Sri Lanka rated firms less exposed to sovereign downgrade, Fitch explains how
ECONOMYNEXT – Sri Lanka’s companies are less exposed to government credit risk than and banks and insurance companies, and have had generally higher local ratings following a re-caliberation of the domestic scale in the wake of a sovereign downgrade.
Fitch downgraded Sri Lanka’s sovereign rating to ‘CCC’ as money printing triggered forex shortages and which was worsened by a tax cut.
“The performance of Fitch-rated corporates has remained robust despite the weak macroeconomic environment,” the rating agency said.
“Even during the ongoing pandemic, almost all rated corporates have performed better than our expectations, with earnings of most reaching pre-pandemic levels by the quarter ending September 2020.
“A sovereign default can be significantly more disruptive to the domestic economy and funding markets than the impact of the sovereign downgrades seen over the last few years.”
In a Q and A Fitch has answered frequent questions raised.
Scale Recalibrated on Sovereign Downgrade
The recalibration of Fitch Ratings’ Sri Lankan National Rating scale following the downgrade of the Sri Lanka sovereign rating to ‘CCC’ from ‘B-’ on 27 November 2020 has resulted in the National Ratings of most corporates being grouped at the upper end of the rating scale. The revised relationship between international and national scale ratings is shown in the table on the left.
This reflects our view that most rated corporates are less vulnerable to any sovereign financial distress than most financial institutions. Top corporates have strong business profiles, low leverage and sound liquidity that underpin our view. They have limited exposure to the government compared with financial institutions, unless linked directly or indirectly to the sovereign.
Sri Lanka’s national scale ratings are denoted by the unique identifier ‘(lka)’. National scales are not comparable with Fitch’s international ratings scales or with other jurisdictions’ national rating scales.
Sri Lanka Telecom PLC (AA-(lka)/Stable) and Ceylon Electricity Board (AA-(lka)/Stable), whose ratings are driven by the sovereign, are now at the highest point on the national scale that corresponds to an international scale rating of ‘CCC’. The National Ratings of other corporates, while influenced by the macroeconomic environment, are not constrained by the sovereign rating.
The following are some recent questions from investors about the recalibration and impact on corporate ratings in Sri Lanka:
What Investors Want to Know: Impact of Sri Lanka National Scale Recalibration on Corporate Ratings
Corporates with Strong Business Models and Solid Liquidity Less Vulnerable to a Sovereign Default than Financial Institutions
Why did Fitch Recalibrate the National Rating Scale?
Fitch recalibrates National Rating Correspondence Tables to limit rating movements in the national scale that result from systemic factors. For instance, a sovereign rating change could drive multiple international rating changes, which would affect a large number of issuers on the national scale if a reassessment of the rating relationship between international and national ratings is not undertaken.
As per Fitch’s National Scale Rating Criteria, the starting point to derive a National Long-Term Rating (NLTR) is a local currency international scale rating or Issuer Default Rating (IDR), which reflects an issuer’s ability to repay local-currency obligations.
Upon the sovereign rating downgrade, Fitch re-assessed the Local-Currency IDRs of local corporates in line with its criteria. IDRs of corporates that are directly linked to the sovereign were lowered to reflect the revised sovereign rating (as per our Government Related Entities Rating Criteria). For others, any changes reflected changes to the trading performance, forecast cash generation and liquidity following the downgrade of the sovereign rating.
The agency then recalibrated the national rating scale to best reflect the relative credit strength between local corporates, banks and non-bank financial institutions, and insurance companies, keeping the ‘AAA(lka)’ reference point at ‘B-‘ on the international rating scale in line with the National Rating Criteria.
Are Some Corporates Less Vulnerable to a Sovereign Default than Banks?
Corporates’ credit profiles are impacted by the wider, non-sector specific context in which it operates. However, corporates with strong business risk profiles, low leverage, and the ability to continue to access domestic banks and other funding channels following a sovereign default are less vulnerable, although not immune, to a post-default environment than banks.
The impact of a recessionary environment on a corporate’s cash generation, including impact of changes in currency-exchange rates, are factored into our financial forecasts that are used in determining corporate ratings. Liquidity is a key component of corporate rating analysis; international scale credit assessments of issuers with weak business profiles and/or high short-term debt maturity profiles which could be easily starved of liquidity during a sovereign financial distress will be assessed at the lower-end of the rating scale.
