Downgrading Sri Lanka’s international sovereign rating resembles the recent unwarranted downgrade by Moody’s Investors Service a few days prior to the announcement of the National Budget 2022, Sri Lanka’s Central Bank said.
Releasing a statement the bank said the sense of urgency on the part of an internationally recognised rating agency to downgrade Sri Lanka is inconceivable, particularly considering the fact that Fitch was being constantly updated by Sri Lankan authorities on the latest developments in all sectors of the economy and imminent foreign exchange inflows.
Fitch Ratings downgraded Sri Lanka’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘CC’, from ‘CCC’ on 17 December 2021. Fitch typically does not assign Outlooks or apply modifiers for sovereigns with a rating of ‘CCC’ or below.
Fitch Ratings (Fitch), in a rather hasty move, downgraded Sri Lanka’s international sovereign rating on 17 December 2021, demonstrating its failure to recognise the positive developments taking place in Sri Lanka, in an environment in which the entire world is grappling with multiple waves of the COVID-19 pandemic. This action resembles the recent unwarranted downgrade by Moody’s Investors Service a few days prior to the announcement of the National Budget 2022. The sense of urgency on the part of an internationally recognised rating agency to downgrade Sri Lanka is inconceivable, particularly considering the fact that Fitch was being constantly updated by Sri Lankan authorities on the latest developments in all sectors of the economy and imminent foreign exchange inflows.
In particular, despite the lockdown measures that had to be introduced in the third quarter of 2021, the real economy averted a deep contraction during the quarter, signalling Sri Lanka’s adaptability to the new normal. Real GDP, in fact, expanded by 4.4 per cent (year-on-year) during January-September 2021, reaffirming the strong possibility of above 4 per cent growth in 2021. High frequency data on activity point towards a strong recovery of the economy surpassing the pre-pandemic level. The Manufacturing Purchasing Managers’ Index reached 61.9 in November 2021, the highest reading for a month of November on record, and way above the pre-pandemic level of activity. Indices of the Colombo Stock Exchange reached historical highs, with a large number of Initial Public Offerings taking place in 2021. Credit extended to the private sector expanded by over Rs. 685 billion in the ten months to October 2021, compared to about Rs. 260 billion in the same period last year.
The trade deficit continued to decline from May 2021 on a month-on-month basis, supported by record high export earnings. Earnings from merchandise exports recorded an all time high in October 2021, and preliminary information indicates that earnings have exceeded this record level in November 2021. With the exchange rate remaining stable since April 2021, excepting a few speculation-driven deviations, the conversion of export proceeds and other foreign exchange earnings has also improved substantially in recent weeks. An exponential growth in tourist arrivals is observed on a monthly basis, indicating an early reversal of the annual foreign exchange revenue loss of around US dollars 5 billion in the period ahead.
The prospects for workers’ remittances are bright, with the resumption of worker migration, increased demand for Sri Lankan workers particularly from the Middle East and efforts to facilitate worker remittances through formal channels through an attractive incentive package. With such measures, the external current account balance is expected to be maintained at growth supporting levels, thereby accommodating equity capital to the financial account through direct investment to the identified projects in the Colombo Port City and Industrial Zones, in addition to the expected monetisation of non strategic and underutilized assets.
These developments and the rapid vaccination drive, which is being rolled out nationally, would help realise the potential of the economy over the near to medium term.
Fitch has also failed to recognise the fiscal reforms introduced through the National Budget 2022. With the introduction of new tax measures, upgraded tax administration systems, and the revival of the economy, the year 2022 is expected to deliver a substantial increase in Government revenue. Increasing the retirement age of public sector employees and measures to enhance the viability of state owned business enterprises are notable reforms, and issuing quarterly warrants for Government institutions instead of annual warrants are expected to instill financial discipline in the utilisation of the allocations, thereby cushioning the expenditure side. Such revenue and expenditure side measures would pave the way for a reduction in the fiscal deficit and financing needs of the Government, contributing to a sustainable debt level.
The domestic market has responded positively to expected path of fiscal consolidation, and interest rates have stabilised, following an initial overshooting, at market clearing levels. The Central Bank’s holdings of Government securities have also declined notably as a result of improved subscription at primary market auctions and active open market operations.
Contrary to Fitch’s unfounded claims on increased probability of a default event over the coming months, the measures undertaken by the Government and the Central Bank to secure support from friendly nations in the region are nearing fruition, thereby offsetting pressures on the balance of payments in the period ahead. The Six-Month Road Map for Ensuring Macroeconomic and Financial System Stability clearly articulated the expected cashflows by December 2021 and by March 2021, and the Government and the Central Bank remain confident that these inflows will materialise, and the end-2021 level of Gross Official Reserves will remain above US dollars 3 billion. Fitch appears to have completely ignored the standby SWAP facility with the People’s Bank of China of around US dollars 1.5 billion, of which the drawal is imminent. The credit lines and other inflows expected following high-level meetings in India and the Middle Eastern and other regional economies are also not given due consideration by Fitch in arriving at this decision.
