Moody’s downgrades Sri Lanka; outlook changed to Stable

• Rating agency troubled mostly by possible weakening of institutions and governance
• Says refinancing risks and stretched budget deficit exacerbated by pandemic
• Projects Sri Lanka’s annual external debt repayments at US $ 4bn between 2020 and 2025
• Estimates fiscal deficit to be 8-9% of GDP; debt-to-GDP to rise to around 100%

Moody’s Investors Service yesterday downgraded Sri Lanka’s long-term foreign currency issuer and senior unsecured ratings to Caa1, from B2 and changed the outlook to stable, after more than five months since the rating agency put the country’s sovereign rating under review for downgrade on April 17.

Moody’s, one of the big three global rating agencies, cited heightened refinancing risks and stretched fiscal deficit among others for the downgrade, as the pandemic tightened the country’s external position while it necessitated the government to stretch its budget to provide assistance to businesses and the people affected by the pandemic.
The two-notch downgrade, which was unusual, also came at a time when the Sri Lankan economy was making notable strides in many areas, including agriculture, manufacturing, services, exports, employment 
and wages.

However, Moody’s appeared to have been troubled by the fiscal and external pressures, which render a limited scope for reforms to address long-standing credit vulnerabilities, “denoting weakening institutions and governance”, triggering the rating action.

“Governance considerations are an important driver of today’s decision to downgrade the rating,” Moody’s said.
Sri Lanka has approximately US $ 4.0 billion in external debt repayments between 2020 and 2025, Moody’s estimates.

Sri Lanka raised US $ 1.2 billion from the China Development Bank in March and it finalised a US $ 400 million swap facility with the Reserve Bank of India, as it seeks to diversify its funding to non-market sources while it plans to return to external capital markets by late this year or early next year, as the global market unease caused by the pandemic dissipates.

“Nevertheless, delays in securing additional funding from multilateral and bilateral creditors, in addition to the IMF’s Rapid Financing Facility, mean that the financing sources for upcoming repayments in the next few years are not secured and risk coming at high costs,” Moody’s cautioned. 

“Sri Lanka continues to face very tight external financing conditions and a significant decline in revenue from a sharp and prolonged economic slowdown. 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,” the rating agency added.

On the fiscal front, Moody’s is of the opinion that the significant social and policy hurdles will inhibit the medium-term fiscal consolidation and projects the fiscal deficit to be in the range of 8 to 9 percent of GDP during 2020 and 2021.

“Sri Lanka’s already narrow revenue base will be slow to recover amid weaker economic growth and expenditure pressure from public sector wage hikes and higher debt servicing costs will continue to limit flexibility, likely beyond the most acute phase of the economic and financial shock,” Moody’s opined.

Due to the requirement of higher borrowings to fund the stretched fiscal deficit, combined with the slower nominal GDP and a weaker rupee, Moody’s projections showed Sri Lanka’s debt-to-GDP to rise to around 100 percent. The rating agency also said the current shock would also challenge the country’s monetary policy effectiveness. But the data has shown that the current Monetary Policy has been the most effective in its entire history.

Making sense of what its ‘stable’ outlook means, Moody’s said it reflects the rating agency’s assessment of balanced credit risks at the Caa1 rating level.

Finance Ministry says Moody’s analysis erroneous and reckless 

The Finance Ministry called yesterday’s rating action by Moody’s was based on an “erroneous analysis”, as the rating report failed to do justice to the ground reality of the ongoing rapid economic recovery, backed by vastly improved business confidence arising from the return of political and policy stability after a lapse of five years.

A Finance Ministry statement said such announcement is also unwarranted, specially at a time when the new government is about to announce its budget for 2021, spelling out the policy framework proposed in the medium term.

The statement highlighted how Sri Lanka swiftly addressed the outbreak of COVID-19 in the country and stressed that the country is now on a recovery path towards growth.

It noted that merchandise exports have almost reached pre-pandemic levels and remittance income has picked up, despite the initial expectation of a slowdown.

The statement also said foreign direct investment, which slowed in the first half, appears promising looking ahead, particularly with the expected inflows to the Port City project and for new manufacturing projects.

“The expected finalisation of new legislation for the Port City within a month will result in the realisation of investment by those who have already completed due diligence on such investment,” the statement said.

With regard to portfolio flows, the statement noted that foreign inflows to the government securities market have already shown signs of resumption.

It also said domestic economic activity has shown remarkable turnaround with the government’s programmes to support entrepreneurs.

“… available economic indicators point towards a promising recovery in the second half of the year, flowing the setback in the first half,” it said.

As a result of these developments, the Finance Ministry said the exchange rate has sharply appreciated since mid-April and remains stable at appreciated levels, allowing the Central Bank to accumulate reserves through market purchase of foreign exchange.

By end-August, Sri Lanka’s foreign reserves stood at US $ 7.4 billion.

The Finance Ministry pointed out that Sri Lanka’s foreign currency inflows would be further enhanced with the currency swap agreements with the central banks of friendly countries and the expected second tranche of the foreign currency term financing facility proceeds from the China Development Bank, in October 2020.

The Finance Ministry statement also pointed out that on the back of over 11 years of well-anchored mid-single-digit levels of inflation, the Central Bank has pursued an increasingly accommodative monetary policy.

“Hence, both fiscal and monetary policies have prioritised supporting people, businesses and thereby the economy without jeopardising the macroeconomic balance of the country,” it added.

Given these circumstances, the Finance Ministry stressed the government’s willingness and ability to meet its debt obligations, as it has done in the past. Sri Lanka has curtailed import of non-essential goods with a view to prioritise external debt service obligations.

“… all payment transactions for the payment of the international sovereign bond of US $ 1 billion, maturing on October 4, 2020, have already been lined up and funds will be credit to the paying agent’s account on October 2, 2020.

It is puzzling that Moody’s has downgraded Sri Lanka on the eve of this repayment, which seems similar to the previous premature and reckless downgrades by rating agencies in the immediate aftermath of the end of the internal conflict in 2009 and during the political impasse at end-2018,” the statement noted.

The Finance Ministry invited investors not to be dissuaded by the unwarranted rating downgrade and the erroneous analysis published recklessly but to be guided by improving economic conditions in the country.

“As in the past, any investor can approach the Finance Ministry, Money and Capital Market and State Enterprise Reforms State Ministry and Central Bank of Sri Lanka and highest level officials of these entities remain committed to facilitate any one-on-one or roadshow discussions with investors.

In addition, the government will commence regular roadshows to strengthen investor relations, following the announcement of the National Budget in November 2020, which will provide further clarity on the government’s medium-term fiscal and financing plans,” the statement noted.