Despite the past week being overshadowed by the first review of the Extended Fund Facility (EFF) by the International Monetary Fund (IMF), the country achieved a special milestone as it saw the first sovereign rating upgrade since the start of 2020, with Standard & Poor’s (S&P) raising its long and short-term local currency sovereign credit ratings on Sri Lanka to ‘CCC+/C’ from ‘SD/SD’ (Selective Default).
S&P said that it had raised its outlook on the long-term local currency rating to stable, reflecting the balance of improvements to the Government’s debt profile achieved through its domestic restructuring exercises.
This is the first time in the last three years that an international rating agency has seen stability in Sri Lanka’s debt, local or foreign. Sri Lanka’s long-term local currency rating by S&P went from ‘B-’ in May 2020 to ‘SD’ by September 2023 as the Domestic Debt Optimisation (DDO) was being finalised. Meanwhile, the long-term foreign currency rating went from ‘B-’ in May 2020 to ‘SD’ by April 2023 as the country announced suspension of foreign debt servicing.
However, does the rating upgrade have any impact on the market, Government, or the interest paid by the Government on local borrowings?
What does it mean to the Government?
Speaking to The Sunday Morning, Softlogic Stockbrokers Co-Head of Research Raynal Wickremeratne said that a ‘CCC+’ meant that the Government could start borrowing again, although there would be very few lenders.
When Sri Lanka suspended foreign debt servicing in April 2022, its foreign currency credit rating went to SD while the local currency started to downgrade until the Government announced the DDO programme in June 2023.
Wickremeratne said that the rating upgrade was a major positive sign and the more the country’s credit rating rose, the more the cost of borrowing would reduce, with more people willing to lend to Sri Lanka. Moreover, he said that the rating upgrade would also be an advantage for Sri Lanka when negotiating with external creditors.
He said that although the rating upgrade was for local currency debt, this was a rating for Sri Lanka. “This is effectively applicable for foreign debt and Sri Lanka’s image in the foreign market.”
However, he said that the sustainability of domestic debt would depend on the sustainability of external debt. Being unable to pay external debt will force borrowing from the domestic market, which will eventually make domestic debt unsustainable.
No impact on yield rates, debt sustainable at the moment
Also speaking to The Sunday Morning, Capital Alliance Ltd. (CAL) Chief Strategist Udeeshan Jonas said the rating upgrade would not change the yield rates of Government securities, with a rating upgrade on local currency debt expected following the completion of the DDO.
He said that the yield rates would depend on the completion of the external debt restructuring.
He also noted that according to the rating upgrade, Sri Lanka’s domestic debt was sustainable at the moment but “six months down the line, if the Government is unable to meet the fiscal target then the problem can come again”.
“One is the fiscal [target] going off track and second is the external debt restructuring not being completed. If not, we will continue to borrow at higher rates and in six months, the problem will return,” Jonas said.
He also confirmed that the outcome of the first review of the IMF would also be an important credit rating outlook for the next six months.
The IMF mission on Wednesday (27) said that there was no fixed timeline for the disbursement of the second tranche of $ 330 million as the IMF needed to agree on the set of policies and reforms to achieve the revenue collection target for 2024 as Sri Lanka had fallen 15% short of the 2023 revenue target and the financial assurance on the completion of external debt restructuring.
According to the S&P statement, it will lower the long-term local currency ratings on Sri Lanka if there are indications of further restructuring of obligations denominated in Sri Lankan Rupees to commercial creditors.
It said that developments that could precede these indications included a rapid rise in inflation, a further rise in the Government’s interest burden, or a significantly worse fiscal performance by the Government, leading to local currency funding pressures.
However, S&P said that its sovereign ratings did not reflect the Government’s capacity and willingness to service financial obligations to public sector enterprises or similar official creditors.
“Nevertheless, we view the completion of this restructuring exercise, in addition to the restructuring to superannuation funds, as supportive of Sri Lanka’s near-term creditworthiness on its local currency obligations because it will further reduce refinancing needs as well as the Government’s interest bill,” said the statement.
Foreign DFIs
First Capital Holdings PLC Chief Research and Strategy Officer Dimantha Mathew said that the rating upgrade would not have any significant impact on domestic lenders, noting that the impact would be on the foreign side where Development Finance Institutions (DFIs) may look at lending to local banks and other finance companies. “But I don’t think that will happen at this moment of time until the external debt restructuring also gets completed,” he added.
Moreover, he noted that there could be demand from the foreign investors on the domestic debt market, such as Government securities, but said that it could come after external debt had been restructured. Mathew also said that the premium still attached to domestic debt would continue despite an improvement in credit until external debt was restructured.
How can the rating upgrade further?
Wickremeratne said that achieving the targets laid out by the IMF, with structural changes leading to the improvement of foreign reserves, and reducing the deficit would enable further rating upgrades.
He said that the mode of repayment of external debt following the completion of the external debt restructuring along with increases in US Dollar earnings from export, remittances, and tourism would lead to a scenario where the credit rating agencies would be able to identify ahead of time some of the key changes that could happen in the economy and how they could impact the economy positively.
“This could be the case if, for example, the Government’s fiscal metrics and the performance of the Sri Lankan economy improve much more quickly than we expect.”
International market access
Speaking at an event organised by CAL in early September, Central Bank of Sri Lanka (CBSL) Governor Dr. Nandalal Weerasinghe said that based on the IMF’s debt sustainability analysis, Sri Lanka did not need international market access until 2027.
He said that he did not see the need to access the commercial market, as about $ 7 billion in foreign inflows from the World Bank, the Asian Development Bank (ADB), and the IMF were in the pipeline for the next four years.
“Even though the access can be open quite soon, if we over-perform compared to the baseline scenarios of the IMF and the completion of debt restructuring, there will be an upgrade in terms of sovereign ratings that will open up the markets,” he said. However, he added that depending on the market conditions and Sri Lanka’s credit ratings, it was difficult to predict when Sri Lanka would be able to access international markets.
Weerasinghe noted that if the Government was having a reasonable budget deficit, there was no need to raise commercial financing as it had the access to the ADB and World Bank while bilateral project loans would open after the completion of external debt restructuring.
S&P in its statement said that although Sri Lanka’s ongoing restructuring efforts would help to stabilise the Government’s fiscal dynamics, according to its assessment, net general Government indebtedness would remain at a very high level of more than 100% of the GDP through at least 2026.
“Likewise, we estimate that the Government’s interest burden will be more than 70% of revenues for 2023 and will remain above 50% in 2026. These outcomes will be highly dependent on the pace of nominal GDP growth, fiscal consolidation and revenue growth, prevailing interest rates in the economy, and future restructuring outcomes, among other variables,” S&P said.