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Sri Lanka is negotiating a USD one billion loan from India to import goods from the country, the governor of the Central Bank Ajith Nivard Cabraal said on Wednesday, amidst a shortage of almost all essential commodities.

Cabraal also said that Sri Lanka is negotiating another loan from China as part of an attempt to restructure its debt repayment. The loan amount has not been decided. He said that Sri Lanka is negotiating a USD 1 billion facility with India to import goods from the country.

Cabraal said that this will also help Sri Lanka in its debt repayment and promote more trade with the respective countries.

Last week, President Gotabaya Rajapaksa told the visiting Chinese foreign minister Wang Yi that Sri Lanka would be helped if the debt could be restructured.

“We have an understanding that they would assist us in making the repayments in that form. So maybe there is a possibility that we would have a new loan coming in order to cushion our debt repayments to China”, Cabraal said.

Cabraal said Sri Lanka’s debt repayments this year would amount to about USD 6 billion. “We are confident we can pay all of them despite current difficulties we are facing,” he said, adding that the USD 500 million international sovereign bond (ISB) repayment due next will be duly paid.

The government in the past week faced lobbying by the trade chambers who advocated an ISB default in order to pay for imports.

Sri Lanka is currently experiencing a shortage of almost all essentials due to a shortage of dollars to pay for the imports.

Cabraal defended the Central Bank’s decision to sell more than half of its gold reserves last month in order to supplement the foreign exchange reserves.

The Central Bank economic indicators dated January 7 showed that gold reserves had fallen to US dollars 175 million in December from 382 million.

Cabraal said the gold-selling was part of reserves management adopted by the Central Bank and could be brought to the bank in the future.

The government officials said the USD one billion loans from India would be restricted to food imports. Agriculturists have warned of food shortages in the country during the next two months.

Standard and Poor’s has downgraded Sri Lanka to ‘CCC’ from an earlier ‘CCC+’ with the outlook negative at the lower level as the currency continued to be under pressure from liquidity injections though reserves were boosted in December with a swap from China.

Sri Lanka is now making liquidity injections mostly to sterilize interventions with bond markets operating after price controls were lifted.

If the government signals an intention to restructure commercial debt rating would be further downgraded.

“Foreign exchange resources will be further pressured over the coming quarters by additional external sovereign debt maturities and current account requirements,” the S&P said.

“These developments indicate a rising probability of sovereign default scenarios playing out over the next 12 months in the absence of an unforeseen positive development.”

“The negative outlook reflects our expectation that Sri Lanka’s external financial position will deteriorate further over the coming quarters.

“This would affect Sri Lanka’s ability to service its debt over the next 12 months.”

The rating agency said a “relief package” while boosting economic activity would also weaken the government’s fiscal position and worsened the risks associated with the government’s already-high debt burden.

The handouts mostly went to state workers who were hit by high inflation created by past money printing who were beginning to protest demanding salary hikes.

S&P said it may revise the outlook to stable or upgrade the rating if Sri Lanka can “significantly boost” reserves or its economic recovery is much stronger than expected.

“This could lower the risks associated with the government’s debt-servicing capacity,” the agency said.

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However other analysts have warned for some time that stronger the economic and credit recovery as liquidity injections made to enforce low rates, the bigger the hit on the balance of payments as the new money turns into imports which are not controlled.

the full statement is reproduced below:

Sri Lanka Rating Lowered To ‘CCC/C’ On Increasing External Financing Risks; Outlook Negative

Overview

Sri Lanka’s external position continues to weaken owing to elevated external obligations and uneven access to financing.

Foreign exchange resources will be further pressured over the coming quarters by additional external sovereign debt maturities and current account requirements.

These developments indicate a rising probability of sovereign default scenarios playing out over the next 12 months in the absence of an unforeseen positive development.

We lowered our long-term sovereign credit rating on Sri Lanka to ‘CCC’, from ‘CCC+’ previously. At the same time, we affirmed our ‘C’ short-term credit rating on the government.

The outlook on the long-term rating is negative.

