Moody’s: Sri Lanka’s credit profile balances progress on reforms against vulnerability to tightening financial conditions

August, 22, 2018

Moody's Investors Service says that the credit profile of the Government of Sri Lanka (B1 negative) is supported by the authorities' progress in implementing reforms, which entail fiscal consolidation and a build-up of foreign exchange reserves.

Sri Lanka also benefits from moderate per capita income levels and stronger institutions than those of many similarly rated sovereigns.

Credit challenges include high government debt levels, very low debt affordability and a fragile external payments position.

Moody's conclusions are contained in its just-released credit analysis titled "Government of Sri Lanka -- B1 Negative" and which examines the sovereign in four categories: economic strength, which Moody's assesses as "moderate (+)"; institutional strength "moderate (-)"; fiscal strength "very low (-)"; and susceptibility to event risk "moderate".

The report constitutes an annual update to investors and is not a rating action.

Moody's explains that under Sri Lanka's IMF Extended Fund Facility program, the government is committed to broadening and deepening its revenue base, strengthening the credibility and effectiveness of monetary policy, implementing liability management strategies, and pursuing legislation that ensures deficit and debt consolidation efforts endure after the program ends in June 2019.

The negative outlook on the sovereign's rating reflects Moody's view that Sri Lanka's credit profile is dominated by the government's and country's elevated exposure to refinancing risk. In particular, Sri Lanka could face significantly tighter external refinancing conditions during the next five years, which would quickly lead to much weaker debt affordability, especially if the currency depreciates at the same time.

The negative outlook signals that a rating upgrade is unlikely.

Moody's would consider returning the rating outlook to stable if Moody's concludes that external and domestic refinancing risks will likely diminish. That conclusion could be prompted by a faster and more sustained buildup of non-debt-creating foreign exchange inflows than Moody's currently expects, the demonstrated effectiveness of liability management strategies to smooth and lengthen maturity payments, and, over time, significant fiscal reforms that markedly improve fiscal strength.

But, Moody's would consider downgrading the sovereign rating if Moody's concludes that external and domestic refinancing capacity will not improve, and Sri Lanka will likely face difficulties in refinancing its domestic or external debt affordably.

Evidence that the implementation of key policies — including further fiscal consolidation, monetary policy independence from fiscal developments, and the diversification of financing sources or liability management — is not effective would likely negatively affect Sri Lanka's access to and cost of finance.

A marked weakening in reserve adequacy from already low levels, and a stop to or reversal in fiscal consolidation that raises the prospect of higher government debt and prevents the likely decline in gross borrowing requirements could also prompt a rating downgrade.