Moody’s Investors Service (“Moody’s”) has today placed the Government of Sri Lanka’s long-term foreign-currency issuer and senior unsecured B2 ratings under review for downgrade.
The decision to place Sri Lanka’s ratings on review for downgrade is prompted by Moody’s assessment that the acute tightening in global financing conditions, fall in export revenue, and sharp slowdown in GDP growth as a result of the global coronavirus outbreak exacerbate Sri Lanka’s existing government liquidity and external vulnerability risks, raising risks of heightened financing stress and macroeconomic instability. Moreover, the economic and financial shock will further dim medium-term prospects for reforms that would meaningfully strengthen Sri Lanka’s fiscal and external position.
The rapid and widening spread of the coronavirus outbreak, deteriorating global economic outlook, and falling asset prices are creating a severe and extensive credit shock across many sectors, regions and markets. The combined credit effects of these developments are unprecedented. Moody’s regards the coronavirus outbreak as a social risk under its ESG framework, given the substantial implications for public health and safety.
For Sri Lanka, the current shock transmits mainly through capital outflows, a marked local currency depreciation, wider risk premia and a sharp drop in GDP growth that raise the sovereign’s debt burden, liquidity pressures and cost of external debt servicing. This shock occurs at a time when Sri Lanka’s credit profile is highly vulnerable given low reserve coverage of large forthcoming external debt payments and very weak debt affordability. At the same time, Sri Lanka’s relatively robust institutions and governance strength compared to similarly rated peers and a sizeable banking sector may support the government’s access to funding at manageable costs.
The review period, which may extend beyond the usual three-month horizon, will allow Moody’s to assess the capacity of the government to secure financing at manageable costs and in a way that does not further
weaken the country’s external position and threaten macroeconomic stability. The review will also assess the likelihood of the government being able to stabilize its debt burden and restore better debt affordability once the most acute phase of the shock has passed.
Concurrently, Sri Lanka’s local currency bond and deposit ceilings remain unchanged at Ba2. The Ba3 country ceiling for foreign currency bond and B3 ceiling for foreign currency bank deposits also remain unchanged.
These ceilings act as a cap on the ratings that can be assigned to the obligations of other entities domiciled in the country.
RATINGS RATIONALE / FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS
RATIONALE FOR INITIATING A REVIEW FOR DOWNGRADE ON SRI LANKA’S B2 RATINGS
ACUTE TIGHTENING IN GLOBAL FINANCING CONDITIONS, ECONOMIC SHOCK, HEIGHTEN SRI LANKA’S LIQUIDITY AND EXTERNAL VULNERABILITY
Like other emerging and frontier market sovereigns, Sri Lanka faces a severe tightening in financing conditions and fall in revenue, including export revenue, from a sharp economic slowdown. Compared to most other sovereigns, this shock occurs at a time when Sri Lanka’s credit profile is highly vulnerable given low reserve coverage of large forthcoming external debt payments, and very weak debt affordability. Prior to the coronavirus outbreak, the government’s fiscal position had already begun to weaken, amplifying long-standing debt affordability, liquidity and external credit weaknesses.
Tightening external financial conditions have resulted from large capital outflows and increased pressure on the exchange rate. The Sri Lankan rupee has depreciated approximately 6% against the US dollar since the beginning of March, while spreads on Sri Lankan international sovereign bonds over US Treasuries have widened sharply in recent weeks to around 1600 basis points, indicating significantly impaired market access.
These conditions are raising Sri Lanka’s cost of servicing external debt, weigh on foreign exchange reserves and jeopardize macroeconomic stability.
Meanwhile, the ongoing global shock will significantly curtail demand for Sri Lanka’s textile and garment exports in major markets including the US and Europe, in addition to a domestic lockdown curbing domestic demand, which will only be partially buffered by income support from policy measures. Moody’s expects Sri Lanka’s economy to grow just 1.5% in 2020, with risks skewed to the downside. Weaker foreign exchange inflows from exports, tourism activity and overseas remittances will further weaken Sri Lanka’s already fragile external position, despite some relief from a lower imports bill.
The government’s external debt service payments amount to approximately $4 billion between 2020 and 2025[1], in addition to financing part of the wider budget deficit externally. International sovereign bonds account for a sizeable portion of maturing government debt over this period, including upcoming payments of $1 billion each in October 2020 and July 2021. In the current market conditions, refinancing these maturities on international markets would come at considerable costs.
Moody’s expects that Sri Lanka will reorient some of its external funding to international and bilateral creditors.
At this stage, financing from official sources to cover Sri Lanka’s need beyond the immediate term has not been fully secured yet. Sri Lanka may obtain some liquidity relief for instance from participation in the initiative just outlined by the G20 or similar global efforts. However, missed or delayed payments of contractually obligated interest or principal owed to private sector creditors constitute a default under Moody’s definition.
The government may also rely more on domestic financing but refinancing external debt domestically would dent reserves further, potentially putting more pressure on the exchange rate. Moreover, domestic debt generally comes at higher costs and shorter maturities than external debt.
Overall, a higher cost of debt, lower revenue and higher expenditure to support the economy will widen the budget deficit, to over 8% of GDP in 2020-21 according to Moody’s projections. Combined with slower nominal GDP growth and a weaker exchange rate, the government’s debt burden will rise to close to 100% of GDP.
Debt affordability, already one of the weakest amongst the sovereigns that Moody’s rates, will worsen further with interest payments comprising more than 50% of government revenue in 2020-21.
