced a revised 2015 budget targeting a fiscal deficit of 4.4% of GDP and a 14.1% growth in overall government revenues. Government revenues increased by 18.4% over the first five months of the year, driven primarily by an improvement in import duties and excise tax collection, and dividends from state-owned enterprises. Meeting the deficit target will depend on whether government expenditures, targeted to increase by 10.4% to fund higher healthcare, education, public sector salaries and pension spending, are kept in check.
Government policies are increasingly important in addressing Sri Lanka’s macroeconomic challenges, which stem from high government debt, subdued international trade, and the potential for capital outflows from emerging markets ahead of an increase in interest rates by the US Federal Reserve and China’s slowing economy. Sri Lanka’s growth, still robust relative to peers, has slowed to 6%-7% in recent years from more than 10% on average in the early 2000s.
Political gridlock before the election threatened to exacerbate the slowdown by thwarting investment. The UNP government’s reviews of projects approved by the previous government delayed their execution, while political opponents’ challenges to the appointments of officials by the UNP government diverted time and resources away from economic policy formulation and implementation. If the current structure of government limits the negative effect that such political differences had on business confidence, the economic outlook will improve.