Conversely, bank ratings are usually constrained by the sovereign rating, due mainly to the strong correlation between sovereign and bank credit profiles. This is because banks typically have high exposure to the government, the wider domestic economy and local financial markets.
In a stressed environment that follows a sovereign default in particular, we believe stronger corporates with sufficient on-balance sheet liquidity can weather some period of financial market stress, although accessibility to external capital may be limited (but not completely shut out), and may come at a high cost.
A corporate’s ability to repay its foreign-currency obligations is nevertheless subject to the transfer- and convertibility risk (T&C risk) of a country. T&C risk, which is closely related to sovereign ratings, captures the risk of imposition of exchange controls that would prevent or materially impede an issuer’s ability to convert local currency for the repayment of foreign-currency obligations. As such, most corporates’ foreign-currency international ratings are constrained by the Country Ceiling, which for Sri Lanka is level with its IDR at ‘CCC’.
T&C considerations therefore apply only to foreign-currency ratings and may not directly be relevant for national ratings assessments. However, the inability to service debt or if operations of a corporate are severely affected by T&C restrictions imposed by a sovereign, could have an impact on its local-currency ratings, and therefore its National ratings as well.
What are Key Credit Drivers of Top-Rated Corporates?
Most Fitch-rated corporates at AA(lka) or above benefit from strong business models, and should therefore continue to be able to access local bank funding following a sovereign default.
Corporates rated ‘AA(lka)’ or higher benefit from leading market positions in their respective industries. In addition, issuers rated higher at ‘AA+(lka)’ and ‘AAA(lka)’ benefit from more ‘defensive’ demand for their products and services – such as telcos, pharmaceuticals, grocery retail, alcoholic beverages – or operate in protected industries with high entry barriers such as local crude palm oil producers. Demand for these goods and services are more resilient to a recessionary environment.
Furthermore, corporates rated ‘AA+(lka)’ and ‘AAA(lka)’ have low leverage and solid liquidity, which act as buffers against a prolonged deterioration in operating cash flows in the event revenues fall.
Some issuers benefit from a degree of support from stronger shareholders based overseas, which is not affected by challenges in the domestic economic environment.
How is the Macroeconomic Environment Factored Into Corporate Ratings?
Fitch evaluates the risks of rated entities and structures under a variety of scenarios to ensure rating stability. The ratings-case and stress-case forecasts help to determine the amount of headroom in a company’s credit ratings, and inform the appropriateness of a rating change or change in rating Outlook.
Scenarios are developed based on the potential risks an issuer may encounter through both ratings and stress cases. Financial projections are based on the issuer’s current and historical operating and financial performance, its strategic orientation and analysis of wider industry trends. The macroeconomic backdrop for the ratings case may be supported by Fitch’s latest Global Economic Outlook commentary and forecasts
How is the Operating Environment Incorporated into Corporate Ratings?
In assessing corporate ratings, Fitch takes into consideration country risk in the form of operating environment (OE) and transfer and convertibility (T&C) risk. Our OE assessment captures Fitch’s view of a particular country’s economic environment and financial market development, and World Bank scores for systemic governance.
T&C risk, which is closely related to sovereign ratings, captures the risk of imposition of exchange controls that would prevent or significantly impede the private sector’s ability to convert local currency for the repayment of foreign-currency obligations. T&C considerations therefore only apply to foreign-currency ratings, and are not relevant in national ratings assignment.
The OE reflects the wider context in which the rated issuer operates, irrespective of its sector. In emerging markets especially, the OE can result in a lower rating profile depending on the level of challenge posed by that environment. The OE is a blend of Fitch’s assessment of the Economic Environment, Financial Access, and Systemic Governance of the issuer and the major jurisdictions in which the issuer operates.
The latest published OE sub-factor scores for Sri Lanka are Economic Environment (bb), Financial Market Development (b), and Systemic Governance (bbb).
Fitch holds the OE to be an asymmetric consideration. Companies can both succeed and fail in the most hospitable environments, rendering that environment a neutral consideration, but a higher-risk environment can actively constrain a company’s potential.
An OE score of ‘b+’ would be a drag if a corporate’s intrinsic IDRs were in the ‘BB’ category or above. A ‘b’ or ‘b-‘ OE could also be a drag for ratings in the high ‘B’ category, but an OE score by itself does not drag corporate ratings down to the ‘CCC’ category or below.
