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Wednesday March 29th, 2023

Moody’s downgrades Sri Lanka sovereign rating to Caa2

ECONOMYNEXT – Moody’s Investors Service has downgraded Sri Lanka’s sovereign rating to Caa2 from Caa1, taking the country’s credit deeper into speculative grade as foreign reserves continued to fall amid money printing and crippled forex markets.

“A large financing envelope that Moody’s considers to be secure remains elusive and the sovereign continues to rely on piecemeal funding such as swap lines and bilateral loans, although prospects for non-debt generating inflows have improved somewhat since Moody’s placed Sri Lanka’s rating under review for downgrade,” the rating agency said.

“Persistently wide fiscal deficits due to the government’s very narrow revenue base compound this challenge by keeping gross borrowing needs high and removing fiscal flexibility.

“The decision to downgrade the ratings is driven by Moody’s assessment that the absence of comprehensive financing to meet the government’s forthcoming significant maturities, in the context of very low foreign exchange reserves, raises default risks.”

Liquidity injections and dysfuctional forex markets due to loss of confidence in the domestic currency, had made it difficult to transfer wealth out of the country through the credit system not just for debt but also for current transactions. As a result the country is also seeking credit lines for imports.

The full statement is reproduced below:

Rating Action: Moody’s downgrades Sri Lanka’s rating to Caa2; outlook stable

28 Oct 2021

Singapore, October 28, 2021 — Moody’s Investors Service (“Moody’s”) has today downgraded the Government of Sri Lanka’s long-term foreign currency issuer and senior unsecured debt ratings to Caa2 from Caa1 under review for downgrade.

The outlook is stable. This concludes the review for downgrade initiated on 19 July
2021.

The decision to downgrade the ratings is driven by Moody’s assessment that the absence of comprehensive
financing to meet the government’s forthcoming significant maturities, in the context of very low foreign exchange reserves, raises default risks.

In turn, this assessment reflects governance weaknesses in the ability of the country’s institutions to take measures that decisively mitigate significant and urgent risks to the balance of payments.

External liquidity risks remain heightened.

A large financing envelope that Moody’s considers to be secure remains elusive and the sovereign continues to rely on piecemeal funding such as swap lines and bilateral loans, although prospects for non-debt generating inflows have improved somewhat since Moody’s placed Sri Lanka’s rating under review for downgrade. Persistently wide fiscal deficits due to the government’s very narrow revenue base compound this challenge by keeping gross borrowing needs high and removing fiscal flexibility.

The stable outlook reflects Moody’s view that the pressures that Sri Lanka’s government faces are consistent with a Caa2 rating level. Downside risks to foreign exchange reserves adequacy remain without comprehensive financing and narrow funding options. Should foreign exchange inflows disappoint, default risk would rise further.

However, non-debt generating inflows particularly from tourism and foreign direct investment (FDI) may accelerate beyond Moody’s current expectations, which, coupled with the track record of the authorities to put together continued, albeit partial, financing, may support the government’s commitment and ability to repay its debt for some time.

Sri Lanka’s local and foreign currency country ceilings have been lowered to B2 and Caa2 from B1 and Caa1, respectively.

The three-notch gap between the local currency ceiling and the sovereign rating balances relatively predictable institutions and government actions against the very low foreign exchange reserves
adequacy that raises macroeconomic risks, as well as the challenging domestic political environment that weighs on policymaking.

The three-notch gap between the foreign currency ceiling and local currency ceiling takes into consideration the high level of external indebtedness and the risk of transfer and convertibility
restrictions being imposed given low foreign exchange reserves adequacy, with some capital flow
management measures already imposed.

RATINGS RATIONALE
RATIONALE FOR THE DOWNGRADE TO Caa2

Moody’s initiated a review for downgrade on Sri Lanka’s ratings to assess the prospects for significant external financing to materially and durably lower the risk of default stemming from the country’s very low foreign exchange reserves adequacy. Although the potential for non-debt generating inflows has increased somewhat in recent months, the improvement in tourism and FDI prospects is highly tentative.

At the same time, a large external financing envelope that Moody’s considers to be secure remains highly unlikely. In turn, external liquidity risks for Sri Lanka’s government will remain heightened over the coming years, raising the risk of default.