PROSPECTS FOR REFORMS THAT WOULD ADDRESS LONG-STANDING VULNERABILITIES PUSHED FURTHER
Moody’s expects the current environment to challenge Sri Lanka’s institutions in managing the country’s twin deficits, which will constrain the authorities’ ability to deliver a credible and effective policy response, further dimming medium-term prospects for reforms that would meaningfully strengthen Sri Lanka’s fiscal and external position.
Fiscal policy is unlikely to mitigate the effects of the ongoing shock for some time, given constrained fiscal policy space. Moody’s expects Sri Lanka’s narrow revenue base, with revenue of 12.6% of GDP as of 2019[2], will deteriorate further amid weaker economic growth and large-scale tax relief measures enacted last year.
Expenditure pressure from public sector wage hikes and higher debt servicing costs will continue to limit flexibility, probably beyond the most acute phase of the economic and financial shock.
The current shock will also challenge monetary policy effectiveness. The central bank has undertaken substantial liquidity injections over the past month to ease domestic credit conditions. Nonetheless, given Sri Lanka’s worsening external position, risks are skewed towards more pronounced pressure on the rupee.
Further currency depreciation may result in higher inflation, given the pass-through to prices for Sri Lanka’s import-reliant economy. Moody’s expects this challenging trade-off between anchoring inflation expectations and supporting growth and a potential rise in borrowing costs to constrain monetary policy effectiveness.
Longer term, Moody’s expects the ongoing shock to at least delay economic, fiscal and monetary reforms.
Even after the parliamentary elections which have been postponed from 25 April to an undetermined date, policy scope for reforms that would address hurdles to economic competitiveness, very weak public finances and a strengthened monetary regime is likely to be very limited for some time.
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
Environmental considerations are material to Sri Lanka’s credit profile. Variations in the seasonal monsoon can have marked effects on real GDP growth and rural household incomes. Although the agriculture sector comprises only around 7% of the total economy, it employs around 25% of Sri Lanka’s total labor force.
Moreover, the natural disasters – including drought, flash foods, and tropical cyclones — that Sri Lanka is exposed to contribute to supply-side inflationary pressures on major food items part of the consumer price basked, as well as higher import needs, both for food stocks and oil imports.
Social considerations are material to Sri Lanka’s credit profile. Moody’s regards the coronavirus outbreak as a social risk under its ESG framework, given the substantial implications for public health and safety. While Sri Lankan authorities have initiated a domestic lockdown to prevent potential community transmission of the virus, this will come at cost to domestic economic activity. Moreover, the acute financing risks explained above are triggered by heightened uncertainty about the impact of the global coronavirus outbreak. In general, social considerations relevant to Sri Lanka’s credit profiles include relatively good access to basic education and environmental quality, set against weaknesses in provision of some other basic services. As Sri Lanka’s population continues to grow, the government will face ongoing fiscal pressures to deliver high-quality social services and infrastructure.
Governance considerations are material to Sri Lanka’s credit profile and are captured in our assessment of institutions and governance strength. These considerations primarily relate to the slow pace of reform implementation, as well as political risks, which impair the effectiveness of fiscal and economic policymaking.
FACTORS THAT COULD LEAD TO A DOWNGRADE OF THE RATING
Moody’s would likely downgrade Sri Lanka’s rating should it become increasingly likely that financing of the government’s debt will come at significant financial costs and/or weaken reserves adequacy further. Should the probability increase that Sri Lanka’s government debt will continue to rise markedly beyond Moody’s baseline projections, with a related further deterioration in debt affordability, this would also likely result in a downgrade of the rating. A significant probability of missed or delayed payments of contractually obligated interest or principal owed to private sector creditors, potentially as part of a broad initiative, would also likely be negative for the rating.
FACTORS THAT COULD LEAD TO CONFIRMATION OF THE RATING AT THE CURRENT LEVEL
Moody’s would likely confirm the rating if Sri Lanka’s financing risks diminished materially and durably. This could stem from a credible and secure financing strategy that maintained a manageable cost of debt and prevented a further decline in foreign exchange reserves adequacy.
Additionally, implementation of fiscal measures that pointed to a material narrowing of deficits in the next few years and contributed to lower the government’s medium-term borrowing needs would be positive for Sri Lanka’s rating.
GDP per capita (PPP basis, US$): 13,443 (2018 Actual) (also known as Per Capita Income)
Real GDP growth (% change): 3.2% (2018 Actual) (also known as GDP Growth)
Inflation Rate (CPI, % change Dec/Dec): 0.4% (2018 Actual)
Gen. Gov. Financial Balance/GDP: -5.3% (2018 Actual) (also known as Fiscal Balance)
Current Account Balance/GDP: -3.2% (2018 Actual) (also known as External Balance)
External debt/GDP: 59.2% (2018 Actual)
Economic resiliency: ba1
Default history: No default events (on bonds or loans) have been recorded since 1983.
On 14 April 2020, a rating committee was called to discuss the rating of the Sri Lanka, Government of. The main points raised during the discussion were: The issuer’s economic fundamentals, including its economic strength, have not materially changed. The issuer’s institutions and governance strength, have not materially changed. The issuer’s governance and/or management, have not materially changed. The issuer’s fiscal or financial strength, including its debt profile, has not materially changed. The systemic risk in which the issuer operates has not materially changed. The issuer has become increasingly susceptible to event risks.
