• Says Sri Lanka's external position continues to weaken owing to elevated external obligations and uneven access to financing
• Forecasts foreign exchange resources will be further pressured over the coming quarters by additional external sovereign debt maturities and current account requirements
• Opines 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
• Says economic recovery under pressure from pandemic, external stresses
• Estimates real GDP growth at 2.2% in 2022 compared with its estimate of 3% expansion in 2021
• Acknowledges Govt. has maintained a supportive fiscal policy stance despite its weak finances

S&P Global Ratings yesterday 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,” it said. 

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

S&P said it could lower their ratings if Sri Lanka's fundraising a ctivities fall short of Government targets or its foreign exchange reserves erode further beyond their expectations, leading to higher risk on the sovereign's ability to service debt.

 They stated they 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.

Commenting on the upside scenario, S&P said it 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 they expect. This could lower the risks associated with the Government's debt-servicing capacity.

S&P said 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 $ 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,” S&P said. 

It also said 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% expansion in 2021,” S&P said. 

It added the Government has maintained a supportive fiscal policy stance despite its weak finances.

In January 2022, the Government announced a $ 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,” S&P said, adding that high fiscal deficits over an extended period will worsen the Government's very high debt levels. 

S&P is of the view that 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 $ 1.6 billion in November 2021 to $ 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 $ 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 favourable terms, as well as their willingness to continue to lend to the Government.

Govt. says unwarranted rating action by S&P