ECONOMYNEXT – Standard and Poor’s, a rating agency, has confirmed a selective default (SD) rating on foreign currency debt, and said the outlook on rupee debt rated at CCC- will remain negative.

“The negative outlook on the long-term local currency rating reflects a high risk to commercial debt repayments over the next six months in the context of Sri Lanka’s economic, external, and fiscal pressures,” the rating agency said.

“We could lower the long-term local currency ratings on Sri Lanka if there are indications of nonpayment or restructuring of Sri Lankan rupee-denominated obligations.”

“We could revise the outlook to stable or raise the long-term local currency sovereign credit ratings if we perceive that the likelihood of the government’s local currency debt being excluded from any debt restructuring has increased.

“This could be the case if, for example, the government’s fiscal sustainability metrics improve much more quickly than we expect.”

The full statement is reproduced below:

Sri Lanka Ratings Affirmed; Outlook On Local Currency Rating Remains Negative

Overview

• Sri Lanka will likely have another year of economic contraction in 2023, coinciding with extremely challenging fiscal conditions for the government and substantial external vulnerabilities.

• Nevertheless, conditions in the country are beginning to stabilize. The establishment of a new IMF Extended Funding Facility (EFF) program in March 2023 is an important step toward reform and recovery over the next three to four years.

• We affirmed our long-term and short-term foreign currency sovereign credit ratings on Sri Lanka at ‘SD/SD’ (selective default). At the same time, we affirmed our ‘CCC-/C’ local currency sovereign ratings on Sri Lanka.

• The negative outlook on our ‘CCC-‘ long-term local currency sovereign credit rating on Sri Lanka reflects the high risk that the government could restructure its local currency debt to restore the sustainability of its fiscal settings.

Rating Action

On April 26, 2023, S&P Global Ratings affirmed its long-term and short-term foreign currency sovereign credit ratings on Sri Lanka at ‘SD/SD’. At the same time, we affirmed our ‘CCC-‘ long-term and ‘C’ short-term local currency sovereign ratings. The outlook on the long-term local currency rating remains negative.

We also retained our transfer and convertibility assessment at ‘CC’.

Outlook

Our long-term foreign currency rating on Sri Lanka is ‘SD’ (selective default). We do not assign outlooks to ‘SD’ ratings because they express a condition and not a forward-looking opinion of default probability.

The negative outlook on the long-term local currency rating reflects a high risk to commercial debt repayments over the next six months in the context of Sri Lanka’s economic, external, and fiscal pressures.

Downside scenario

We could lower the long-term local currency ratings on Sri Lanka if there are indications of nonpayment or restructuring of Sri Lankan rupee-denominated obligations.

Upside scenario

We could revise the outlook to stable or raise the long-term local currency sovereign credit ratings if we perceive that the likelihood of the government’s local currency debt being excluded from any debt restructuring has increased. This could be the case if, for example, the government’s fiscal sustainability metrics improve much more quickly than we expect.

We could raise our long-term foreign currency sovereign credit rating upon completion of the government’s bond restructuring. The rating would reflect Sri Lanka’s creditworthiness post-restructuring.
Our post-restructuring ratings tend to be in the ‘CCC’ or low ‘B’ categories, depending on the sovereign’s new debt structure and capacity to support that debt.

Rationale

Our ratings on Sri Lanka reflect the government’s continued non-service of its international sovereign bonds (ISBs), as well as deep underlying fiscal, economic, and external weaknesses.

The Sri Lankan government is in comprehensive negotiations to restructure its foreign currency obligations. Once an agreement is made, and timely service of all commercial foreign currency obligations resumes, we may raise the foreign currency ratings on Sri Lanka to reflect the sovereign’s underlying creditworthiness.

Sri Lanka has endured an extended period of extremely challenging macroeconomic conditions, including a severe deterioration in public finances, economic growth, and external liquidity. These conditions are beginning to stabilize, but we anticipate that a meaningful recovery will only begin after 2023.
Institutional and economic profile: Economy to contract again in 2023, but at a more moderate pace

• The Sri Lankan economy will contract by about 1.8% this year, compared with a 7.8% contraction in 2022, as activity gradually stabilizes.

