Going against the rising tide of rating agencies

  • On whom do market participants rely?

By Naomi Wickremarathna

Once again, an international rating agency has decided to put Sri Lanka’s foreign currency long-term issuer and senior unsecured debt ratings under review for downgrade, and also once again, the rating agency has been slammed by the Ministry of Finance for their decision to review Sri Lanka for downgrade.

Early last week, Moody’s Investors Service announced the decision, noting that the decision to place the ratings under review for downgrade is driven by Moody’s assessment that Sri Lanka’s increasingly fragile external liquidity position raises the risk of default.

“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,” the statement added.

The rating would likely be downgraded in a status quo scenario where the financing of Sri Lanka’s large external debt repayments remained uncertain while foreign exchange reserves adequacy still looked likely to continue deteriorating.

According to Moody’s, although the Government has secured some financing, mainly from bilateral sources, its financing options remain narrow with borrowing costs in international markets still prohibitive. Absent of large and sustained capital inflows through a credible external financing strategy, Moody’s expects Sri Lanka’s foreign exchange reserves to continue declining from already low levels, further eroding its ability to meet sizable and recurring external debt servicing needs, and increasing balance of payment risks.

“Extremely weak debt affordability – with interest payments absorbing a very large share of the Government’s very narrow revenue base – compounds the debt repayment challenge,” it said.

The rating review is said to focus on assessing whether the sovereign can use a period provided by its current foreign exchange reserves and bilateral arrangements to implement measures that widen and increase its financing sources for the medium term, and thereby avoid default for the foreseeable future.

Sri Lanka’s foreign currency country ceiling has been lowered to Caa1 from B3, while the local currency country ceiling remains unchanged at B1. The three-notch gap between the local currency ceiling and the sovereign rating balances relatively predictable institutions and government actions against the low and declining foreign exchange reserves adequacy that raises macroeconomic risks as well as the challenging domestic political environment that weighs on policy-making. 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. These ceilings typically act as a cap on the ratings that can be assigned to the obligations of other entities domiciled in the country.

Meanwhile, Moody’s expects the coverage by foreign exchange reserves of external repayments to continue falling from already low levels. As of the end of June, Sri Lanka’s foreign exchange reserves (which in Moody’s definition exclude gold and special drawing rights) amounted to just around $ 3.6 billion, down 30% since the start of the year and insufficient to cover the Government’s annual external debt repayments of around $ 4-5 billion alone over the next four to five years. Taking into account plausible projections for the balance of payments, the country’s foreign exchange reserves will fall further over the next two to three years, unless Sri Lanka manages to markedly raise capital inflows.

Moody’s baseline scenario assumes that the Government and the Central Bank of Sri Lanka (CBSL) will continue to secure some foreign exchange resources and financing support through a combination of project-related multilateral loans as well as official sector bilateral assistance including central bank swaps, commercial bank loans, and the divestment of some state-owned assets – albeit at a relatively slow pace.

Meanwhile, Sri Lanka’s current account deficit is likely to remain stable and relatively narrow compared to peers at around 1-2% of GDP over the next few years, with the gradual recovery of the tourism sector partly hampered by the ongoing wave of infections and border restrictions. Foreign direct investment (FDI) has the potential to pick up with the development of the Colombo Port City and the Government’s privatisation plans, although amounts are likely to increase only gradually over time.

By contrast, Moody’s does not assume that the Government will enter into programme-based financing facilities with multilateral development partners at this stage, which significantly narrows its external financing options. Furthermore, while the Government has historically relied on international market access to finance its fiscal deficits and external repayment needs, borrowing costs remain prohibitive with Sri Lanka’s government bond spreads to US Treasuries still very wide at more than 1,600 basis points, compared to around 500 basis points before the onset of the coronavirus pandemic.

The decision to place Sri Lanka’s ratings on review for downgrade is prompted by Moody’s assessment that the acute tightening in global financing conditions, fall in export revenue, and sharp slowdown in GDP growth as a result of the global coronavirus outbreak exacerbate Sri Lanka’s existing government liquidity and external vulnerability risks, raising risks of heightened financing stress and macroeconomic instability.

However, a few hours after Moody’s made this announcement, the Ministry of Finance, disagreeing with the rationale behind the international rating agency’s decision, issued a press release, expressing dismay at the announcement made by Moody’s Investors Service on  Monday (19), as it has placed Sri Lanka’s rating as “under review for downgrade” in spite of the financial measurements already taken by the Government of Sri Lanka.

The Ministry said that the actions of Moody’s could possibly create an uncertainty among the investors who have faith in Sri Lanka’s in-store banks and other investments, indicating that Sri Lanka would lose the existing investors due to the impact of the statement made by Moody’s.

The statement further said that the Sri Lankan Government has lined up funds to repay its foreign debt liabilities and that includes the international sovereign bonds (ISB) as well.

Meanwhile, it is quite important to note here a statement made by Harvard University Centre for International Development Director of Growth Lab Prof. Ricardo Hausmann in a webinar held last year on Sri Lanka’s economy.

In the case of Sri Lanka, there is pretty much no difference between the opinion of a rating agency and market participants, according to Prof. Hausmann. If the rating agencies are signalling that with these interest rates, Sri Lanka cannot access the market, it actually means the country cannot rollover the debt voluntarily.

“As a result, the country will have to hold onto maturing debt with no market access. Right now, you have reserves but you can see the path to dwindling of your reserves. But these reserves are used to paying for imports and not just debt servicing,” he added.

When reserves are dwindled and markets are not choosing the country to lend or invest money, the country heads towards a severe economic issue where even the rest of the reserves would be drained. If there is no external support; the time period that would be taken for the rest of the reserve would be faster than it used to be.

Prof. Hausmann firmly stated that distinction by rating agencies is really about what the market thinks about Sri Lanka, and not about whether the Ministry of Finance and the market believe in the credit rating agency or not. Instead of shooting back at rating agencies, maybe it is time Sri Lanka take measures to address the issues pointed by Moody’s.

On 28 September, Moody’s Investors Service downgraded the Sri Lankan Government’s long-term foreign currency issuer and senior unsecured ratings to Caa1 from B2 and changed the outlook to “Stable”. This concluded the review for downgrade initiated on 17 April 2020.

The decision to downgrade Sri Lanka’s rating to Caa1 reflects Moody’s assessment that the coronavirus-induced shock, which Moody’s regard as a social risk, will significantly weaken Sri Lanka’s already fragile funding and external positions.

“Heightened liquidity and external risks stem from Sri Lanka’s limited secured funding sources to meet its material external debt service payments over the coming years, during which period market refinancing will remain vulnerable to shifts in investor sentiment. At the same time, fiscal and external pressures will continue to limit the scope for reforms to address long-standing credit vulnerabilities, denoting weakening institutions and governance, an important driver of today’s rating action,” Moody’s stated.

Two days following the rating, the CBSL issued a statement stating that Moody’s rating downgrade fails to recognise and do justice to the ground reality of the ongoing rapid economic recovery backed by vastly improved business confidence arising from the return of political and policy stability after a lapse of five years.

“Sri Lanka, like many of its peers in the emerging market group, experienced initial capital outflows, exchange rate depreciation, slowdown in activity, and pressure on government finances in response to the effects of the Covid-19 pandemic. But the swiftness with which decisions were taken following the landslide victory of the Government enabled Sri Lanka to move along a recovery path towards growth and stability,” the Central Bank noted.