Sri Lanka’s foreign exchange reserves adequacy has fallen further since Moody’s initiated the review. Foreign exchange reserves (excluding gold and SDRs) amounted to $2 billion as of the end of September, compared to $3.6 billion as of the end of June and $5.2 billion at the beginning of the year. The reserves are sufficient to cover only around 1.3 months of imports and are significantly below the government’s external repayments of around $4-5 billion annually until at least 2025.

Moody’s baseline scenario continues to assume that the authorities will manage to obtain some foreign
exchange resources and financing through a combination of project-related multilateral financing, official sector bilateral assistance including central bank swaps, commercial bank loans, the divestment of state-owned assets, and measures by the Central Bank of Sri Lanka (CBSL) to capture some export receipts and remittances.

However, the amounts are generally modest, the arrangements piecemeal, and of relatively short
maturity besides multilateral funding for project loans.

Meanwhile, ongoing efforts under the authorities’ six-month roadmap to promote macroeconomic and financial stability will likely boost FDI somewhat, and the reopening of international borders without quarantine requirements for fully vaccinated travellers will support the gradual recovery of tourism-related receipts.

However, while Sri Lanka’s potential suggests that sizeable foreign exchange receipts could be generated, this potential has remained only partially realised for many years and realising it now is subject to the confidence and risk appetite of investors and travellers, both of which are highly uncertain.

Therefore, although reserves are likely to rise slightly over the next few months on the back of some of these inflows materialising, Moody’s expects them to remain insufficient to provide a buffer to meet the government’s external repayment needs.

Meanwhile, Moody’s assumes that Sri Lanka will not participate in a financing programme with the International Monetary Fund or other multilateral development partners for the foreseeable future, while international bond markets remain prohibitive as a source of external financing.

Heightened liquidity risks are compounded by Moody’s expectation that the government’s fiscal deficit will remain wide over the next few years, which will keep borrowing needs high and remove fiscal flexibility.

Although government revenue is likely to rebound alongside the economy — Moody’s projects real GDP will grow by an average of around 5% in 2022-23 — it will stay low in the absence of revenue reforms.

Moody’s estimates that revenue will remain around 10% of GDP over the next few years. At the same time, interest payments will continue to absorb around 60-70% of revenue, leaving the government with politically challenging tradeoffs in rationalising across social spending and development expenditure.

As such, Moody’s sees limited prospects for meaningful expenditure cuts, implying still wide fiscal deficits of 8.0-8.5% of GDP in 2022-23, compared to an average of 5.7% over 2016-19.

The wide deficits correspond to a gross borrowing requirement of around 25-27% of GDP per year over 2022- 23.

While Moody’s assumes that the government can continue to access local currency financing given the
size of the domestic savings pool and excess domestic liquidity in the banking system, this comes at a cost on the overall interest bill and does not address foreign-currency debt repayments.

RATIONALE FOR THE STABLE OUTLOOK

The stable outlook reflects Moody’s view that the pressures that Sri Lanka’s government faces are consistent with a Caa2 rating level.

The risk that foreign exchange reserves will continue to fall and increase the likelihood of default remains material, since the foreign exchange inflows available so far are generally piecemeal in the case of swaps and bilateral loans, and uncertain in the case of non-debt generating inflows.

That said, the authorities have a track record of securing some financing, even if only partial and at some cost, to support the government’s commitment and ability to repay its external debt.

Moreover, notwithstanding the significant uncertainty as discussed above, foreign direct investment and in particular tourism-related receipts have the potential to accelerate in an upside scenario and supplement the authorities’ ability to keep default at bay.

For tourism, the relatively high vaccination rate compared to emerging market and regional peers may support a quicker recovery in arrivals compared to Moody’s baseline assumptions. For foreign direct investment, the country’s status as a growing regional hub for transport and logistics as well as financial and technological services — helped by free trade agreements with large neighbouring countries such as India and Pakistan — may support long-term inflows, although as mentioned
above this potential has remained only partially realised for some time.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Sri Lanka’s ESG Credit Impact Score is highly negative (CIS-4), reflecting its highly negative exposure to environmental and social risks. Ongoing challenges to institutional and policy effectiveness and a very high debt burden constrain the government’s capacity to address ESG risks.

The exposure to environment risk is highly negative (E-4 issuer profile score). 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 almost 30% 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 is highly negative (S-4 issuer profile score). Balanced against Sri Lanka’s relatively good access to basic education, which has continued to improve throughout the country in the post-civil war period, are weaknesses in the provision of some basic services in more remote and rural areas, such as water, sanitation and housing. As the country’s population continues to grow, the government will face greaterconstraints in delivering high-quality social services and developing critical infrastructure amid ongoing fiscal pressures.

