Sri Lanka sovereign rating downgraded to Caa2 by Moody’s

Thursday October 28, 2021 4:04 pm

ECONOMYNEXT – Moody’s Investors Service has downgraded Sri Lanka’s sovereign rating to Caa2 from Caa1, taking the country’s credit deeper into speculative grade as foreign reserves continued to fall amid money printing and crippled forex markets.

“A large financing envelope that Moody’s considers to be secure remains elusive and the sovereign continues to rely on piecemeal funding such as swap lines and bilateral loans, although prospects for non-debt generating inflows have improved somewhat since Moody’s placed Sri Lanka’s rating under review for downgrade,” the rating agency said.

“Persistently wide fiscal deficits due to the government’s very narrow revenue base compound this challenge by keeping gross borrowing needs high and removing fiscal flexibility.

“The decision to downgrade the ratings is driven by Moody’s assessment that the absence of comprehensive financing to meet the government’s forthcoming significant maturities, in the context of very low foreign exchange reserves, raises default risks.”

Liquidity injections and dysfuctional forex markets due to loss of confidence in the domestic currency, had made it difficult to transfer wealth out of the country through the credit system not just for debt but also for current transactions. As a result the country is also seeking credit lines for imports.

The full statement is reproduced below:

Rating Action: Moody’s downgrades Sri Lanka’s rating to Caa2; outlook stable

28 Oct 2021

Singapore, October 28, 2021 — Moody’s Investors Service (“Moody’s”) has today downgraded the Government of Sri Lanka’s long-term foreign currency issuer and senior unsecured debt ratings to Caa2 from Caa1 under review for downgrade.

The outlook is stable. This concludes the review for downgrade initiated on 19 July
2021.

The decision to downgrade the ratings is driven by Moody’s assessment that the absence of comprehensive
financing to meet the government’s forthcoming significant maturities, in the context of very low foreign exchange reserves, raises default risks.

In turn, this assessment reflects governance weaknesses in the ability of the country’s institutions to take measures that decisively mitigate significant and urgent risks to the balance of payments.

External liquidity risks remain heightened.

A large financing envelope that Moody’s considers to be secure remains elusive and the sovereign continues to rely on piecemeal funding such as swap lines and bilateral loans, although prospects for non-debt generating inflows have improved somewhat since Moody’s placed Sri Lanka’s rating under review for downgrade. Persistently wide fiscal deficits due to the government’s very narrow revenue base compound this challenge by keeping gross borrowing needs high and removing fiscal flexibility.

The stable outlook reflects Moody’s view that the pressures that Sri Lanka’s government faces are consistent with a Caa2 rating level. Downside risks to foreign exchange reserves adequacy remain without comprehensive financing and narrow funding options. Should foreign exchange inflows disappoint, default risk would rise further.

However, non-debt generating inflows particularly from tourism and foreign direct investment (FDI) may accelerate beyond Moody’s current expectations, which, coupled with the track record of the authorities to put together continued, albeit partial, financing, may support the government’s commitment and ability to repay its debt for some time.

Sri Lanka’s local and foreign currency country ceilings have been lowered to B2 and Caa2 from B1 and Caa1, respectively.

The three-notch gap between the local currency ceiling and the sovereign rating balances relatively predictable institutions and government actions against the very low foreign exchange reserves
adequacy that raises macroeconomic risks, as well as the challenging domestic political environment that weighs on policymaking.

The three-notch gap between the foreign currency ceiling and local currency ceiling takes into consideration the high level of external indebtedness and the risk of transfer and convertibility
restrictions being imposed given low foreign exchange reserves adequacy, with some capital flow
management measures already imposed.

RATINGS RATIONALE
RATIONALE FOR THE DOWNGRADE TO Caa2

Moody’s initiated a review for downgrade on Sri Lanka’s ratings to assess the prospects for significant external financing to materially and durably lower the risk of default stemming from the country’s very low foreign exchange reserves adequacy. Although the potential for non-debt generating inflows has increased somewhat in recent months, the improvement in tourism and FDI prospects is highly tentative.

At the same time, a large external financing envelope that Moody’s considers to be secure remains highly unlikely. In turn, external liquidity risks for Sri Lanka’s government will remain heightened over the coming years, raising the risk of default.

Sri Lanka’s foreign exchange reserves adequacy has fallen further since Moody’s initiated the review. Foreign exchange reserves (excluding gold and SDRs) amounted to $2 billion as of the end of September, compared to $3.6 billion as of the end of June and $5.2 billion at the beginning of the year. The reserves are sufficient to cover only around 1.3 months of imports and are significantly below the government’s external repayments of around $4-5 billion annually until at least 2025.

