Moody’s affirms Sri Lanka’s ratings at B1; maintains negative outlook

• Flags low fiscal strength, challenging political environment, fiscal consolidation beyond IMF program and external vulnerability
• Warns Govt. could face tighter debt refinancing conditions in next few years 
• Says continued fiscal consolidation and strengthening reserves key to improving credit profile 
• Debt likely to be about 70% of GDP by turn of the decade, debt affordability to remain weak despite plans to include more domestic financing  
• Expects the overall current account deficit to be around 2.5% of GDP in the next few years or $ 2.6 b
• Believes negative outlook signals an upgrade is unlikely 
• But fiscal reforms targeted at more revenue and debt affordability could prompt Moody’s to stabilise outlook

Moody’s Investors Service yesterday affirmed Sri Lanka’s foreign currency issuer and senior unsecured ratings at B1 and maintained the negative outlook.

The decision to affirm the rating at B1 reflects Sri Lanka’s progress in implementing the planned reform program, which entails fiscal consolidation and a build-up of foreign exchange reserves buffers, ahead of the end of the IMF Extended Fund Facility program in June 2019, along with its moderate per capita income levels and stronger institutions relative to many similarly-rated sovereigns. 

This is balanced against Moody’s expectation that the sovereign’s fiscal strength will remain very low and government liquidity and external vulnerability risk will remain rating constraints.

The decision to maintain the negative outlook reflects Sri Lanka’s ongoing high vulnerability to a potential tightening in external and domestic financing conditions, given relatively large borrowing needs, reliance on external funding and still low reserves adequacy. That feature dominates Sri Lanka’s credit profile. 

The Government could face significantly tighter refinancing conditions at some point during the next few years, which would quickly lead to much weaker debt affordability and a higher debt burden, especially if the currency depreciated at the same time.

Concurrently, the local-currency bond and deposit ceilings remain unchanged at Ba1. The foreign-currency bond ceiling is unchanged at Ba2 and the foreign currency deposit ceiling at B2.

Moody’s affirms

Under its IMF Extended Fund Facility Program, Sri Lanka continues to advance reforms that support fiscal consolidation and attempt to reduce external vulnerabilities. Progress in fiscal consolidation and in building up reserves buffers strengthens the credit profile by providing greater assurance of Sri Lanka’s ability to refinance its domestic and external debt at affordable costs.

The Government’s commitment to continue broadening and deepening its revenue base, including through implementation of the Inland Revenue Act (IRA), which came into effect in April 2018, will bolster revenue generation. Moreover, legislative measures pursuant to changes in the Fiscal Management Responsibility Act aim to apply fiscal rules that ensure deficit and debt consolidation efforts endure beyond the conclusion of the IMF program.

In addition, the planned changes to the Monetary Law Act should strengthen the credibility and effectiveness of Sri Lanka’s monetary policy, helping the Central Bank anchor inflation expectations and prevent fiscal dominance. If effective, this would contribute to stabilising the cost of debt at lower levels and as a result enhance fiscal flexibility.

The Active Liability Management Act (ALMA) will provide the Government with some flexibility to smooth the timing of its debt refinancing operations within a given year. Over time, the effective use of the ALMA may allow the Sri Lankan Government to somewhat smooth the consecutive large debt maturities over the period 2019-2023 and to prevent the recurrence of such a concentration in the future. However, during the next few years the gains will be limited given the high frequency of debt repayments.

In addition, the Government plans to further diversify external funding sources through the issuance of the Chinese renminbi or Japanese yen denominated bonds, as well as loans from other bilateral or multilateral lenders. 

Balancing Sri Lanka’s credit strengths is very low fiscal strength, which will remain a key source of risk over the next few years, despite prospects for the further narrowing of the budget deficit and gradual decline in government debt as a share of GDP. The country’s reliance on external financing without commensurate foreign exchange inflows also means that Sri Lanka’s external position remains fragile, despite a build-up in foreign exchange reserves recently.

As a baseline, Moody’s assumes broadly stable overall financing conditions for the Government. Under this assumption, together with continued fiscal consolidation after the end of the IMF program, albeit at a slower pace, Moody’s expects the Government’s debt burden to continue to decline over the remainder of the decade.

However, even in the absence of shocks, debt will only fall slowly to around 70% of GDP by the turn of the decade, from 77% of GDP in 2017.