The influence of governance is highly negative (G-4 issuer profile score). While international surveys point to stronger governance in Sri Lanka relative to rating peers, including in judicial independence and control of corruption, institutional challenges are significant, particularly in the pace and effectiveness of reforms.

Domestic political developments also tend to weigh on fiscal and economic policymaking.

GDP per capita (PPP basis, US$): 13,223 (2020 Actual) (also known as Per Capita Income)

Real GDP growth (% change): -3.6% (2020 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 4.6% (2020 Actual)

Gen. Gov. Financial Balance/GDP: -11.1% (2020 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -1.3% (2020 Actual) (also known as External Balance)

External debt/GDP: 61.0% (2020 Actual)

Economic resiliency: ba2

Default history: No default events (on bonds or loans) have been recorded since 1983.

On 25 October 2021, 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 not materially changed.

The issuer’s fiscal or financial strength, including its debt profile, has not materially changed. The
issuer’s susceptibility to event risks has not materially changed.

FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS

The Caa2 rating takes into account a non-negligible probability of default. The rating would likely be upgraded if the risk of default were to diminish materially and durably.

This could stem from the government delivering a credible and secure medium-term external financing strategy that maintained a manageable cost of debt, and a faster and more sustained buildup in non-debt creating foreign exchange inflows.

Additionally, implementation of fiscal consolidation measures, particularly greater revenue mobilisation, that pointed to a material narrowing of fiscal deficits in the next few years and contributed to lower annual borrowing needs, would also be credit positive.

The rating would likely be downgraded if the prospects for foreign exchange inflows were to significantly weaken, resulting in a further deterioration in foreign exchange reserves adequacy and leading to a higher probability of default or greater risk of material losses should default occur than consistent with a Caa2 rating.

Additionally, a further rise in the government’s debt burden and weakening in debt affordability from already very weak levels that constrained its ability to finance itself domestically would also likely result in a downgrade of the rating.

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Sri Lanka stocks weaken for the second session on profit taking

ECONOMYNEXT – Sri Lanka’s stocks closed weaker on Tuesday for the second consecutive session mainly driven by month-end profit-taking by investors, according to brokers.

The main All Share Price Index (ASPI) closed down 0.56 percent or 51.81 points to 9,233.40.

The market has been on a downward trend since last week as investors are adopting a wait-and-see approach until more clarity is given regarding local debt restructuring after the International Monetary Fund approved the extended loan facility.

“The market is down as the selling trend continues,” said Ranjan Ranatunga of First Capital Holdings, speaking to EconomyNext.

“As there is a price decline in all shares across the board, combined with the month ending followed by margin calls, the market continued on a downward trend.”

The market generated a slow and thin turnover of 860 million rupees.

The main contributor to the turnover is Lanka IOC, following news that the Sri Lanka cabinet has granted approval for three oil companies from China, the United States, and Australia in collaboration with Shell Pl to lease 150 fuel stations for each company to operate in the local market.

The fears of debt restructuring mainly affected the banking and financial sectors, which dragged the index down for the day.

The market saw a net foreign inflow of 30.9 million rupees, and the total offshore inflows recorded so far in 2023 are 1.01 billion rupees.

The most liquid index, S&P SL20, closed 0.81 percent or 21.68 points down at 2,656.30.

The market saw a turnover of 860 million on Tuesday, below this year’s daily average of 1.8 billion rupees.

Top losers were Vallibel One, John Keells Holdings, and Hatton National Bank.

Analysts said the downward trend is expected to continue for the rest of the week as profit-taking is expected to continue. (Colombo/March28/2023)

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Sri Lanka rupee closes weaker at 325/328 to dollar, bond yields up

ECONOMYNEXT – Sri Lanka’s treasury bond yields were up at close on Tuesday and the rupee closed weaker in the spot market, dealers said.

A 01.07.2025 bond was quoted at 31.20/60 percent on Tuesday, up from 30.75/31.00 percent on Monday.

A 15.09.2027 bond was quoted at 28.25/29.00 percent, up from 28.10/60 percent from Monday.

Sri Lanka rupee opened at 325/328 against the US dollar steady, from 322/325 from a day earlier. (Colombo/ March28/2023)

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Sri Lanka Telecom on track rating upgrade track on planned stake sale: Fitch

ECONOMYNEXT – Sri Lanka Telecom has been place on watch for a possible rating upgrade after the government, which has defaulted on its sovereign debt said it will sell down its majority stake.

