Fitch rating downgrade further narrows SL’s foreign finance avenues
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Global credit rating agency Fitch has downgraded Sri Lanka’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to ‘B+’ from ‘BB-’. Further, the country’s credit outlook is downgraded from ‘stable’ to ‘negative’ indicating a significantly weak credit risk. The negative outlook means more downgrades are on the cards. The issue ratings on Sri Lanka’s senior unsecured foreign- and local-currency bonds are also downgraded to ‘B+’ from ‘BB-’. The Country Ceiling is downgraded to ‘B+’ from ‘BB-’ and the Short-Term Foreign-Currency IDR is affirmed at ‘B’.
Fitch made this announcement on Monday citing significant debt maturities, weak public finances, depleting foreign reserves and high foreign debt share as major drivers of the downgrade. Nevertheless, Sri Lanka’s relatively higher economic growth and better human development indicators combined with a basic level of political stability support the rating at ‘B+’, according to Fitch.
Moody’s report too is negative
Fitch’s downgrade coincided with an announcement made on the same day by Moody, another global rating agency, stating that the government’s recourse to multilateral financing from IMF and ADB underscores its large external financing needs and the limited scope for market financing to meet those needs, revealing Sri Lanka’s credit-negative vulnerability to external event risk. Moody’s rating of Sri Lanka stands at ‘B1 stable’. However, Sri Lanka’s external vulnerability indicator (ratio of current debt commitments plus non-resident deposits to official foreign exchange reserves), has risen and is higher than B1-rated peers, says Moody.
Vicious circle of indebtedness and sovereign rating
Foreign lenders depend heavily on credit rating agencies in assessing the creditworthiness of potential borrowers. The lower the credit rating assigned to a particular country or a company, the higher the risk premium involved and interest rates to be quoted. The Fitch downgrade has adverse implications for Sri Lanka’s foreign finance which is already in poor shape providing itself the basis for the downgrade. The rating cut will add pressure to the government in its effort to seek foreign borrowings. The government will not only have difficulties in raising more funds but it will also have to bear high interest costs for new loans to cover the risk premium as reflected in the rating downgrade.
This forms a vicious circle – poor external finances leads to a rating downgrade which in turn, tightens foreign exchange availability thus, worsening the already-hit external finances. Empirical studies conducted in several countries suggest that there is highly significant positive effect on dollar bond rates when emerging market sovereign bonds are put on review with negative outlook. By contrast, positive outlook announcements do not have a significant impact on dollar bond rates. Hence, announcements of rating agencies are alleged to be pro-cyclical, meaning ratings are stricter during an economic downturn, compared with an expansion.
Countries like Sri Lanka with a higher rollover rate of debt and limited channels of capital inflows are more prone to pro-cyclical rating announcements. Sri Lanka will have to pay higher interest rates for its new sovereign bonds following the rating cut. Emerging market economies like Sri Lanka are already facing high interest rates in capital markets and withdrawal of foreign participation in sovereign bonds consequent to the rate hike by the US Fed last December, as pointed out in a previous article of this series. These economies are also encountering a reversal of private capital flows in recent months.
Macro-financial risks of accumulated debt
Sri Lanka has failed to achieve export-led growth despite the economy being liberalised almost four decades ago. GDP growth in recent years has been driven by the non-tradable sector dominated by locally rendered services – construction, transport, domesti trade and banking. The former government’s debt-funded infrastructure projects boosted construction activities and GDP growth since the cessation of the war in 2009. Such accumulated debt has posed tremendous macro-financial risks as elaborated in my column appeared on February 21.
The then government utilised considerable proportions of commercial borrowings for less-productive ventures such as Mattala Airport, Hambantota Port and Suriyawewa cricket stadium without adhering to the standard project evaluation procedures. As such projects do not generate sufficient revenue to raise government revenue or foreign exchange earnings, the debt rollover or taking fresh loans to settle maturing loans has become the norm.
The government’s outstanding external debt including government guaranteed loans is amounted to around US$30 billion. The country’s total external debt is around $44 billion which is equivalent to as much as 57 per cent of GDP. A net foreign exchange outflow of $4.5 billion on account of loan repayments and interest payments is projected for the next 12 months, as against the official foreign reserve stock of only $6.3 billion. Given the insufficient export earnings to meet the rising import payments, fresh foreign borrowings are essential to meet to settle the maturing foreign loans.
Heavy pressure on exchange and interest rates
The exchange rate is already under severe pressure in recent months due to capital outflows, import surge and debt service payments. The rupee depreciated by 8 per cent against the US dollar during the last six months. Further depreciation could be anticipated in view of the bleak balance of payments outlook and capital outflows. This will further enhance the pressures on both the government budget and external finances. The rating downgrade by Fitch makes it more difficult for the government to borrow from capital markets.
The weak external finances and overheating of the economy have compelled the Central Bank to tighten its monetary policy by raising its Statutory Reserve Ratio (SRR) and Policy Rates in recent weeks. Concurrently, 364 day-Treasury Bill yield rose to 8.50 per cent by the end of February from 6.13 per cent a year ago. This means the government has to incur higher interest cost now for domestic borrowings as well. The government’s increased reliance on domestic funding sources amid foreign capital shortages will have further upward effects on interest rates.
Infrastructure funding problematic
The rating downgrade has occurred at a crucial time when the government is trying hard to mobilise foreign resources to fund its ambitious mega-infrastructure projects. The government in its development efforts has heavy reliance on urban-centred and service-oriented projects like the Port City and Megapolis. These projects involve heavy foreign exchange commitments during their construction phase adding to the already high debt burden of the country.
The flagship project Megapolis earmarks foreign capital costs to the tune of $40 billion for its completion over the next 15 years. Much of the infrastructure development has to be funded by foreign commercial borrowings, given the low level of FDI inflows amounted to an estimated $750 million last year, compared with a peer like Vietnam which attracted $15 billion. Mobilisation of funds would be further difficult amid the country’s lower credit rating, apart from the current global financial turmoil.
Way out
As reiterated in this series, fiscal imbalances have been the root cause of the economic ailments in Sri Lanka over the years which ultimately have led to downgrade the credit rating. The budget deficit is likely to be as much as 7 per cent of GDP this year. The government has sought assistance from the IMF to deal with the financial difficulties. Widening the direct tax base and restructuring the expenditure commitments are inevitable to have an agreement with the IMF so as to rectify the macroeconomic disarrays. It is not going to be easy as evident from the withdrawal of many revenue and expenditure proposals in budget-2016 which would have eased the fiscal burden to a certain extent.
The latest reversal is the re-introduction of the fertiliser subsidy on the drective of the President heeding to the aggressive agitations by farmers and neglecting the wisdom that might have gone into this particular budget proposal. The Ministry of Finance is fast losing its grip in handling fiscal policy in unprecedented manner. All these complications reflect the lack of political will and courage to put the house in order with a robustly-crafted policy framework disregarding the adverse electoral consequences. In the absence of corrective policy actions in the pipeline, further credit rating downgrades are imminent.
(The writer, an
economist, academic and former central banker, can be reached at
sscolom@gmail.com)