Moody’s baseline scenario continues to assume that the authorities will manage to obtain some foreign
exchange resources and financing through a combination of project-related multilateral financing, official sector bilateral assistance including central bank swaps, commercial bank loans, the divestment of state-owned assets, and measures by the Central Bank of Sri Lanka (CBSL) to capture some export receipts and remittances.

However, the amounts are generally modest, the arrangements piecemeal, and of relatively short
maturity besides multilateral funding for project loans.

Meanwhile, ongoing efforts under the authorities’ six-month roadmap to promote macroeconomic and financial stability will likely boost FDI somewhat, and the reopening of international borders without quarantine requirements for fully vaccinated travellers will support the gradual recovery of tourism-related receipts.

However, while Sri Lanka’s potential suggests that sizeable foreign exchange receipts could be generated, this potential has remained only partially realised for many years and realising it now is subject to the confidence and risk appetite of investors and travellers, both of which are highly uncertain.

Therefore, although reserves are likely to rise slightly over the next few months on the back of some of these inflows materialising, Moody’s expects them to remain insufficient to provide a buffer to meet the government’s external repayment needs.

Meanwhile, Moody’s assumes that Sri Lanka will not participate in a financing programme with the International Monetary Fund or other multilateral development partners for the foreseeable future, while international bond markets remain prohibitive as a source of external financing.

Heightened liquidity risks are compounded by Moody’s expectation that the government’s fiscal deficit will remain wide over the next few years, which will keep borrowing needs high and remove fiscal flexibility.

Although government revenue is likely to rebound alongside the economy — Moody’s projects real GDP will grow by an average of around 5% in 2022-23 — it will stay low in the absence of revenue reforms.

Moody’s estimates that revenue will remain around 10% of GDP over the next few years. At the same time, interest payments will continue to absorb around 60-70% of revenue, leaving the government with politically challenging tradeoffs in rationalising across social spending and development expenditure.

As such, Moody’s sees limited prospects for meaningful expenditure cuts, implying still wide fiscal deficits of 8.0-8.5% of GDP in 2022-23, compared to an average of 5.7% over 2016-19.

The wide deficits correspond to a gross borrowing requirement of around 25-27% of GDP per year over 2022- 23.

While Moody’s assumes that the government can continue to access local currency financing given the
size of the domestic savings pool and excess domestic liquidity in the banking system, this comes at a cost on the overall interest bill and does not address foreign-currency debt repayments.

RATIONALE FOR THE STABLE OUTLOOK

The stable outlook reflects Moody’s view that the pressures that Sri Lanka’s government faces are consistent with a Caa2 rating level.

The risk that foreign exchange reserves will continue to fall and increase the likelihood of default remains material, since the foreign exchange inflows available so far are generally piecemeal in the case of swaps and bilateral loans, and uncertain in the case of non-debt generating inflows.

That said, the authorities have a track record of securing some financing, even if only partial and at some cost, to support the government’s commitment and ability to repay its external debt.

Moreover, notwithstanding the significant uncertainty as discussed above, foreign direct investment and in particular tourism-related receipts have the potential to accelerate in an upside scenario and supplement the authorities’ ability to keep default at bay.

For tourism, the relatively high vaccination rate compared to emerging market and regional peers may support a quicker recovery in arrivals compared to Moody’s baseline assumptions. For foreign direct investment, the country’s status as a growing regional hub for transport and logistics as well as financial and technological services — helped by free trade agreements with large neighbouring countries such as India and Pakistan — may support long-term inflows, although as mentioned
above this potential has remained only partially realised for some time.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Sri Lanka’s ESG Credit Impact Score is highly negative (CIS-4), reflecting its highly negative exposure to environmental and social risks. Ongoing challenges to institutional and policy effectiveness and a very high debt burden constrain the government’s capacity to address ESG risks.

The exposure to environment risk is highly negative (E-4 issuer profile score). Variations in the seasonal monsoon can have marked effects on rural household incomes and real GDP growth: while the agricultural sector comprises only around 8% of the total economy, it employs almost 30% of Sri Lanka’s total labour force.

Natural disasters including droughts, flash floods and tropical cyclones that the country is exposed to also contribute to higher food inflation and import demand. Moreover, ongoing development projects to improve urban connectivity have increased the rate of deforestation, although the country continues to engage development partners to preserve its natural capital, such as its mangroves.

