SL’s sovereign rating down two notches to Caa1, from B2

Moody’s Investors Service has downgraded Sri Lanka’s sovereign rating two notches to Caa1, from B2, citing wide budget deficits, slow reforms and weak institutions.

Being downgraded can have a big impact on a country’s ability to borrow money on the markets. Investors see it as a riskier bet and demand higher returns to lend to governments. As a country moves a step closer to junk, like Sri Lanka (SL) did last Tuesday, investors see more risk and governments are left with fewer options to rescue the economy.

Countries that have been downgraded in recent years include Brazil, the US, the UK, South Africa and a few Eurozone governments. Credit ratings are widely used to assess the risk that a firm will default, and the probability of rating changes is used in pricing debt and in risk management. The use of credit ratings for credit risk measurement and management is particularly important under the new government. Consequently, the cabinet has stimulated much interest in the modelling of rating migration for both risk management and faster growth in Sri Lanka (SL).

The downgrade has come as the country grapples with recession and massive economic devastation from the lockdown called to contain the spread of the coronavirus.

Threats to the rating Continuing deterioration in fiscal strength

Very weak structural growth

Risk of the debt burden climbing faster and further

Weaker debt affordability and access to funding Constrained capacity to stimulate growth, compounded by unprecedented global deterioration Limited reforms do not constitute a step change

Weak economic and fiscal fundamentals could exacerbate adverse capital flows

Moody’s forecasts

Moody’s warned that achieving meaningful savings in the public sector wage bill will be challenging. Sri Lanka was downgraded from B1 to B2 in November 2018 – meaning its obligations to the credit agency are considered speculative and are subject to high credit risk. Moody’s cautioned of a further slip in ratings, citing rising risks of heightened financial stress and macroeconomic instability, due to the economic impact of the coronavirus. Moody’s expects Sri Lanka’s economy to grow just 1.5 per cent in 2020, the statement said. The country’s manufacturing and service sectors hit record lows in March, the Central Bank said in a statement, weeks after it announced that the trade deficit had widened in January.

Weaker foreign exchange inflows from exports, tourism activity and overseas remittances will further weaken Sri Lanka’s already fragile external position, the rating agency said. It added that Sri Lanka will continue to face mounting fiscal pressures to deliver high- quality social services and infrastructure with the rising population. Moody’s said implementing fiscal measures to narrow trade deficits and minimize borrowing needs would be positive for Sri Lanka’s rating.

Sri Lanka’s economy is in a troubled state after it failed to raise US$220 million through development bonds in late March. The IMF has also said it is likely to delay issuing a $190 million tranche of a loan worth $ 1.5 billion disbursed over four years.

Triggers for further negative ratings action

Very weak growth

Failure to reduce the primary deficit

Rising threat to SL’s access to financing at manageable costs A higher-than-projected debt ratio associated with a greater uncertainty of eventual stabilization Weaker institutional policymaking capacity

Moody’s highlighted the following flags in this regard: Government’s ability in the next year to contain the effects of the global recession on the SL economy

Government’s ability to promote a recovery through agreement and implementation of reforms Acting on the framework for reliable electricity supply

Fiscal reforms to contain expenditure and enhance revenues Triggers for further positive ratings action

The outlook could shift to stable if government’s fiscal consolidation tracked Moody’s central expectations, if financing risks remained low and if there was a slow, but durable, pick-up in growth

A shift to a stable outlook would be consistent with a gradual reduction in SL’s primary deficit and a stabilization in the debt ratio below 90%

What does this mean for Sri Lanka?

Higher borrowing costs for government will crowd out spending on much-needed social and economic programmes. A further knock to business sentiment could lead to lower rates of fixed investment, weaker growth and increased downward pressure on employment. A more depreciated currency leads to a higher cost of imported goods which could raise inflation and limit the extent to which the Sri Lanka Central Bank can react to the COVID- 19 crisis. ( The writer is attached to the Faculty of Management Studies and Commerce at University of Sri Jayewardenepura)