Moody’s Investors Service yesterday affirmed Sri Lanka’s foreign currency issuer and senior unsecured ratings at B1 but maintained the negative outlook, which it first assigned to the island nation’s credit rating in June, 2016 and maintained during last year too.
“The decision to affirm the rating at B1 reflects Sri Lanka’s progress in implementing the planned reform programme, which entails fiscal consolidation and a build-up foreign exchange reserves buffers, ahead of the end of the IMF Extended Fund Facility programme in June 2019, along with its moderate per capita income levels, and stronger institutions relative to many similarly-rated sovereigns,” Moody’s said.
The rating agency cited 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 as the key reasons for its decision to maintain the negative outlook.
Moody’s said 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.
Under its IMF Extended Fund Facility programme, Sri Lanka continues to advance reforms that support fiscal consolidation and attempt to reduce external vulnerabilities.
Progress in fiscal consolidation and in building up of 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 new Inland Revenue Act (IRA), which came into effect in April 2018, is expected to bolster the government revenue generation by broadening and deepening its revenue base.
Also, the 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 programme.
In addition, the planned changes to the Monetary Law Act should is expected to 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, effective use of the ALMA may allow the Sri Lankan government to smooth somewhat the consecutive large debt maturities over the period 2019-2023 and to prevent the recurrence of such a concentration in future.
“During the next few years, however, 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 Chinese renminbi or Japanese yen denominated bonds, as well as loans from other bilateral or multilateral lenders,” Moody’s noted.
Meanwhile, the rating agency said low fiscal strength will remain a key source of risk for Sri Lanka over the next few years, despite prospects for 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 programme, 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 percent of GDP by the turn of the decade, from 77 percent 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 percent of GDP in 2018 and, in the baseline, forecasts them to fall to a still-high level of 13 percent by 2020.
A significant proportion of the government’s debt is financed at short maturities, including Treasury bills equivalent to around 12.5 percent of outstanding domestic debt, or about 5 percent of GDP in 2017.
Moody’s estimates that the government will have made principal payments on external debt of around US $3.8 billion per year, on average, from 2016-18.
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 percent in the next few years, well above the median level of B-rated sovereigns.
The rating agency expects Treasury bond maturities to fall to around 2 percent of GDP, on average per year over the period from 2019-2023, from about 4 percent of GDP in 2018, providing some space for the government to increase local-currency borrowings to finance the fiscal deficit.
Rationale for negative outlook
Elaborating on the rationale for maintaining the negative outlook, Moody’s said Sri Lanka’s credit profile is dominated by the government’s and the country’s elevated exposure to refinancing risk.
According to Moody’s 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 US $3.5 billion per year (about US$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 percent of GDP in the next few years, or around US$2.6 billion on average per year,” the rating agency noted.
Meanwhile, Moody’s noted that 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,” Moody’s said.