Moody’s places SL rating on review for downgrade

• 3-month or longer window for rating assessment
• Downgrade likely unless Govt. finds way to manage debt repayments without costly financing or reserve reduction 
• Fiscal measures to reduce deficits and lower Govt. borrowing a plus point 
• Moody’s expected growth of 1.5% for 2020, budget deficit of 8%
• Warns debt to GDP could grow to 100% by 2021 
• Concerned debt affordability will reduce further due to financial market volatility and weak macroeconomic fundamentals 

International rating agency Moody’s yesterday 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 was 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, the agency said in a statement.  

“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.”

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.

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.

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,” it said.

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 stabilise 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.

Tightening external financial conditions have resulted from large capital outflows and increased pressure on the exchange rate. The 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 1,600 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 jeopardise 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, 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.

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.

In the 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.