Moody's Ratings (Moody's) has today (23) upgraded the Government of Sri Lanka's long-term foreign currency issuer rating to Caa1 from Ca. The outlook is stable. Previously, the rating was on review for upgrade.

The decision to upgrade the issuer rating to Caa1 is driven by the conclusion of the restructuring of Sri Lanka's international bonds held by private-sector creditors, which reduces the default risk on new and future issuances. At Caa1, Sri Lanka's credit profile reflects the reduction in external vulnerability and government liquidity risk and prospects for fiscal and debt sustainability, from a weak starting point, which are underpinned by ongoing reforms under the government's programmes with development partners including the International Monetary Fund (IMF). Willingness and capacity to implement reforms speak to Sri Lanka's governance and also underpin the rating action. However, these credit supports are balanced against still weak debt affordability and a high debt burden compared to peers, which limit the government's fiscal flexibility and capacity to address underlying social challenges.

The stable outlook reflects balanced risks to the ratings. On the upside, the government's commitment to and continued implementation of reforms may strengthen its credit profile beyond our current assumptions, to a level consistent with a higher rating. On the downside, the still narrow government revenue base and limited fiscal space, combined with the reliance on external financing, pose asymmetric risks to the credit profile should the global macroeconomic environment become less supportive for a sustained economic recovery and further reform implementation.

This rating action concludes the review that we initiated on 28 November 2024.

Concurrently, we have assigned definitive Caa1 foreign currency senior unsecured ratings to Sri Lanka's new USD-denominated issuances, specifically the macro-linked bonds (MLBs), the governance-linked bond (GLB), as well as the step-up and past-due interest (PDI) bonds, from provisional (P)Caa1 ratings. We have also withdrawn the Ca foreign currency senior unsecured rating on Sri Lanka's July 2022 bond, of which $268 million remains outstanding after the settlement of bonds in the government's exchange offer, for business reasons.

Sri Lanka's local and foreign currency country ceilings have been raised to B1 from Caa1 and B3 from Ca, respectively. The three-notch gap between the local currency ceiling and the sovereign rating balances a contained government footprint, against still relatively limited but increasing foreign exchange buffers that confer macroeconomic risks, as well as a challenging domestic political and policymaking environment due to underlying social pressures. The two-notch gap between the foreign currency ceiling and local currency ceiling takes into consideration the high level of external indebtedness although the rebuilding of foreign exchange buffers is reducing the risk of transfer and convertibility restrictions.

RATINGS RATIONALE

RATIONALE FOR UPGRADING THE ISSUER RATING TO Caa1

Sri Lanka's government announced that the exchange offer it made on 25 November 2024 has been successful, resulting in the exchange of all past international bond issuances except $268 million of its July 2022 bond. The successful exchange concludes the restructuring of Sri Lanka's international bonds and reduces the default risk on the new and future issuances.

Prior to the restructuring of international bonds, Sri Lanka had already reached agreements with its main bilateral creditors, which include Paris Club members and India (together the Official Creditor Committee) as well as China, and China Development Bank. The agreements have either come into effect or will do so in the coming weeks. The government also restructured part of its domestic debt over July to September 2023 in its Domestic Debt Optimisation (DDO) initiative. The DDO covered the local currency debt held by the Central Bank of Sri Lanka (CBSL) and superannuation funds, as well as the USD-denominated Sri Lanka Development Bonds (SLDBs) and Foreign Currency Banking Units (FCBUs) held by domestic investors including banks.

Sri Lanka's credit fundamentals have improved over the past two years, aided by effective policy adjustments that have led to a stabilisation of the macroeconomic environment, as well as debt restructuring and ongoing reforms under the government's programmes with the IMF and other development partners. External vulnerability and government liquidity risk have both declined from elevated levels. The restructuring has also had a limited impact on the banking sector, reflecting Sri Lanka's wider domestic investor base compared to peers.

Foreign exchange reserves have quadrupled since the default as sizeable financing inflows from development partners, the suspension of external debt repayments to bilateral and commercial creditors, an improvement in current account dynamics, as well as substantial purchases of foreign exchange by CBSL have helped Sri Lanka rebuild its foreign exchange buffers. As of the end of November 2024, foreign exchange reserves (excluding gold and special drawing rights) amounted to $6.4 billion, up from $1.6 billion in April 2022 and sufficient to cover slightly more than 3 months of total goods and services imports over the next year. We project that foreign exchange reserves will rise to cover more than 4 months of imports and all of the country's external debt due by the end of 2026 and over the following 2-3 years. The higher level of foreign exchange buffers will be anchored by supportive balance of payments dynamics, including further external financing inflows from official and private sector sources, as well as our expectations that the current account will be largely in balance or in a small deficit over the next 2-3 years. At the same time, Sri Lanka's external repayment profile will remain benign at less than 2% of GDP annually over the next few years even as debt repayments fully resume post-restructuring, and we expect the government's gross financing needs to fall to average around 15% of GDP, still sizeable but materially lower than before the sovereign defaulted.

Besides the reduction in liquidity risks, Sri Lanka's fiscal and debt dynamics are also improving, albeit from a weak starting point. We expect Sri Lanka's fiscal deficit to narrow to 5-6% of GDP in 2025-26, compared to our estimate of 7% of GDP for 2024 and an average deficit of 11% of GDP in 2021-22 around the time of the default. The reduction in the deficit has been driven by revenue measures that have significantly widened the government's revenue base from 8.3% of GDP in 2021-22 to our estimate of around 14% of GDP in 2024. These revenue measures include raising the value added tax and corporate income tax rates, lowering the personal income tax free allowance, and strengthening tax administration.