Rating Action

SINGAPORE (S&P Global Ratings) Jan. 12, 2022–S&P Global Ratings today lowered its long-term sovereign credit rating on Sri Lanka to ‘CCC’, from ‘CCC+’ previously. The outlook is negative. At the same time, we affirmed our ‘C’ short-term credit rating.

Outlook

The negative outlook reflects our expectation that Sri Lanka’s external financial position will deteriorate further over the coming quarters. This would affect Sri Lanka’s ability to service its debt over the next 12 months.

Downside scenario

We could lower our ratings if Sri Lanka’s fundraising activities fall short of government targets or its foreign exchange reserves erode further beyond our expectations, leading to higher risk on the sovereign’s ability to service debt.

We could also lower the ratings if the government signals its intention to restructure its outstanding commercial debt, implying that investors would receive less value than that promised on the original securities.

Upside scenario

We may revise the outlook to stable, or raise the rating, if Sri Lanka can significantly boost external buffers or its economic recovery is much stronger than we expect. This could lower the risks associated with the government’s debt-servicing capacity.

Rationale

The downgrade reflects continued deterioration in Sri Lanka’s ability to maintain sufficient foreign exchange resources to meet elevated external obligations. The Sri Lankan government faces increasingly likely default scenarios without unforeseen significant positive developments.

Timely debt service will likely become increasingly difficult over the next 12 months, given Sri Lanka’s vulnerable external profile, sizable fiscal deficits, heavy government indebtedness, and hefty interest payments. These factors significantly constrain our ratings. Macroeconomic policies, including the recent introduction of a US$1.2 billion relief package, have provided some support to the pandemic-hit economy. But they have also weakened the government’s fiscal position and worsened the risks associated with the government’s already-high debt burden.

Institutional and economic profile: Economic recovery under pressure from pandemic, external stresses

Sri Lanka’s economic recovery will be challenged by the ongoing pandemic and external financial stresses, hampering consumer sentiment. This could affect access to capital.

We forecast real GDP growth at 2.2% this year, compared with our estimate of 3.0% expansion in 2021.

The government has maintained a supportive fiscal policy stance despite its weak finances.

Sri Lanka’s economy will face sustained headwinds from the pandemic and external financial conditions this year, limiting its recovery potential. The Sri Lankan economy contracted by 1.5% year on year in the third quarter of 2021, reflecting the effects of a severe wave of COVID-19 in the country that peaked in August. A delayed reopening of international tourism also weighed on the economy.

In 2020, the government introduced broad-based import controls to manage foreign exchange outflows, and these are likely to progressively weigh on affected economic sectors. The Central bank of Sri Lanka (CBSL) also hiked its standing deposit and lending facility rates by 50 basis points (bps) in August 2021, in addition to a subsequent 200 bps hike to its statutory reserve ratio. Consumer Price Index inflation, which is currently above 11%, is likely to weigh on consumer sentiment and could place further downside pressure on the currency over the coming quarters.

The advent of the omicron variant of the coronavirus is leading to surging case numbers around the world, and this is likely to further delay the recovery of Sri Lanka’s tourism sector. While domestic case levels remain relatively stable at the time of publication, the risk of another large COVID-19 wave in Sri Lanka is considerable.

Given the highly contagious nature of the omicron variant, a steep escalation in new infections could have a disruptive impact on the economy, even if it does not severely strain the healthcare system. Uneven external demand conditions in countries managing record case numbers could also diminish an important source of support for Sri Lanka’s economy over the next few months.

We forecast the economy will expand 2.2% in real terms in 2022, following our estimate of 3.0% expansion in 2021, and growth will likely average 2.7% during 2022-2025. This will bring per capita income to about US$3,750 in 2022, translating into real GDP per capita growth of 1.6% on a 10-year weighted-average basis. While this growth is comparable to peers at a similar income level, we believe it is substantially below Sri Lanka’s potential.

Sri Lanka’s current political settings are characterized by a ruling coalition with a solid parliamentary majority. However, President Gotabaya Rajapaksa in December 2021 unexpectedly introduced a measure that will prorogue parliament for an extra week until Jan. 18, 2022. Cabinet meetings on negotiating a reform and funding package with the International Monetary Fund (IMF) have so far ended with no substantive agreement, according to media reports, indicating differing views among the policymakers involved.