“The rating reflects the potential rating upside due to weakening linkages with SLT’s parent, the government of Sri Lanka (Long-Term Local-Currency Issuer Default Rating: CC), due to the government’s plan to sell its 49.5 percent stake in the company,” the rating agency said.

“Fitch will resolve the RWP when the proposed disposal becomes practically unconditional, which
may take more than six months.”

The agency said it expect SLT’s revenue growth to slow to a low single-digit percentage in 2023 amid weakening consumer spending due to consumers increasingly prioritising essential needs, such as food and medicine, as real income has fallen significantly following the currency depreciation and unprecedently high inflation.

The full statement is reproduced below;

Fitch Places Sri Lanka Telecom’s ‘A(lka)’ Rating on Watch Positive

Fitch Ratings – Colombo – 27 Mar 2023: Fitch Ratings has placed Sri Lanka Telecom PLC’s (SLT) National Long-Term Rating of ‘A(lka)’ on Rating Watch Positive (RWP).

The RWP reflects the potential rating upside due to weakening linkages with SLT’s parent, the government of Sri Lanka (Long-Term Local-Currency Issuer Default Rating: CC), due to the government’s plan to sell its 49.5% stake in the company. Fitch will resolve the RWP when the proposed disposal becomes practically unconditional, which may take more than six months.

SLT’s ratings are currently constrained by its parent’s weak credit profile under Fitch’s Parent and Subsidiary Linkage (PSL) Rating Criteria. SLT’s Standalone Credit Profile (SCP) is stronger than that of the state, reflecting the company’s market leadership in fixed-line services, second-largest share in mobile, ownership of an extensive optical fibre network and a strong financial profile. The extent of SLT’s rating upside, following the proposed disposal, will depend on the credit profile of its new parent, the linkage strength with SLT according to our PSL criteria, and the proposed funding structure.

KEY RATING DRIVERS

Disposal Plan: SLT announced on 20 March 2023 that the Sri Lankan cabinet has granted in-principle approval to sell the 49.5% stake in SLT held by the state. The disposal is part of a plan to restructure state-owned entities (SOEs) to improve the state’s financial position. SLT said steps have yet to be taken to identify potential buyers and it will take at least eight to 12 months to finalise the transaction. We believe the government will push through the disposal as SOE restructuring is an integral part of the IMF’s financial support to Sri Lanka.

Sovereign Ownership Pressures Rating: We assess the legal ring-fencing and access and control between SLT and the state as ‘Open’ under the PSL criteria, given the absence of regulatory or self-imposed ring-fencing of SLT’s cash flow and the government’s significant influence over the subsidiary’s operating and financial profile. SLT’s second- biggest shareholder, Malaysia-based Usaha Tegas Sdn Bhd with a 44.9% stake, has no special provisions in its shareholder agreement to dilute the government’s influence over SLT.

Higher Rating: However, the PSL criteria allows for a stronger subsidiary to be notched above the weaker parent’s consolidated profile in extreme situations, such as when a parent is in financial distress but the subsidiary continues to operate independently and its banking access appears unaffected. We do not believe SLT is at risk of default in the next 12 months, as it has sufficient liquidity and its debt does not carry cross-default clauses that can be triggered by the parent’s distress.

SLT’s ‘A(lka)’ rating therefore reflects its relativities with national peers, but is still below its SCP due to the drag from state ownership. We apply our PSL criteria because our Government-Related Entities (GRE) Rating Criteria states that in cases where the SCP of the GRE is higher than the government’s IDR, the relevant considerations of the PSL criteria will be applied to determine whether the IDR of the GRE is constrained or capped at the government’s rating level.

Weak Demand in 2023: We expect SLT’s revenue growth to slow to a low single-digit percentage in 2023 amid weakening consumer spending. Consumers are increasingly prioritising essential needs, such as food and medicine, as real income has fallen significantly following the currency depreciation and unprecedently high inflation. SLT’s subscriber numbers and minutes of usage have already fallen in 2022. Competition has also intensified, especially in the mobile segment, leading to lower realisation of recently introduced tariff hikes.

Weak demand should be offset to an extent by increased migration to SLT’s fibre-to-the- home (FTTH) network, from its own copper network, and subscriber additions. FTTH carries higher revenue per user than the copper network. SLT had 475,000 FTTH connections, a 35% increase yoy, by end-2022.