Although the change in president and government point to underlying social challenges that may make further fiscal consolidation difficult, announcements thus far – including the staff-level agreement on the third review under Sri Lanka's IMF programme – suggest that the new administration is committed to structural reforms and the IMF programme. Some reprioritisation of reform measures and targets is likely, but we expect the broad reform trajectory to remain intact.

Balanced against these credit supports are still weak debt affordability and a still high debt burden compared to peers. Although Sri Lanka's debt affordability has and will continue to improve, we expect interest payments to continue to absorb a very high level of around 40-50% of government revenue into the foreseeable future. Sri Lanka's debt affordability will remain among the weakest across sovereigns we rate and constrains its credit profile. Likewise, while we expect Sri Lanka's debt burden to decline to around 95% of GDP by the end of this year after the restructuring of international bonds, and to below 90% within the next 2-3 years from a peak of 114% at the end of 2022, the debt burden will remain high compared to peers.

RATIONALE FOR THE STABLE OUTLOOK

The stable outlook reflects balanced risks to the ratings.

On the upside, the government's commitment to and continued implementation of reforms may strengthen its credit profile beyond our current assumptions, to a level consistent with a higher rating. In particular, the government has exceeded its revenue targets under its IMF programme and is targeting further increases in revenue over the coming years. While we believe the social backdrop remains challenging, significant revenue increases can contribute to material improvements in debt affordability and reduction in debt burden beyond our expectations.

On the downside, the still narrow government revenue base and limited fiscal space, combined with the reliance on external financing, pose asymmetric risks to the credit profile. Although we expect global growth to remain steady, which will support continued recovery of Sri Lanka's economy, any slowdown in global growth affecting the demand for the country's exports could result in balance of payments imbalances and threaten the recovery and reform momentum.

RATIONALE FOR ASSIGNING DEFINITIVE Caa1 RATINGS ON THE NEW DEBT ISSUANCES

The final terms of the new debt issuances indicate that they will constitute direct, unconditional and unsecured obligations of the government, and will rank pari passu among themselves and equally with all of the government's other unsecured and unsubordinated obligations of the government.

We have assigned Caa1 ratings to the USD-denominated MLBs, GLB, as well as the step-up and PDI bonds, from provisional (P)Caa1 ratings. The MLBs will vary in payment based on a point-in-time comparison of GDP outcomes to be conducted by November 2028, affecting both coupon payments and principal repayments from 2028. In particular, the principal value will range between 79% and 122% of the notional amount exchanged in the offer depending on realised GDP outcomes as published by the IMF compared to the IMF's currently published baseline projections. Importantly, once the point-in-time comparison is conducted and any adjustments to contractual obligations are made, there will be no other source of variation to debt payments. Also, any revisions to GDP outcomes at a later date will not impact the payments determined by the point-in-time comparison. The GLB does not involve any changes to the principal value compared to the notional amount exchanged in the offer, but has a step-down feature in coupon payments from December 2028 if key performing indicators and data disclosure requirements are met. In rating the MLBs and GLB, we do not assess the likelihood of any of the GDP outcomes or criteria determining the payments. Our ratings reflect our assessment of Sri Lanka's ability and willingness to meet its contractual obligations.

RATIONALE FOR WITHDRAWING THE Ca RATING ON THE JULY 2022 BOND

We have decided to withdraw the rating(s) for our own business reasons. Please refer to Moody's Ratings' Withdrawal of Credit Ratings Policy, available on our website, https://ratings.moodys.com, for more information.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Sri Lanka's ESG credit impact score (CIS-4) indicates that the rating is lower than it would have been if ESG risk exposures did not exist. This reflects weak governance that leads to very low resilience to environmental and social risks.

Sri Lanka's exposure to environment risk (E-4 issuer profile score) is driven mainly by its physical climate vulnerability. Variations in the seasonal monsoon can have marked effects on rural household incomes and real GDP growth: while the agricultural sector comprises only around 8% of the total economy, it employs more than a quarter of Sri Lanka's total labour force. Natural disasters including droughts, flash floods and tropical cyclones that the country is exposed to also contribute to higher food inflation and import demand. Moreover, ongoing development projects to improve urban connectivity have increased the rate of deforestation, although the country continues to engage development partners to preserve its natural capital, such as its mangroves.

The exposure to social risk (S-4 issuer profile score) reflects the constraints the government will face in delivering high-quality social services and developing critical infrastructure as the population continues to grow, given its still relatively narrow revenue base. Our assessment also balances Sri Lanka's relatively good access to basic education, which has continued to improve throughout the country in the post-civil war period, against weaknesses in the provision of some basic services in more remote and rural areas, such as water, sanitation and housing.

The weak governance profile (G-4 issuer profile score) reflects challenges in policymaking that led to a deterioration in the government's credit fundamentals and debt default, although the return of reform appetite and implementation of credit supportive measures is helping to restore some policy credibility. Domestic political developments also tend to weigh on fiscal and economic policymaking. International surveys continue to point to aspects of governance that are stronger in Sri Lanka relative to rating peers, including in judicial independence and control of corruption.

GDP per capita (PPP basis, US$): 14,455 (2023) (also known as Per Capita Income)

Real GDP growth (% change): -2.3% (2023) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 4.2% (2023)

Gen. Gov. Financial Balance/GDP: -8.3% (2023) (also known as Fiscal Balance)

Current Account Balance/GDP: 1.8% (2023) (also known as External Balance)

External debt/GDP: 65% (2023)

Economic resiliency: ba3

Default history: At least one default event (on bonds and/or loans) has been recorded since 1983.

On 18 December 2024, a rating committee was called to discuss the rating of the Sri Lanka, Government of. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have not materially changed. The issuer's institutions and governance strength, have materially increased. The issuer's fiscal or financial strength, including its debt profile, has not materially changed. The issuer has become less susceptible to event risks. ESG (Governance) was a key driver of this rating action.