The fact that Fitch Ratings decided to downgrade Sri Lanka without waiting until the first test date of 31 December 2021 shows nothing but recklessness, which could only hurt investors if decisions are made based on this downgrade. It must also be noted that the Government has given a clear assurance that Sri Lanka will honour all debt obligations in the period ahead, and Sri Lanka has not delayed a single payment even under severe stresses that were caused by the COVID-19 pandemic over the past two years.
Therefore, all stakeholders of the economy, including international investment partners, are requested not to be dissuaded by this unjustified rating action, but instead, work with Sri Lanka to surf the turbulent tides, which are expected to settle in the next few days. A detailed Press release on the progress of expected foreign inflows as envisaged in the Six-Month Road Map will be published this week.
Fitch Downgrades Sri Lanka’s Long-Term Foreign-Currency IDR to ‘CC’
Fri 17 Dec, 2021 – 11:31 AM ET
Fitch Ratings – Hong Kong – 17 Dec 2021: Fitch Ratings has downgraded Sri Lanka’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘CC’, from ‘CCC’. Fitch typically does not assign Outlooks or apply modifiers for sovereigns with a rating of ‘CCC’ or below.
A full list of rating actions is at the end of this rating action commentary.
KEY RATING DRIVERS
The downgrade reflects our view of an increased probability of a default event in coming months in light of Sri Lanka’s worsening external liquidity position, underscored by a drop in foreign-exchange reserves set against high external debt payments and limited financing inflows. The severity of financial stress is illustrated by elevated government-bond yields and downward pressure on the currency.
We have affirmed the Long-Term Local-Currency IDR at ‘CCC’, as authorities have continued access to domestic financing, despite high and still-rising government debt and an elevated debt service burden.
Sri Lanka’s foreign-exchange reserves have declined much faster than we expected at our last review, owing to a combination of a higher import bill and foreign-currency intervention by the Central Bank of Sri Lanka. Foreign exchange reserves have declined by about USD2 billion since August, falling to USD1.6 billion at end-November, equivalent to less than one month of current external payments (CXP). This represents a drop in foreign-currency reserves of about USD 4 billion since end-2020.
We believe it will be difficult for the government to meet its external debt obligations in 2022 and 2023 in the absence of new external financing sources. Obligations include two international sovereign bonds of USD500 million due in January 2022 and USD1 billion due in July 2022. The government also faces foreign-currency debt service payments, including principal and interest, of USD6.9 billion in 2022, equivalent to nearly 430% of official gross international reserves as of November 2021. Cumulative foreign-currency debt service, including interest and principal, amounts to about USD26 billion from 2022 through to 2026.
The timing and availability of external resources is unclear and may not be readily available for debt service. The central bank published a six-month roadmap in October that outlined plans to raise additional external borrowings through a number of channels, including bilateral and multilateral sources, syndicated loans and through the monetisation of under-utilised assets in 1Q22.
A drawdown on the existing currency swap facility with the People’s Bank of China (PBOC) could boost reserves by up to CNY10 billion (USD1.5 billion equivalent). However, even with resources from the swap facility, foreign exchange reserves are likely to remain under pressure, in our view. Additional sources of financing could come from an economic support package from India, which contains a swap facility under the South Asian Association for Regional Cooperation currency framework of USD400 million, a swap facility with the Qatar Central Bank, remittances securitisation and a revolving credit facility with the Bank of China Limited (A/Stable). However, even if all these sources are secured, we believe it will be challenging for the government to maintain sufficient external liquidity to allow for uninterrupted debt servicing in 2022.
Press reports suggest the government may be contemplating IMF financing; an IMF programme would unlock multilateral financing, but we believe the Fund could well suggest restructuring to bring about debt sustainability.
Sri Lanka’s external finances are further challenged by a persistent current account deficit, resulting in downward pressure on the exchange rate. We estimate that the deficit widened to about 5.7% of GDP in 2021 and expect it to remain at about 4.0% in 2022, before falling to 2.1% by 2023. A plunge in remittances, a weak tourism recovery and rising imports have contributed to the wider current account deficit. Travel and tourism, an important economic driver, has been hit hard by the COVID-19 pandemic and the outlook for a recovery remains uncertain given the emergence of new highly transmissible virus variants.
