Improving export performance would help Sri Lanka to meet its heavy external debt service commitments, Fitch Ratings said on Thursday (31).

Fitch says although Sri Lanka's policy environment has improved after the resolution of last year's political crisis and the recovery in tourism has been faster than expected following April's bombings, country's external debt service obligations remain high.

In a new report on Asia Pacific frontier markets, the rating agency says the diverging APAC frontier market sovereign ratings in recent years reflect Vietnam's lengthening record of macroeconomic stability while Mongolia, Sri Lanka and Pakistan have faced external vulnerabilities.

The report noted that  while the near-term external and fiscal financing constraints have eased with the resumption of the country's IMF program and sovereign bond issuance of USD4.4 billion, Sri Lanka's external debt service obligations remain high.

“Substantial redemptions will contribute to Sri Lanka's total external debt service of about USD19 billion in 2020-2023 against foreign exchange (FX) reserves of USD7.6 billion at end-September,” the rating agency added.

However, Fitch noted that Improving export performance would help Sri Lanka meet the heavy external debt service commitments, although it is unclear how far it will be able to follow Vietnam's lead by enhancing competitiveness and attracting FDI.

Moreover, the rating agency warned that In Sri Lanka, political tensions could resurface around November's presidential elections, which could result in policy slippage.

The full report reproduced below:

Fitch Rtgs: APAC Frontier Sovereigns Diverge; Vietnam Achieves Stable Growth

Fitch Ratings-Hong Kong-31 October 2019: Diverging APAC frontier market sovereign ratings in recent years reflect Vietnam's lengthening record of macroeconomic stability while Mongolia, Sri Lanka and Pakistan have faced external vulnerabilities, Fitch Ratings says. Our Positive Outlook on Vietnam suggests this divergence could continue, notwithstanding the varying degrees of stabilisation seen in the other three sovereigns' credit profiles.

This year, we have affirmed the four sovereign ratings at 'BB' (Vietnam), 'B' (Sri Lanka and Mongolia), and 'B-' (Pakistan). The revision of our Outlook on Vietnam to Positive in May reflected improving economic management, current account surpluses, falling government debt, high growth and stable inflation.

The delayed payment on a Vietnamese government-guaranteed loan in September was paid in full within the month and Fitch understands the administrative problems that gave rise to this delay are being addressed. Therefore, the delayed payment does not have an immediate impact on the rating.

Vietnam's economic expansion has been driven by strong FDI, mostly into the manufacturing sector, and steady export growth. Exports as a share of Vietnamese GDP rose from 2011-2018, while the ratio fell in both Sri Lanka and Pakistan. Vietnam's current account surpluses have helped build up external buffers and its external liquidity ratio is well above the 'BB' category median, although funding costs will rise over time as Vietnam moves from concessional to market funding.

GDP growth remained strong in 9M19 at 7.0% yoy and a similar annual growth rate in the last quarter would maintain Vietnam as one of the fastest-growing economies in APAC and in the 'BB' rating category globally. Vietnam appears to be benefitting from near term trade diversion and production shifts resulting from US-China trade tensions, although large-scale relocation of manufacturing to Vietnam will take time, and the country's high degree of trade openness means it may ultimately feel affects from the trade war.

Sri Lanka's policy environment has improved after the resolution of last year's political crisis and the recovery in tourism has been faster than expected following April's bombings. Near-term external and fiscal financing constraints have eased with the resumption of the country's IMF programme and sovereign bond issuance of USD4.4 billion.

Pakistan has also benefited from an IMF programme approved in July and policy measures to narrow the current account deficit. These have helped lower the trajectory of gross external financing needs.

However, both countries' external debt service obligations remain high. Substantial redemptions will contribute to Sri Lanka's total external debt service of about USD19 billion in 2020-2023 against foreign exchange (FX) reserves of USD7.6 billion at end-September. Pakistan's annual external debt service obligations amount to around USD8 billion-9 billion for the next several years (liquid FX reserves were around USD8 billion at end-September), partly due to increasing repayments related to loans under the China-Pakistan Economic Corridor.

Improving export performance would help Sri Lanka and Pakistan meet their heavy external debt service commitments, although it is unclear how far they will be able to follow Vietnam's lead by enhancing competitiveness and attracting FDI. Both lag Vietnam in the World Bank's ease of doing business ranking. Pakistan is one of the 10 economies where the business climate has improved the most over the past year, but further reforms could be politically challenging, and adherence to previous IMF programmes has been uneven. In Sri Lanka, political tensions could resurface around November's presidential elections, which could result in policy slippage.

A history of sharp policy swings around election cycles is also a key rating consideration in the case of Mongolia. Mongolia's rating was upgraded in mid-2018, following improvements in fiscal and external metrics, underpinned by a three-year IMF Extended Fund Facility. Since then, credit trends have remained positive including robust growth and further improvements in public finances. We expect a second consecutive budget surplus in 2019. However, risks from a still-to-be-completed financial sector Asset Quality Review and the potential for political shocks or fiscal slippage ahead of parliamentary elections next year have constrained positive rating momentum.