Flexibility and performance profile: External stress escalating on higher current and financial account obligations

Sri Lanka’s external profile has weakened, with reserves facing consistent pressure from high current and financial account obligations.

Sri Lanka’s fiscal deficit is likely to remain elevated even as the economy gradually recovers.

The government’s interest burden is likely to remain very high as its debt level continues to rise in line with its deficits.

Sri Lanka’s external position remains a key vulnerability of the ratings, with its foreign exchange buffer narrowing. While the central bank’s foreign exchange reserves reportedly rose from approximately US$1.6 billion in November 2021 to US$3.1 billion in December, this remains slightly less than two months’ worth of import cover. December’s reserves were likely boosted by the central bank’s drawdown on a previously agreed Chinese renminbi (RMB) 10 billion swap facility with the People’s Bank of China (PBoC). Sri Lanka’s government has indicated that additional agreements with other central banks and bilateral lenders are in the offing, but its deteriorating creditworthiness may complicate efforts to secure fresh funding.

Additional inflows may be insufficient to offset pre-determined short-term drains on foreign reserves estimated at US$6.6 billion over the next 12 months. The ability of the government to secure additional foreign financing over the next two quarters will be a key determinant of its ability to prevent a deeper external liquidity crisis.

Financing conditions on international capital markets remain challenging for Sri Lanka. These conditions are unlikely to improve over the next 12 months due to rising inflation pressures, and prospects of a faster-than-expected policy tightening in advanced economies. While the government has been able to maintain some dollar funding via Sri Lanka Development Bonds (SLDBs) purchased by domestic creditors, demand for these bonds appears to have diminished. Success in rolling over SLDBs is crucial to the government’s debt-servicing capacity. In turn, this will heavily depend on domestic creditors’ ability to access external financing under favorable terms, as well as their willingness to continue to lend to the government.

We estimate that Sri Lanka’s current account deficit rose considerably in 2021 to about 3.4% of GDP versus a shortfall of just 1.3% in 2020. Higher energy prices are weighing on the country’s goods trade balance, and the delayed recovery of the international tourism sector is limiting the pace of service export growth. While we expect Sri Lanka’s current account position to gradually improve over the coming quarters, the shortfall will place additional pressure on its external liquidity position in addition to capital and financial account obligations.

Sri Lanka’s gross external financing needs as a percentage of current account receipts plus usable reserves should average 145% over 2022-2025, in our assessment. We also forecast that Sri Lanka’s external debt net of official reserves and financial sector external assets will remain elevated at about 163% over the same period.

Persistent deficits in Sri Lanka’s fiscal position will place additional strain on its ability to meet financial obligations, absent considerable improvement. With more than 70% of government revenues required to service interest payments, the government’s heavy debt burden limits its ability to accumulate policy buffers, which are crucial in times of stress. The COVID-19 pandemic has further weighed on government finances by dampening domestic economic activity and lowering excise duty earnings.

Sri Lanka’s 2022 budget includes some revenue enhancements, including an increase in the financial services value-added tax rate, revisions to excise duties on cigarettes and liquor, and a one-off surcharge on high-earning individuals and companies. Taken together, these will boost revenue generation in 2022; however, additional revenue reforms will likely be required to meaningfully raise the government’s revenue-to-GDP ratio over the next few years.

The government in January 2022 also announced a US$1.2 billion relief package, including a special monthly payment to qualifying public servants, retirees, and military personnel. This package is likely to push the fiscal deficit higher than the budgeted shortfall for this year.

We estimate a deficit of 11.1% of GDP for Sri Lanka in 2021, and the government’s fiscal shortfall will likely hit 9.8% in 2022. If revenue growth underperforms the government’s targets, we believe capital expenditure may be cut to partially offset the deficit.

High fiscal deficits over an extended period will worsen the government’s very high debt levels. We expect the increase in net general government debt to average 9.3% over 2022-2025 in our base case, where we assume that the government is able to continue to raise equivalent financing. Net general government debt exceeded 100% of GDP in 2020 and will continue to increase over the next five years, in our view. We add the CBSL’s drawdown on the PBoC swapline in our calculation of the government’s debt.

