Moody's downgrades Sri Lanka's ratings to B2

Moody's Investors Service (Moody's) on Tuesday downgraded the politically-troubled Sri Lankan Government’s foreign currency issuer and senior unsecured ratings to B2 from B1 and changed the outlook to stable from negative.

The decision to downgrade the rating to B2 is “driven by Moody's view that ongoing tightening in external and domestic financing conditions and low reserve adequacy, exacerbated most recently by a political crisis which seems likely to have a lasting impact on policy even if ostensibly resolved quickly, have heightened refinancing risks beyond levels anticipated when the rating agency affirmed the rating at B1 with a negative outlook in July”, the rating agency said in a public announcement.

Moody's said its projections include a slower pace of fiscal consolidation than assumed in July to reflect disruption to fiscal policy implementation in a period of political turmoil.

The stable outlook denotes balanced credit risks at the B2 rating level. Moody's expectation is that, despite the current political crisis, any future government will remain broadly focused on implementing important fiscal, monetary and economic reforms that would strengthen the credit profile over the medium term. However, Moody's assessment is that the government's debt refinancing will remain highly vulnerable to sudden shifts in investor sentiment in a period of further tightening in financing conditions and political and policy uncertainty, with limited buffers to face such risk.

“Concurrently, Moody's lowered the local-currency bond and deposit ceilings to Ba2 from Ba1. The foreign currency bond ceiling was lowered to Ba3 from Ba2 and the foreign currency deposit ceiling was lowered to B3. Sri Lanka's low foreign exchange reserve coverage of large external debt repayments over the next five years exacerbates its reliance on external bilateral and commercial lenders' willingness to refinance maturing debt. The risks related to that structural external vulnerability are rising in an environment of tightening financing conditions globally and, most recently, heightened domestic political tensions which threaten to undermine international investors' confidence and the flow of foreign capital, from private markets and international bilateral lenders, into Sri Lankan financial assets,” it said.

Tightening external financial conditions and domestic political instability are resulting in capital outflows and placing increasing pressure on the exchange rate and foreign exchange reserves.

Combined, these factors are raising the value and cost of external debt. If prolonged, tightening global financial conditions and domestic political instability could hinder the government's access to global capital markets, curb foreign direct investment inflows to the country and reduce funding from international lenders. Such conditions would undermine the sovereign's ability to meet its large external repayment obligations. The government will need to make principal payments on external debt that could be as high as $4 billion per year between 2019 and 2023, in addition to financing part of the budget deficit externally, Moody’s added.

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 be about 180 per cent in 2019 and 2020, higher than previously expected and much higher than the median level for B-rated sovereigns.

Moody’s said going forward, the government may pursue a range of financing options, including international US dollar bond issuance, yuan and yen-denominated bond issuances, and loans from China (A1 stable), West Asia or other bilateral and multilateral lenders. These options may somewhat mitigate but are unlikely to materially reduce refinancing risks, as ongoing tightening in financing conditions raise uncertainty around the timing and availability of funding sources.

A steady and credible implementation of planned fiscal and economic reforms would improve Sri Lanka's ability to sustain investor confidence through the upcoming period of large debt maturities. However, the likelihood of the government pursing its reform agenda on the previously planned schedule has fallen following recent political events that have interrupted the reform momentum. Moody's does not expect the current political crisis to be fully resolved rapidly, and the crisis is in any event likely to leave its mark on the pace and content of the reform programme. Even if past episodes of political disruption have not changed the broad direction of reforms in Sri Lanka, delays in the pace of reform will at a minimum limit the government's ability to respond to changing market conditions.

Moody’s said the stable outlook denotes balanced risks at the B2 rating level. Against the backdrop of ongoing political turmoil, there may be changes or delays to policies that could result in a slower pace of fiscal consolidation in the short term. However, Moody's expects the broad direction of policy will remain focused on gradually narrowing fiscal deficits and lowering government debt, independent of political shocks. The government had planned further reforms to broaden and deepen its revenue base and pursue binding fiscal rules, including implementing a medium-term debt strategy and establishing a debt management agency.

Although these measures are reflected in Moody's fiscal projections, their effectiveness in raising revenue and maintaining a prudent fiscal stance could be higher than currently assumed.