The exposure to social risk is highly negative (S-4 issuer profile score). Balanced against Sri Lanka’s relatively good access to basic education, which has continued to improve throughout the country in the post-civil war period, are weaknesses in the provision of some basic services in more remote and rural areas, such as water, sanitation and housing. As the country’s population continues to grow, the government will face greater constraints in delivering high-quality social services and developing critical infrastructure amid ongoing fiscal pressures.

The influence of governance is highly negative (G-4 issuer profile score). While international surveys point to stronger governance in Sri Lanka relative to rating peers, including in judicial independence and control of corruption, institutional challenges are significant, particularly in the pace and effectiveness of reforms.

Domestic political developments also tend to weigh on fiscal and economic policymaking.

GDP per capita (PPP basis, US$): 13,223 (2020 Actual) (also known as Per Capita Income)

Real GDP growth (% change): -3.6% (2020 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 4.6% (2020 Actual)

Gen. Gov. Financial Balance/GDP: -11.1% (2020 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -1.3% (2020 Actual) (also known as External Balance)

External debt/GDP: 61.0% (2020 Actual)

Economic resiliency: ba2

Default history: No default events (on bonds or loans) have been recorded since 1983.

On 25 October 2021, 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 fiscal or financial strength, including its debt profile, has not materially changed. The
issuer’s susceptibility to event risks has not materially changed.

FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS

The Caa2 rating takes into account a non-negligible probability of default. The rating would likely be upgraded if the risk of default were to diminish materially and durably.

This could stem from the government delivering a credible and secure medium-term external financing strategy that maintained a manageable cost of debt, and a faster and more sustained buildup in non-debt creating foreign exchange inflows.

Additionally, implementation of fiscal consolidation measures, particularly greater revenue mobilisation, that pointed to a material narrowing of fiscal deficits in the next few years and contributed to lower annual borrowing needs, would also be credit positive.

The rating would likely be downgraded if the prospects for foreign exchange inflows were to significantly weaken, resulting in a further deterioration in foreign exchange reserves adequacy and leading to a higher probability of default or greater risk of material losses should default occur than consistent with a Caa2 rating.

Additionally, a further rise in the government’s debt burden and weakening in debt affordability from already very weak levels that constrained its ability to finance itself domestically would also likely result in a downgrade of the rating.

Govt. says rating agency Moody’s downgrade ill-timed,

SL says rating agency Moody’s downgrade ill-timed, unacceptable rating renews concerns of subjectivity
Expresses strong displeasure over downgrade ahead of 2022 Budget
Flags off serious governance weaknesses of Moody’s where it systematically overlooks positive developments and expectations in emerging market economies, but attributes much greater weight to downside risks

The Government yesterday blasted Moody’s downgrade of Sovereign rating saying it was ill-timed and unacceptable whilst the move renews concerns over subjectivity.

“The Government wishes to express strong displeasure,” said a statement in response to Moody’s recent assessment that led to the rating action, after being placed under review for downgrade three months ago in a similar fashion.

“Once again, Moody’s irrational rating action with regard to Sri Lanka comes a few days before a key event, namely the announcement of the Government Budget for 2022, and this apparent hastiness and the view expressed during discussions with Moody’s analysts that the nature of the Budget is irrelevant to the financing plans of the Government clearly demonstrates the lack of understanding of such analysts,” the statement said.

“It also reflects serious governance weaknesses of such agencies, where they systematically overlook the positive developments and expectations in emerging market economies, but attribute much greater weight to downside risks,” the Government added.

It alleged that Moody’s assessment has also failed to take into account the latest developments in strengthening the country’s external position through an array of measures, some of which have already yielded intended outcomes, as announced by the Central Bank of Sri Lanka (CBSL) on 26 October.

Moreover, it stated that the assessment exposes the rating agency’s ignorance on the well-established political stability within a democratic setup, when it claims about “governance weaknesses” and “challenging domestic political environment”, and its obvious insensitivity to the challenges faced by a country that is recovering from adverse external events without bringing pain to investors who have stood by Sri Lanka during various difficulties that the country has undergone in the past.

In addition to the six-month strategy articulated in the Road Map presented by the CBSL on 1 October, Moody’s assessment has failed to recognise the medium to long-term funding arrangements that are being finalised with various bilateral sources, which are due to be materialised in the near-term.

They include, among others, credit lines of several billions of dollars from India and the Middle Eastern counterparts to procure petroleum; an arrangement for a large forex loan from a Middle Eastern nation as a bilateral long-term loan, and the proposals received for the syndicated loan arrangement that are being evaluated at present.

