Downgrade debacle!

• Major blow to unity Govt. as Fitch downgrades Sri Lanka to ‘B+’ from ‘BB-’; Outlook Negative
• Increased refinancing risks, significant debt maturities, weaker public finances and decline in foreign exchange reserves given as reasons
• However, continued strong macroeconomic growth, positive human development indicators and relative political stability keeps Sri Lanka above some peers

Delivering a major blow to the unity Government, Fitch yesterday downgraded Sri Lanka’s ratings to B+ Outlook Negative from BB- on account of increasing refinancing risks, growing debts and decline of reserves.

Under the new ratings Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) changed to ‘B+’ from ‘BB-’. A Negative Outlook has been assigned to the IDRs, Fitch noted in a statement. The issue ratings on Sri Lanka’s senior unsecured foreign- and local-currency bonds are also downgraded to ‘B+’ from ‘BB-’. The Country Ceiling is downgraded to ‘B+’ from ‘BB-’ and the Short-Term Foreign-Currency IDR is affirmed at ‘B’.

Several key rating drivers were also given by Fitch to explain the decision. These included increased refinancing risks, significant debt maturities, weaker public finances and decline in foreign exchange reserves. However, continued strong macroeconomic growth, positive human development indicators and relative political stability keeps Sri Lanka above some peers, the statement observed. 

Central Bank Governor Arjuna Mahendran last week expressed hopes a fresh programwith the IMF would reassure rating agencies but acknowledged fiscal consolidation remained the “single largest concern” of the Government.   

“The Sri Lankan sovereign faces increased refinancing risks on account of high upcoming external debt maturities. Further, the sovereign’s external liquidity position remains strained, reflecting pressure on foreign exchange reserves,” the rating agency said. 

In Fitch’s view, this partly reflects a weakening in policy coherence that increases the likelihood of Sri Lanka requiring external liquidity support from the IMF and other multilateral institutions. Sri Lanka’s external liquidity ratio, as measured by Fitch at the end of 2015, was 70.9%, which is far below the median of ‘B’-rated peers’ of 171.9% and the ‘BB’ median of 152.4%.

“Sri Lanka faces significant debt maturities in 2016 amid the country’s vulnerability to a shift in investor sentiment. Fitch estimates the sovereign’s external debt service to be close to $ 4billion for the rest of 2016, compared with FX reserves of $ 6.3 billion (end-January 2016). Sri Lanka’s vulnerability to a shift in investor sentiment was evident when investors sold-off the equivalent of nearly $ 2 billion in local-currency government securities in 2015.”

A further outflow from treasury bills and treasury bonds, which account for about 31% of the country’s FX reserves, could put more pressure on reserves. However, prevailing low oil prices will continue to support Sri Lanka’s current-account deficit in the near term. Fitch expects the current-account deficit to remain manageable at about 3% of GDP over 2016-17.

The deterioration in Sri Lanka’s fiscal finances is driven partly by consistently low general government revenues. At an estimated 13% of GDP, Sri Lanka’s gross general government revenues remain far below the ‘B’ median of 25.4% and the ‘BB’ median of 26%. The 2016 budget did little to address this issue directly and absent any significant fiscal consolidation, Fitch expects continued fiscal slippage over 2016-17. Sri Lanka’s gross general government debt (GGGD) burden is estimated to have increased to more than 75% of GDP by the end of 2015, up from 71% at the end of 2014 and much higher than the ‘B’ median of 52% of GDP and ‘BB’ median of 43.6%.

Fitch has revised downwards its forecast for foreign-exchange reserves, with reserve coverage of current external payments now forecast to decline to 2.9 months in 2016 from an estimated 3.4 months in 2015. This forecast compares unfavourably with Fitch’s earlier forecast of 3.9 months for 2016 and is well below the ‘BB’ median of 4.2 months. While the authorities have undertaken certain measures to support external finances, including entering into bilateral swaps with other central banks, Fitch does not view this to be a sustainable way to improve the stability of the external finances.

 Foreign-currency debt portion remains high. Sri Lanka has also increased its issuance of foreign-currency debt, which Fitch estimates now makes up close to 46% of total public debt, up from nearly 42% at the end of 2014. This has increased vulnerability of Sri Lanka’s public debt to a significant depreciation of the exchange rate, which would increase the debt burden in local currency terms.

Sri Lanka’s macroeconomic performance remains stronger than some of its peers’ in the ‘B’ and ‘BB’ range with real GDP growth for the five-year period ending 2015 averaging close to 6%, compared with the ‘B’ median of 4.6% and ‘BB’ median of 3.9%. Sri Lanka also continues to score highly, compared with the ‘B’ median, on basic human development indicators, such as education, health and literacy, which is indicated by its favourable ranking in the UN’s Human Development Index. These relative structural strengths, combined with a clean external debt service record and smooth transition of power during the presidential and parliamentary elections in 2015 indicates a basic level of political stability, which supports the rating at ‘B+’.

The Negative Outlook reflects the following risk factors that could, individually or collectively, result in a downgrade of the ratings:

A further increase in external vulnerability driven by a sustained decline in FX reserves reflecting, for instance, reduced international market access and/or a sudden reversal in portfolio inflows.

A further deterioration in policy coherence and credibility that widens macroeconomic imbalances and/or heightens external vulnerabilities.- Continued fiscal slippage resulting in a failure to stabilise the general government debt ratio.

The main factors that could, individually or collectively, lead to a revision of the Outlook to Stable are:

Implementation of a predictable and robust policy framework leading to a reduction in risks to basic economic and financial stability.

-Improvement in Sri Lanka’s public finances underpinned by a credible medium-term fiscal consolidation strategy, including a broadening of the general government revenue base.

-Sustained smaller current-account deficits with higher levels of non-debt capital inflows (FDI) and an increase in foreign exchange reserves.