Why are Most Sri Lankan Corporates Not Rated ‘CCC’ or Below on the International Scale?
Liquidity and refinancing risk of a corporate issuer become key differentiators between corporate IDRs in the lower ‘B’ category versus those in the ‘CCC’ category and below (i.e. ‘CCC+’, ‘CCC’, ‘CCC-’, and ‘CC’). Within the ‘CCC’ category (international scale rating definition: substantial credit risk, a default is a real possibility), a case of deteriorating liquidity buffers and high degree of refinancing risk may be reflected by ‘CCC+’ IDRs; and if the assessed default risk is greater, then corporates would be assessed at lower levels in the ‘CCC’ category, or even at ‘CC’ (international rating definition: very high levels of credit risk – a default of some kind appears probable).
Sierra Cables PLC (AA-(lka)/Stable) is the lowest publicly rated Sri Lankan corporate issuer. Its debt is mostly working capital-related and will be self-unwinding in the event its sales fall, given its tory coverage of total working-capital debt was around 150% at end-December 2020. Sierra has LKR82 million of term loans due in the 12 months from end-2020, and we estimate that its funds from operations (FFO) will be sufficient to meet its repayments.
Sierra has also shown adequate access to local bank debt in the last six months notwithstanding the onset of the Covid-19-led downturn. Its rating is constrained by its small operating scale and the susceptibility of its operating cash flows to business cycles, as demand stems mainly from infrastructure projects.
Issuers rated at ‘AA(lka)’ such as DSI Samson Group Limited, Abans PLC and Singer (Sri Lanka) PLC have more comfortable liquidity positions than Sierra. Their ratings also benefit from stronger business profiles as they are market leaders in their respective industries. Consequently, we expect these ‘AA(lka)’ rated issuers to be well-banked in a local context.
Furthermore, none of the Fitch-rated local corporates have cross-border debt issuance which is more susceptible to capital-market disruptions in the event of a sovereign default.
Why are Sri Lankan Corporates now Rated at ‘AA-(lka)’ or Above on the National Scale?
As per the new national ratings correspondence table published on 22 December 2021, a local-currency international rating of ‘CCC+’ and above now maps to ‘AA-(lka)’ and above on the national scale, while the upper-bound of ‘CCC’ IDRs also corresponds to ‘AA-(lka)’.
Corporates whose credit profiles are driven by the sovereign, such as Ceylon Electricity Board, and those which are constrained by sovereign ownership such as Sri Lanka Telecom, have ratings at ‘AA-(lka)’ – the highest level corresponding to a ‘CCC’ IDR.
As a result, the majority of Sri Lankan corporates’ ratings have been revised to ‘AA-(lka)’ or above to reflect the latest relationship between international and national scale ratings.
If a particular corporate’s international rating corresponds to more than one notch on the national scale, for example ‘B-’ maps to ‘AAA(lka)’ to ‘AA(lka)’, such a corporate will be rated on the national scale based on how its credit profile compares with other local peers.
How Have Corporates Performed Amid Multiple Sovereign Downgrades in the Past?
Sri Lanka’s sovereign rating has been downgraded by five notches since early 2016, owing primarily to its weak external finances. Over this same period, the country’s GDP growth weakened to the low-single digits from the mid-single digits.
The performance of Fitch-rated corporates has remained robust despite the weak macroeconomic environment. The revenue of Fitch-rated corporates has grown at a CAGR of around 10% over 2016-2020 compared with an annual average inflation of around 4.8%. EBITDA has risen at a CAGR of 13% over the same period, resulting in improved profitability. At the same time, most Fitch-rated corporates’ balance sheets have strengthened, with leverage – defined as net adjusted debt / operating EBITDAR – improving.
Even during the ongoing pandemic, almost all rated corporates have performed better than our expectations, with earnings of most reaching pre-pandemic levels by the quarter ending September 2020.
A sovereign default can be significantly more disruptive to the domestic economy and funding markets than the impact of the sovereign downgrades seen over the last few years. The national rating assessments and the relativities reflect their relative ability to perform and service debt obligations. Should the operating environment or funding conditions deteriorate significantly, the international -scale credit assessments would be changed to reflect any increase in credit risk, and national ratings adjusted in line with our criteria.