The Sri Lankan rupee/US dollar spot exchange rate depreciated by 7%-8% since end-2020, and the central bank intervened to support the currency, exacerbating the decline in reserves.
Wide fiscal deficits continue to worsen the outlook for debt sustainability. The 2021 fiscal deficit target of 8.9% of GDP was missed by a wide margin, and we expect the government deficit to widen to about 11.5% of GDP in 2022. We believe 2022 revenue targets are optimistic, especially in light of our expectation of weak economic activity. We forecast general government debt to reach about 110% of GDP by 2022, and to keep rising under our baseline, absent major fiscal consolidation.
We also believe it is unlikely that Sri Lanka will meet its 2025 government debt reduction target of about 89% of GDP or narrow the fiscal deficit to 4.8% of GDP. Rising interest payments are a major driver of the widening deficit and the interest/revenue ratio of at about 95.0% is well above the peer median of 11.3%.
Sri Lanka’s economic performance is likely to weaken in 2022, as the challenging external position and exchange-rate pressure will have knock-on effects on economic activity. Foreign currency shortages in 2021 hampered food and fuel imports, and continued external liquidity stress could worsen supply shortages, hurting economic activity. We expect growth to slow to 2.0% in 2022, from an estimated 3.6% in 2021, before recovering to 4.3% in 2023 partly due to base effects and a gradual easing of domestic pressures, although downside risks to our forecasts remain. Sri Lanka’s economy was expanding at a modest pace prior to the pandemic, which led real GDP to contract by 3.6% in 2020.
ESG – Governance: Sri Lanka has an ESG Relevance Score of ‘5’ for Political Stability and Rights. This reflects the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Sri Lanka has a medium WBGI ranking at the 47th percentile, reflecting a recent record of peaceful political transitions and a moderate level of rights for participation in the political process. As Sri Lanka has a percentile rank below 50 for the governance indicator, this has a negative impact on the credit profile.
ESG – Governance: Sri Lanka has an ESG Relevance Score of ‘5[+]’ for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption. This reflects the high weight that the WBGI has in our proprietary Sovereign Rating Model. Sri Lanka has a medium WBGI ranking at the 53rd percentile, reflecting moderate institutional capacity, established rule of law and a moderate level of corruption. As Sri Lanka has a percentile rank above 50 for the respective governance indicators, this has a positive impact on the credit profile.
Sri Lanka has an ESG Relevance Score of ‘5’ for Creditor Rights, as willingness to service and repay debt is relevant to the rating and is a rating driver for Sri Lanka, as for all sovereigns. Given the increasing possibility of default reflected in the CC rating, this has a negative impact on the credit profile.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
- Failure to service bonded debt obligations within grace periods stipulated in relevant documentation, or unilateral declaration of a debt moratorium
- Launch of a formal debt renegotiation process by authorities or the start of a process that Fitch deems to constitute a default or default-like event
Factors that could, individually or collectively, lead to positive rating action/upgrade:
-External Finances: Improved external liquidity, supported by higher non-debt inflows or lower external sovereign refinancing risk from an enhanced liability profile that allows for smooth servicing of liabilities
- Public Finances: Implementation of a credible medium-term fiscal consolidation strategy that supports a sustained decline in the general government debt/GDP ratio, increasing financing options and reducing the probability of default
- Structural: Improved policy coherence and credibility, leading to more sustainable public and external finances and a reduction in the risk of debt distress
SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
In accordance with its rating criteria, Fitch’s has not utilised the SRM or QO to explain the ratings in this instance. Ratings of ‘CCC+’ and below are instead guided by the rating definitions.
Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a Long-Term Foreign-Currency IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
Sri Lanka has an ESG Relevance Score of ‘5’ for Political Stability and Rights as WBGIs have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and a key rating driver with a high weight.
Sri Lanka has an ESG Relevance Score of ‘5[+]’ for Rule of Law, Institutional and Regulatory Quality and Control of Corruption as WBGIs have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight. As Sri Lanka has a percentile rank above 50 for the respective Governance Indicators, this has a positive impact on the credit profile.
Sri Lanka has an ESG Relevance Score of ‘4’ for Human Rights and Political Freedoms, as the Voice and Accountability pillar of the WBGI is relevant to the rating and a rating driver. As Sri Lanka has a percentile rank below 50 for the respective governance indicator, this has a negative impact on the credit profile.
Sri Lanka has an ESG Relevance Score of ‘5’ for Creditor Rights, as willingness to service and repay debt is relevant to the rating and is a rating driver for Sri Lanka, as for all sovereigns. Given the increasing possibility of default reflected in the CC rating, this has a negative impact on the credit profile. Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of ‘3’. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or to the way in which they are being managed by the entity.