Weakening Profitability: We expect SLT’s EBITDA margin to narrow to around 34% in 2023 (2022: 35.6%) amid lower demand and ongoing cost escalations. All telecom operators increased tariffs by 20%-25% in late 2022 to tackle falling margins. However, the realisation into revenue remains weak, especially in the mobile segment, due to deep price cuts by one of the smaller operators and falling demand. SLT’s fixed-line business is able to maintain stable EBITDA margins due to the recent tariff hike and the FTTH segment’s higher revenue per user.

Leverage to Stabilise: We expect SLT’s EBITDA net leverage to remain around 1.3x in 2023 (2021: 0.9x, 2022: 1.3x) amid falling profitability. However, its leverage is strong for the rating. We expect capex of around LKR25.0 billion annually over 2023-2024 on network upgrades and expanding its fibre infrastructure.

Interest-Rate Hikes, Currency Depreciation Manageable: We expect SLT to maintain its EBITDA interest coverage closer to 4.0x over 2023-2024 (2022: 4.4x) despite interest rates rising almost threefold. Most of SLT’s debt is on variable interest rates, which will raise costs. SLT’s foreign-currency revenue, which accounts for 10%-12% of group revenue, is more than sufficient to meet the group’s foreign-currency operating expenses and interest costs. SLT had around USD10 million in foreign-currency debt at end-
December 2022, compared with USD40 million in foreign-currency cash deposits.

Sector Outlook Deteriorating: Fitch expects the average 2023 net debt/EBITDA ratio for SLT and mobile leader Dialog Axiata PLC (AAA(lka)/Stable) to remain around 1.3x (2022: 1.3x) amid weak margins and high capex. We expect sector revenue growth to slow to 8% in 2023 (2022: 15%), while the average 2023 EBITDA margin for SLT and Dialog should narrow to 31% (2022: 32%) amid low usage and high costs.

DERIVATION SUMMARY
SLT’s SCP benefits from market leadership in fixed-line services and the second-largest position in mobile, along with ownership of an extensive optical fibre network. SLT has lower exposure to the crowded mobile market and has more diverse service platforms than Dialog. However, Dialog has a larger revenue base, lower forecast EBITDA net leverage and a better free cash flow (FCF) profile than SLT. Dialog is rated at ‘AAA(lka)’, while SLT’s rating is under pressure because of the state’s weak credit profile.

SLT has a larger operating scale than leading alcoholic-beverage manufacturer Melstacorp PLC (AAA(lka)/Stable), which distributes spirits in Sri Lanka through its subsidiary, Distilleries Company of Sri Lanka PLC (AAA(lka)/Stable). Melstacorp is exposed to more regulatory risk in its spirits business because of increases in the excise tax, but this is counterbalanced by its entrenched market position and high entry barriers.

Consequently, the company can pass on cost inflation and maintain its operating EBITDA margin, supporting substantially stronger FCF generation than SLT.

KEY ASSUMPTIONS

Fitch’s Key Assumptions within Our Rating Case for the Issuer:

– Revenue growth to slow to 4% in 2023 amid falling subscriber numbers and lower usage due to weakening consumer spending;

– Operating EBITDA margin to narrow by 150bp to 34% in 2023 due to higher costs and lower volume;

– SLT to continue capex on expanding its fibre and 4G network with LKR25 billion spent annually in 2023 and 2024;

– Effective tax rate of 28% from 2023;

– Dividend payout of 33% of net income over 2024-2025

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

– Fitch will resolve the RWP when the proposed disposal becomes practically unconditional, which may take more than six months, and once Fitch has sufficient information on the new majority shareholder’s credit profile and linkages with SLT and the proposed funding structure.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

– Fitch would remove the RWP and affirm the National Long-Term Rating at ‘A(lka)’ with a Stable Outlook if the proposed disposal does not proceed and the linkages with the state remain intact.

LIQUIDITY AND DEBT STRUCTURE

Manageable Liquidity: SLT’s unrestricted cash balance of LKR14 billion at end- December 2022 was sufficient to redeem its contractual maturities of around LKR11 billion. SLT’s short-term working-capital debt amounted to another LKR10.0 billion and we expect the company to roll over the facilities given its solid access to local banks.

Liquidity is further enhanced by about LKR15 billion in undrawn bank credit facilities, although these are uncommitted. SLT typically does not pay commitment fees on its undrawn lines, although we believe most banks will allow the company to draw down the funds because of its healthy credit profile.

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