Sri Lanka’s foreign exchange-denominated debt is vulnerable given the government’s declining foreign exchange reserves and high repayments. The government faces international sovereign bond maturities of US$500 million in January 2022 and US$1 billion in July 2022, in addition to bilateral and official obligations and SLDBs. The central bank has stated that the funds required for the repayment of the January 2022 maturity have already been allocated. Total SLDB maturities in 2022 amount to approximately US$1.45 billion.

A statement published by the office of Sri Lankan President Gotabaya Rajapaksa on Jan. 9, 2022, indicates that the government may seek debt restructuring from Chinese creditors. While additional details are not yet available, Sri Lanka has considerable official and bilateral borrowings from China. Our issuer credit ratings are assessments of default risk on commercial debt, rather than on concessional debt contracted from multilateral or bilateral lenders.

The government has been increasing the share of domestic financing to fund the fiscal deficit. At the same time, domestic interest rates have been kept low partially through liquidity injections by the central bank. While this has capped the effective interest rate on the government’s domestic debt, an increase in domestic liquidity is also likely to put pressure on the exchange rate. Amid high inflation and a currency under pressure, the central bank may hike rates further, potentially pushing the cost of local currency government debt higher as well. The government’s interest burden remains extremely elevated as a proportion of its revenues. We estimate that this ratio will rise to more than 75% this year, the highest among rated sovereigns globally.

We assess the government’s contingent liabilities from state-owned enterprises and its relatively small financial system as limited. However, risks continue to rise due to sustained losses at Ceylon Petroleum Corp., Ceylon Electricity Board, and Sri Lankan Airlines. Sri Lankan banks have purchased substantial quantities of government debt, and the banking sector’s aggregate exposure is more than 20% of system assets.

Sri Lanka’s monetary settings remain a credit weakness, and work toward an updated Monetary Law Act has been suspended since mid-2021. The credibility and effectiveness of the central bank’s monetary policy will be further tested by high inflation, the potential for a faster normalization of global monetary conditions, and the prevailing shortage of foreign exchange in the economy.

The president of debt-ridden Sri Lanka has asked China for the restructuring of its loans and access to preferential credit for imports of essential goods, as the island nation struggles in the throes of its worst economic crisis, partly due to Beijing-financed projects that don’t generate revenue.

President Gotabaya Rajapaksa told visiting Chinese Foreign Minister Wang Yi that it would be “a great relief to the country if attention could be paid on restructuring the debt repayments as a solution to the economic crisis that has arisen in the face of the Covid-19 pandemic,” according to a statement from his office.

Rajapaksa asked Wang for a concessionary credit facility for imports so that industries could run without disruption, the statement said. He also requested assistance to enable Chinese tourists to travel to Sri Lanka within a secure bubble.

Wang and Prime Minister Mahinda Rajapaksa, the president’s brother, later visited Colombo’s Port City, a reclaimed island developed with Chinese investment, where they opened a promenade and inaugurated the sailing of 65 boats to commemorate the 65 years of diplomatic relations between the two countries.

In his speech at the Port City on Sunday, Wang said a persistent and unchecked pandemic had made economic recovery difficult and the two countries must use the anniversary to work closer together.

He did not elaborate nor announce any relief measures.

Wang arrived in Sri Lanka on Saturday from the Maldives on the last leg of a multinational trip that also took him to Eritrea, Kenya and the Comoros in East Africa.

Sri Lanka faces one of its worst economic crises, with foreign reserves down to around US$1.6 billion, barely enough for a few weeks of imports. It also has foreign debt obligations exceeding US$7b in 2022, including repayment of bonds worth US$500 million in January and US$1b in July.

The declining foreign reserves are partly blamed on infrastructure projects built with Chinese loans that don’t make money. China loaned money to build a seaport and airport in the southern Hambantota district, in addition to a wide network of roads.

Central Bank figures show that current Chinese loans to Sri Lanka total around US$3.38b, not including loans to state-owned businesses, which are accounted for separately and thought to be substantial.

“Technically we can claim we are bankrupt now,” said Muttukrishna Sarvananthan, principal researcher at the Point Pedro Institute of Development.