Moody’s estimates that government gross borrowing requirements, incorporating projections on fiscal deficits and maturing government debt repayments, to reach about 18.5% of GDP in 2018 and in the baseline, forecasts them to fall to a still-high level of 13% by 2020. A significant proportion of the Government’s debt is financed at short maturities, including Treasury bills equivalent to around 12.5% of outstanding domestic debt or about 5% of GDP in 2017.

Given a relatively narrow domestic financing market, the Government remains reliant on external bilateral and commercial lenders’ continued willingness to refinance large amounts of foreign currency debt. Moody’s estimates that the Government will have made principal payments on external debt of around $ 3.8 billion per year, on average, from 2016-2018.

Despite Moody’s expectation of a further rise in the level and an improvement in the quality of foreign exchange reserves, persistently low reserves adequacy denotes vulnerability to a shift in foreign financing conditions. Moody’s estimates that Sri Lanka’s External Vulnerability Indicator (EVI), the ratio of external debt payments due over the next year to foreign exchange reserves, will continue to hover around 150% in the next few years, well above the median level of B-rated sovereigns.

The Government’s strategy is to shift some of its funding to domestic, local currency investors, given lower debt repayments on domestic Treasury bonds in the coming years. Moody’s expects Treasury bond maturities to fall to around 2% of GDP on average per year over the period from 2019-2023, from about 4% of GDP in 2018, providing some space for the Government to increase local-currency borrowings to finance the fiscal deficit.

But while this will help reduce exchange rate risk, given local currency interest rates are much higher than the average cost of external debt, debt affordability will remain weak. Interest payments will continue to absorb 37%-40% of revenue in the next couple of years and will remain highly sensitive to either a rise in the cost of debt or a slower revenue increase than currently assumed.

The negative outlook reflects Moody’s view that Sri Lanka’s credit profile is dominated by the Government and country’s elevated exposure to refinancing risk. Sri Lanka could face significantly tighter external refinancing conditions at some point during the next five years, which would quickly lead to much weaker debt affordability, especially if the currency were to depreciate as a result.

With a persistently high debt burden, weak debt affordability, large borrowing needs and low foreign reserve adequacy, Sri Lanka’s vulnerability to a shift in domestic and external financing conditions is high.

In particular, every year between 2019 and 2023, the Government will need to make principal payments on external debt of around $ 3.5 billion per year (about $ 17 billion overall), in addition to financing part of the budget deficit externally. 

For the economy as a whole, part of the current account deficit corresponds to private sector activities also financed externally. Moody’s expects the overall current account deficit to be around 2.5% of GDP in the next few years, or around $ 2.6 billion on average per year.

In general, the Government’s ongoing progress on fiscal consolidation relies on further effective implementation of revenue reforms, which has only started. The need to maintain sizeable primary surpluses over time and beyond the IMF program will test the Government’s resolve, especially if GDP growth remains relatively muted.

Moreover, despite very substantial export potential, Sri Lanka has not yet managed to broaden its export base on a sustained basis. Further, against the backdrop of a fractious political environment, persistent disruptive politics may lead to delays in legislative approval of future reforms and could potentially slow or sidetrack effective implementation of newly-passed reforms. As a result, perceptions that the country’s twin deficits could widen again could reduce investors’ appetite for investment in Sri Lankan debt.

The negative outlook signals that an upgrade is unlikely.

Moody’s would consider returning the outlook to stable should it conclude that external and domestic refinancing risks were likely to diminish. That conclusion could be prompted by a faster and more sustained buildup of non-debt creating foreign exchange inflows than currently expected, which together with the demonstrated effectiveness of liability management strategies, smoothened and lengthened maturity payments, would significantly lower external vulnerability risks.

Over time, the implementation of further significant fiscal reforms that markedly raised government revenue and improved debt affordability and thus fiscal strength could also prompt Moody’s to stabilise the outlook.

Moody’s would consider downgrading the rating if it were to conclude that the external and domestic refinancing capacity will not improve, and that Sri Lanka was likely to face difficulties in refinancing its domestic or external debt at affordable costs. Evidence that the implementation of key policies is not effective, including further fiscal consolidation, monetary policy independence from fiscal developments, diversification of financing sources or liability management would likely have a negative impact on Sri Lanka’s access to and cost of finance.

In particular, a marked weakening in reserve adequacy from already low levels, which could stem from a loss of investor confidence and thereby capital outflows, would put downward pressure on the rating. A halt or reversal in fiscal consolidation that raised prospects of a higher government debt burden and prevented the expected decline in gross borrowing requirements could also prompt a downgrade.