Moody’s downgrades Sri Lanka’s debt rating to Caa2
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.
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.
The principal methodology used in these ratings was
Sovereign Ratings Methodology published in November 2019 and available at
https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1158631.
Alternatively, please see the Rating Methodologies page on www.moodys.com for a
copy of this methodology.
The weighting of all rating factors is described in the
methodology used in this credit rating action, if applicable.
REGULATORY DISCLOSURES
For further specification of Moody's key rating assumptions and sensitivity analysis, see the sections Methodology Assumptions and Sensitivity to Assumptions in the disclosure form. Moody's Rating Symbols and Definitions can be found at: https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004.
For ratings issued on a program, series, category/class of
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relation to each rating of a subsequently issued bond or note of the same
series, category/class of debt, security or pursuant to a program for which the
ratings are derived exclusively from existing ratings in accordance with
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certain regulatory disclosures in relation to the provisional rating assigned,
and in relation to a definitive rating that may be assigned subsequent to the
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For any affected securities or rated entities receiving
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to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure
from rated entity.
The ratings have been disclosed to the rated entity or its
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These ratings are solicited. Please refer to Moody's Policy
for Designating and Assigning Unsolicited Credit Ratings available on its
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Regulatory disclosures contained in this press release apply
to the credit rating and, if applicable, the related rating outlook or rating
review.
Moody's general principles for assessing environmental,
social and governance (ESG) risks in our credit analysis can be found at
http://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1288235.
At least one ESG consideration was material to the credit
rating action(s) announced and described above.
The Global Scale Credit Rating on this Credit Rating
Announcement was issued by one of Moody's affiliates outside the EU and is
endorsed by Moody's Deutschland GmbH, An der Welle 5, Frankfurt am Main 60322,
Germany, in accordance with Art.4 paragraph 3 of the Regulation (EC) No
1060/2009 on Credit Rating Agencies. Further information on the EU endorsement
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