Annual Credit Analysis by Moody’s Investor Services: SL External Debt Servicing for 2020-25 US$25.8B
The US-based Moody’s Investors Services released its latest Economic Analysis Report on Sri Lanka on 26 October
The following are two excerpts from the report:
Overview and outlook
The credit profile of Sri Lanka reflects ongoing government liquidity and external risks, which will be exacerbated by the impact of the coronavirus pandemic.
Key credit challenges include large borrowing requirements with high reliance on external funding and low foreign exchange reserve coverage of forthcoming economy-wide external debt maturities, all set against the government’s very fragile fiscal position.
A volatile domestic political environment can also heighten refinancing risks. Moderate income levels and stronger institutions compared with many peers mitigate these challenges.
The stable outlook denotes balanced credit risks at the Caa1 rating level. On the downside, Sri Lanka’s very large and recurring financing needs over the near to medium-term could put more pressure on the sovereign’s external and liquidity position than we currently expect. On the upside, Sri Lanka’s rating is supported by the country’s relatively high per-capita income and modest economic competitiveness, which provide some prospects for growth to recover robustly. Moderate institutions and governance strength also provides some support compared with similarly rated peers.
We would upgrade Sri Lanka’s rating if financing risks diminished materially and durably. This could stem from the government delivering a credible and secure medium-term financing strategy that maintained a manageable cost of debt and a faster, 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 be positive for Sri Lanka’s rating.
We would be likely to downgrade the rating if external and domestic financing conditions deteriorated to a greater extent than our baseline expectations, contributing to higher repayment stress more consistent with a lower rating.
Additionally, should the probability that Sri Lanka’s government debt will continue to rise markedly beyond our baseline expectations increase, with a related further deterioration in debt affordability, this could also result in a downgrade of the rating.
This credit analysis elaborates on Sri Lanka’s credit profile in terms of economic strength, institutions, governance strength, fiscal strength and susceptibility to event risk, which are the four main analytic factors in our Sovereign Ratings Methodology.
External Sector Risks
We (Moody’s) estimate that government gross borrowing requirements, incorporating projections on fiscal deficits and maturing government debt repayments, will reach about 24% of GDP in 2020 and remain elevated above 20% of GDP through 2022.
While large external debt repayments are a key source of liquidity pressure, a significant portion of annual gross borrowing needs are to roll over the large stock of domestic treasury bills. Short-term debt has increased to around 24% of overall domestic debt and 13% of total outstanding government debt as of June 2020. We estimate domestic debt repayments will average around 16% of GDP over 2020-22.
On the external side, Sri Lanka’s gross external financing needs are large, mostly reflecting maturing government debt repayments (international bonds, bilateral and multilateral loans and concessional debt).
The government’s external debt servicing payments will be about US$4 billion-US$4.5 billion annually over 2020-25, or around US$25.8 billion in total. This includes upcoming international sovereign bond payments of US$1 billion in July 2021, US$500 million in January 2022 and US$1 billion in July 2022. The CBSL settled October 2020’s US$1billion maturity on the government’s behalf, with the central bank conducting OMOs to maintain surplus liquidity and increasing holdings of government debt to prevent a spike in overnight money market rates.
Total external debt servicing obligations do not account for any further external financing of the budget deficit in coming years. Dollar international sovereign bonds account for US$8.4 billion, or about 30%, of all maturing external government debt service payments over 2020-25 (see Graph 1).
At these levels, Sri Lanka’s bond maturities are among the highest of rated frontier market sovereigns as a proportion of foreign exchange reserves. The low reserves highlight the government’s significant exposure to refinancing risk. The government has sought multilateral and bilateral sources for external financing that will help to cover imminent repayments.
We expect that the authorities will increasingly tap domestic financing, particularly given our forecast for wider fiscal deficits in the coming years. However, refinancing external debt domestically would further pressure reserves and potentially stoke tighter liquidity conditions, resulting in greater local currency depreciation. Moreover, domestic debt has come at higher cost and shorter maturities than external debt, particularly when the latter is contracted on more concessional terms.
Since the beginning of the year, the government has sourced some financing from non-market sources, including lending and swap facilities. In March, the government secured a syndicated loan of US$1.2 billion from China Development Bank (A1 stable) while in July, Sri Lanka finalised a US$ 400 million currency swap with the Reserve Bank of India.
We expect negotiations for further assistance, whether through liquidity relief on bilateral debt payments or further lending, to complement these two facilities. Nevertheless, delays in securing additional funding from multilateral and bilateral creditors, in addition to the IMF’s Rapid Financing Facility, mean that the financing sources for repayments in the next few years are not secured and risk coming at a high cost. In addition, while the currency swap facilities do temporarily boost foreign exchange reserves, they are time-bound and represent a liability to the monetary authority. They do not meaningfully increase foreign exchange reserves as do non-debt-creating inflows, such as export receipts or foreign investment, either portfolio or direct.
External vulnerability risk: b
We assess external vulnerability risk at ‘b,’ driven by external payments due over the next year that are materially higher than foreign exchange reserves. Persistently low reserve adequacy denotes Sri Lanka’s high vulnerability to sudden shifts in investor sentiment.
Other sovereigns with a ‘b’ external vulnerability risk score include Bahrain, Belarus and Mongolia (B3 negative). Sri Lanka’s current account deficit narrowed to 2.2% of GDP in 2019 from 3.2% in 2018, primarily because of a contraction in the goods deficit on very weak import growth as the economy remained sluggish following the April 2019 terrorist attack and amid pre-election uncertainty.
We project the current account deficit to widen modestly in 2020 to 2.6% of GDP before returning to closer to 3% of GDP in 2021-22, and to be only partially financed by FDI inflows (see Graphs 32 and 33), which we expect to remain subdued through 2021.
During the first half of 2020, Sri Lanka’s current account deficit was just US$793 million (around 0.9% of 2019 GDP), reflective of weak demand for both exports and imports, the latter of which contracted by a more significant degree because of regulatory measures and the imposition of a domestic lockdown in the second quarter.
Our forecast takes into account substantial import compression, and smaller foreign exchange inflows on weaker garment and textile exports, tourism activity, and remittances from overseas from Sri Lankan workers in oil-producing nations. We forecast foreign exchange reserves to end 2020 and 2021 at around US$6 billion, approximately level with the last two years.
We do not expect the quality of reserves to improve; the percentage of foreign exchange reserves from international swap liabilities has increased as a result of the US$400 million RBI swap and may further increase should that existing line be expanded, or other foreign currency swap lines with bilateral partners be engaged. Ongoing net purchases of foreign exchange from the market through 2020 will offset continued weakness in non-debt-creating foreign exchange inflows.
Despite our expectations of no significant changes in the level and quality of foreign exchange reserves, persistently low reserve adequacy denotes vulnerability to a shift in foreign financing conditions. We estimate that Sri Lanka’s External Vulnerability Indicator (EVI), the ratio of external debt payments due over the next year to foreign exchange reserves, will continue to hover around 200% over the next few years.