“When you have your net external foreign assets have been in the red, that means you are technically bankrupt.”

The situation has left households grappling with severe shortages. People wait in long lines to buy essential goods like milk powder, cooking gas and kerosene. Prices have increased sharply, and the Central Bank says the inflation rate rose to 12.1 per cent by the end of December from 9.9 per cent in November. Food inflation increased to over 22 per cent in the same period.

Because of a currency shortage, importers are unable to clear their cargo containing essentials and manufacturers are not able to buy raw materials from overseas.

Expatriate remittances have also fallen after the government ordered the mandatory conversion of foreign currency and exchange rate controls.

Ratings agency downgrades have resulted in Sri Lanka losing much of its borrowing power. In December, Fitch Ratings noted an increased probability of credit default.

The Central Bank has added a currency swap in Chinese currency worth US$1.5b to the reserves, but economists disagree whether it can be part of foreign reserves or not.

Wang’s visit has again highlighted the regional power struggle between China and India, Sri Lanka’s closest neighbour that considers the island part of its domain.

Before Wang spoke with Sri Lankan leaders, the top Indian diplomat in the country on Sunday morning inaugurated a train service from a station near Colombo to the north using compartments provided through an Indian loan facility.

An Indian embassy statement quoted Vinod Jacob recalling “the priority placed by Indian Prime Minister Narendra Modi on ties with Sri Lanka in line with the ‘Neighbourhood First’ policy.”

He said that a recent statement by India’s External Affairs Minister S Jaishankar that India would support Sri Lanka in difficult times was an affirmation of that policy in the current context.

“We can see Sri Lanka being saddled between India and China for a potential bailout package,” said political analyst Ranga Kalansooriya.

“India is dragging its feet for some time while China is trying to manipulate the situation to the maximum,” he added.

China considers Sri Lanka to be a critical link in its Belt and Road global infrastructure initiative. Relations were recently strained over a shipment of Chinese fertiliser that allegedly contained harmful bacteria, and business agreements that were inked with China’s rivals, the United States and India.

Kalansooriya said that China was unlikely to bail Sri Lanka out of its economic crisis. “They will look for more business opportunities, fishing in the troubled waters of economic doldrums in the country,” he said.

During his visit to Sri Lanka on January 8 and 9, the Chinese Foreign Minister, Wang Yi, had clearly indicated that China is keen on going beyond infrastructural development to investing in industries in the island nation to help it industrialize and develop a “Made in Sri Lanka” brand.

He also urged an early conclusion of the long drawn out negotiations on a Sino-Lankan Free Trade Agreement so that the island’s economy is put on a more solid and modern footing, based on investment and trade.

These proposals are meant to strengthen the Sri Lankan economy and enable it to earn enough to repay debts even as they release China from the charge across the world that it is on a lending spree in poor countries with the aim of taking over their assets if they fail to repay the loans. China is widely accused of practising- “debt-trap diplomacy.”

In Sri Lanka, so far, China has built massive infrastructural facilities like the Hambantota port, the Mattala airport, the Colombo International Container Terminal, the Colombo Port City, the Lotus Tower, a kidney Disease hospital in Polonnaruwa and several highway and railway links. With the result, today, China is the single largest lender to Sri Lanka having displaced Japan. But still, China accounted for only a little over 10% of Sri Lanka’s external debt of US$ 51 billion in 2021.

Yet, the taking over of the Hambantota port on a 99-year lease following the inability of the Lankan government to pay back the US$ 1.1 billion loan taken from China to build the harbor, is widely cited as a classic case of China’s “debt diplomacy”. However, over time, these projects, barring a few like the Lotus Tower, have started generating income. Even the classic White Elephants, the Hambantota port and the Mattala Airport derided by Forbes as the “World’s Emptiest Airport”, are earning money now.

If they took so long to yield returns it was not the fault of China or the assets, but the Sri Lankan government’s lack of interest in making use of the assets in a creative way. For instance, India had submitted a plan to use Mattala airport for domestic flights through a joint venture, but the previous Mathripala Sirisena-Ranil Wickremesinghe government used it for “grain storage”. However, since the Rajapaksa came back to power, the airport has been attracting flights.