• We forecast real GDP will return to expansion in 2024, at a growth rate of 1.5%.

• The government’s EFF agreement with the IMF sets the stage for major policy reforms over the next three to four years. If implemented, these reforms would help to restore Sri Lanka’s growth potential.

Sri Lanka’s economic collapse in 2022 will leave lasting scars on the economy, resulting in slow growth over the next few years. The Sri Lankan economy contracted by 7.8% in 2022, reflecting the effects of widespread political and social disturbances amid shortages of critical imported goods.

These conditions have improved somewhat following the formation of a new government on the heels of the resignation of former President Gotabaya Rajapaksa, and the adoption of emergency measures to ease goods shortages.

However, consumption and investment sentiment and activity will remain depressed this year in the wake of such severe disruptions. A gradual expansion of activity is likely to return from 2024 onward. This will coincide with greater recovery traction for key sectors including tourism and manufacturing.

Sri Lanka has progressively introduced widespread import restrictions over the past three years. These have contributed to a rapid reduction in the country’s current account deficit but have also weighed on economic activity. Officials have stated that these restrictions may be gradually rescinded as the country’s foreign exchange reserves improve.

We forecast the pace of Sri Lanka’s economic contraction will ease to 1.8% this year, before real GDP growth returns at a rate of 1.5% in 2024. Sri Lanka’s nominal GDP per capita has suffered a deep decline owing to both the real economic contraction and a much weaker rupee exchange rate versus the dollar. We expect GDP per capita to fall to just above US$3,200 in 2023, versus more than US$4,000 in 2021, before returning to growth over the subsequent years.

Sri Lanka’s real GDP per capita growth on a 10-year weighted average is -0.9%, still well below the median of its peers at a similar level of income. This reflects primarily the very weak economic performance over recent years, as well as modest growth prospects during the recovery period beyond 2023.

Sri Lanka’s political settings saw significant upheaval in 2022, prior to the appointment of veteran lawmaker Ranil Wickremesinghe as president. The steadier political environment since mid-2022 has allowed the government to complete comprehensive negotiations with the IMF, culminating in the introduction of a sweeping, four-year EFF program in March 2023.

The program introduces an ambitious agenda of policy reforms. These include various new government revenue schemes, restructuring of state-owned enterprises (SOEs), a revised Banking Act, a revamped value-added tax (VAT) system, and quantitative targets aimed at reducing fiscal deficits and boosting foreign exchange reserves. Likewise, the Sri Lankan government will need to restructure its foreign currency debt obligations to meet sustainability requirements that will support continued borrowing from the Fund.

Sri Lanka’s current political settings are characterized by a minority ruling coalition, though policymakers have over the past 12 months shown a greater willingness to agree to difficult economic and fiscal reforms. Political commitment to ongoing reforms will be a critical variable in keeping the IMF reform program on track over the coming years, and in fostering the still nascent economic recovery.
Flexibility and performance profile: Long road to recovery as Sri Lanka emerges from fiscal and external crises

• Sri Lanka’s external profile has stabilized from deep crisis levels in 2022. Resources will remain limited for the next one to two years as thin reserve buffers are gradually rebuilt.

• Sri Lanka’s public finances remain extremely weak. The adoption of revenue reforms, expenditure controls, and faster nominal GDP growth will be necessary to significantly curtail the government’s large fiscal shortfall.

• The government’s interest burden and debt stock remain unsustainable. Improvement in these will be partially dependent on the depth and breadth of debt restructuring agreements.

Sri Lanka’s external position is emerging from deep crisis levels in 2022. The first tranche of IMF funds released in March 2023, along with the government’s external debt moratorium and significant import compression, have re-established a modest quantum of usable foreign exchange reserves available at the central bank. We estimate usable reserves to be about US$1.2 billion as of end-March 2023. This compares with a reported value of less than US$100 million during the second quarter of 2022.

With the IMF program now in place, Sri Lanka is more likely to secure additional funding from other multilateral partners, even as it seeks restructuring agreements on existing credit facilities from bilateral creditors.