In addition, a substantial amount of funds is expected from the already lined-up prioritised project loan related inflows to the Government. The recent discussions on bilateral currency SWAP arrangements with several central banks are also expected to provide the country with additional support in the near-term.

Without considering such cash flows, the Government stated that any assessment on the repayment capacity of the Government carries prejudice. Rating action based on such biased assessment is unfair and detrimental to the country’s prospects, as Sri Lanka is emerging strongly from the adverse effects of the COVID-19 pandemic. Needless to say, such action by an international rating agency calls into question the validity of its advice to the investor community.

Nevertheless, it is clear that international investors have continued to put faith in Sri Lanka’s plans for recovery, as repeatedly reflected in their preference to hold Sri Lanka’s International Sovereign Bonds (ISBs) to maturity, despite claims by Moody’s about a heightened risk of default by Sri Lanka.

The Government is in the process of preparing its Budget for the forthcoming year to be presented on 12 November with economic activities returning to near normalcy, and the country is already experiencing strong signs of revival of tourism and other activities that generate non-debt creating foreign currency inflows, including the monetisation of under-utilised non-strategic assets.

The statement stated that this untimely rating decision taken prior to the Budget shows that Moody’s has not taken all the relevant information to form its assessment of the country’s performance and the expected path, into account. Even a layman would recognise that the Budget is an important statement for a country as it sets the tone for policy initiatives and structural reforms which could help alleviate the external challenges and improve fiscal settings in the near to medium term.

The Government added that legitimacy of financing, in the form of an Appropriation Act, includes all foreign financing with a clear direction of the fiscal path. Therefore, it is surprising that Moody’s fails to provide due consideration to the forthcoming Budget, disregarding the vital information that would be released with the announcement of the Budget, in arriving at its rating action.

Such action by Moody’s is not new to Sri Lanka since Sri Lanka has experienced similar rating action by Moody’s several times in the past as well. For instance, Moody’s placed Sri Lanka on review for downgrade on 17 April 2020 right at the onset of the COVID-19 pandemic and just after the Government signed a Foreign Currency Term Financing Facility (FTFF) with China Development Bank (CDB), hindering the implementation of the arrangement and delaying fund receipts.

The downgrade was affected on 28 September 2020, just ahead of the ISB maturity in October 2020. Further, Moody’s placed Sri Lanka under review for downgrade on 19 July whilst the CBSL was finalising a currency SWAP with the Bangladesh Bank and was about to repay a maturing ISB. Such questionable action generates credibility considerations as to whether Moody’s actions are driven by economic considerations only.

“The GOSL and the CBSL are closely engaging with all stakeholders, including the international investor community,” the statement said.

“Such engagements have helped clear any doubts of investors on the Government’s willingness and the ability to honour all upcoming debt service obligations, as it has done throughout history,” it added.

The Government said the Sri Lankan economy has demonstrated strong signs of broad-based recovery, with a real GDP growth of 8% in the first half of 2021. The vaccination drive is progressing at full strength, covering over 60% of the population with both doses and almost 100% of the population over 30 years, thus providing confidence of a strong rebound in economic activity in 2022.

With the revival in tourism and the fruition of efforts to strengthen foreign exchange earnings through merchandise exports, exports of services, worker remittances, as well as domestic and foreign investments, the medium-term growth path is likely to be robust. Improving performance of merchandise and trade in services in a fairly short period of time has shown the economy’s ability to reach its potential despite misplaced fears raised by Moody’s.

The Government further stated that it is deeply disappointing that Moody’s seems to be attempting to derail this potential of the country by downgrading Sri Lanka’s rating based on a static methodology, which is irrational, particularly at the time of a global pandemic.

The Government’s commitment towards fiscal consolidation through expenditure rationalisation would complement the gradual rise in government revenue with normalising activity, thereby narrowing the fiscal deficit, that has not been recognised by Moody’s.

The pro-growth reforms implemented by the Government has laid the foundation for a domestic production led export-oriented economy over the medium-term, despite some adjustment costs in the transition. Ignoring such ability and commitment of the Government has led to ill-informed conclusions by Moody’s.

Against this backdrop, the Government in its statement reassured all stakeholders, including the international investor community, that Sri Lanka remains committed to honouring all forthcoming obligations in the period ahead.

“The Sri Lankan authorities welcome direct engagement with investors and invite investors for regular one-on-one discussions without being distracted by such unfounded announcements by external agencies,” it added.