In April 2021, the Lankan Minister of Tourism Prasanna Ranatunga stated in parliament that the Mattala International Airport had earned an income of LKR 445 million from its opening to traffic in November 20, 2020. The Minister said that since the opening of the airport, 10,266 aircraft and 58,651 passengers arrived and 73,513 passengers took off.

As for the Humbantota port, it is attracting traffic and will see a jump when plans to build facilities in the hinterland are implemented. According to the website of Hellenic Shipping News, in September 2021, the China Merchants Port Holdings (CMPH) which operates Humbantota port, declared a dividend of LKR 1.05 billion to the Sri Lanka Port Authority (SLPA), while announcing that its first half net profit had shot up by 204.7% to HK$4.71 billion (Rs 120.61 billion), from HK$1.54 billion in 2020.

For the first half of 2021, Hambantota International Port Group handled 790,000 tonnes of bulk cargo. Bulk cargo volume vaulted by 338.9% from the year before. The roll-on/roll-off terminal handled 281,000 vehicles in the first half, up by 56.2% year-on-year. The Humbantota Industrial Park had signed up 27 enterprises, the company said. It is gearing up to become a fully-functional multi-purpose port next year.

The US$ 1.4 billion Colombo Port City constructed by the China Harbor Company, began humming with activity recently, after the Lankan government, at long last, gave it proper legal structure. Designed to be an international financial hub it is expecting two big-ticket Chinese financial companies to set other international investments in motion, according to the Lankan envoy in Beijing Dr.Palitha Kohona.

There is criticism that about 88 hectares were leased to China for 99 years and another 20 hectares were given on freehold to China in the Colombo Port City. But this was done to compensate for the loss of US$ 380,000 per day due to work stoppage caused by a government inquiry which eventually found no wrong doing.

Alternative to Debt Restructuring

Since Sri Lanka is in the thick of a grave financial crisis. Its President Gotabaya Rajapaksa had sought debt restructuring when the Chinese Foreign Minister called on him on January 9. It appears that Wang did not commit himself to restructuring as such but said that China would assist Sri Lanka “in overcoming the temporary difficulties within its capacity.” But he assured Sri Lankan leaders that he would encourage Chinese companies to invest in Sri Lanka to make Sri Lanka industrialize and establish a “Made in Sri Lanka” brand.

“China will continue to assist Sri Lanka in overcoming temporary difficulties within our capacity. We are convinced that Sri Lanka’s economy will walk out of the current predicament and achieve new and greater progress. Colombo Port City and Hambantota Port are the flagship projects of bilateral cooperation in building the Marine Silk Road, and two engines of Sri Lanka’s economic development. China supports Chinese enterprises in investing and developing in Sri Lanka and combining Chinese capital and experience with Sri Lanka’s human resources advantages to help Sri Lanka improve the ability of self-development, accelerate industrialization, and build the brand of Made in Sri Lanka,” Wang told Lankan Prime Minister Mahinda Rajapaksa.

Wang stressed the need to conclude a China-Sri Lanka Free Trade Agreement which had run into opposition from Lankan nationalists.

“Sri Lanka and China should make good use of the two engines, Colombo Port City and Hambantota Port flagship projects, tap the opportunities of the enforcement of the Regional Comprehensive Economic Partnership and China’s vast market, and discuss the restart of talks on a free trade agreement between China and Sri Lanka to send more positive signals to the world and contribute to Sri Lanka’s economic recovery and development.” Wang told President Gotabaya Rajapaksa.

Recent reports showed that Sri Lanka is holding talks with India for a 1.5 billion US dollar SWAP agreement.

But the SWAP facility has not been officially announced by India.

Recently, Sri Lanka had signed an agreement with the Indian Oil Corporation to develop the Trincomalee Oil Tank Farm as a joint venture.

Cabinet approval had been granted recently to import 500 buses and 750 jeeps under a line of credit.

Indian High Commissioner to Sri Lanka Gopal Bagley has paid a visit to New Delhi.

Finance minister Basil Rajapaksa was scheduled to visit India this week.

But the visit was canceled considering the COVID-19 situation in India.