Sri Lanka’s current account deficit fell markedly in 2022 to less than 2% of GDP, versus a shortfall of 3.7% in 2021. We anticipate Sri Lanka will gradually grow its stock of foreign exchange reserves over the next few years, supported by additional borrowing and a lower current account deficit. The restructuring of foreign currency-denominated debt will contribute to Sri Lanka’s more manageable current account deficit through lower interest payments.

Sri Lanka is unlikely to return to international capital markets in the near future. Without access to foreign funding, the government has relied completely on local currency financing.

We forecast Sri Lanka’s gross external financing needs as a percentage of current account receipts plus usable reserves will average about 137% over 2023-2026. Further, Sri Lanka’s narrow net external debt (net of official reserves and financial sector external assets) will likely remain elevated at about 159% of current account receipts over the same period.

Persistently high fiscal deficits in Sri Lanka will be a key target of officials’ reform agenda. Sri Lanka’s interest burden, measured by the ratio of its total interest service costs to general government revenues, is the highest of all rated sovereigns. The government’s ability to strengthen its revenue generation capacity, and the extent of its debt restructuring agreements, will in large part determine the pace of improvement in this metric over the next few years.

Sri Lanka’s 2023 budget includes an ambitious goal to increase revenue to 15% of GDP. Policies that will support this target, some of which were introduced earlier in 2022, include VAT and personal income tax recalibrations, the introduction of additional non tax fees and charges, an increase in fuel excise tax, and the strengthening of tax administration measures. Taken together, these will boost revenue generation; however, more sweeping reforms will likely be required to hit the government’s target.

The Sri Lankan government is negotiating terms for a sweeping restructure of its foreign law foreign currency obligations. It could also amend the terms of its local currency obligations. Restructuring of both types of debt will likely be necessary to significantly reduce debt servicing needs.

Sri Lanka’s local currency debt obligations, which we estimate at about 55% of its total debt stock, now account for the majority of its interest payments. This follows a surge in rupee borrowings over the past year. Our local currency issuer credit ratings on Sri Lanka reflect a continued high risk that the government will adopt changes to the terms of its local currency obligations, potentially by lengthening the maturity of outstanding bonds.

Sri Lankan officials have discussed the possibility of a restructure of government obligations owned by the central bank, as well as a voluntary change of terms to be negotiated with some private sector bondholders.

The government is also engaged in negotiations to manage its considerable obligations to bilateral creditors; we estimate such obligations to be about US$10.6 billion at present. Roughly 80% of this debt is owed to three countries: China, Japan, and India. Our issuer credit ratings are assessments of default risk on commercial debt, rather than on concessional debt contracted from multilateral or bilateral lenders.

The Sri Lankan government is heavily reliant on local currency financing following its foreign currency crisis. Meanwhile, domestic interest rates have risen aggressively alongside extremely high inflation and tighter monetary conditions, driving up the government’s debt service cost. The government’s ability to refinance or restructure these obligations at lower rates of interest, in the absence of central bank purchases, will be a key determinant of its ability to reestablish debt sustainability over the next three to five years.

The Central Bank of Sri Lanka (CBSL) has hiked its standing deposit and lending facility rates by a cumulative 1,050 basis points (bps) since the beginning of 2022. This is an attempt to arrest the rapid depreciation of the Sri Lankan rupee and a record surge in inflation. National consumer price index inflation peaked at 73.7% year on year in September 2022, and has since retreated to 49.2% as of March 2023.

We see inflation running well above trend again this year, though full-year price growth will fall markedly, from 59.2% to about 15%. Some stability in commodity prices, as well as a modest strengthening of the rupee following its collapse in 2022 will help normalization of inflation.

Following severe depreciation and exceptional volatility in 2022, the Sri Lankan rupee is likely to stabilize somewhat over the next 12-24 months, with some bias toward further weakening from current levels.

We assess the government’s contingent liabilities from the financial system as moderate. We also note that Sri Lankan banks have purchased substantial quantities of government debt, with aggregate exposure significantly higher than 20% of system assets. The government is also in the early stages of restructuring key SOEs, in collaboration with the IMF reform program.

Sri Lanka’s monetary settings remain a credit weakness, though work toward an updated Monetary Law Act has resumed now that a new EFF program is in place. If adopted into law, the Act could help to enshrine greater autonomy for the CBSL, which would support more credible and effective monetary policy.