On 20 December, the Government announced that the exchange offer it made on 25 November had been successful, resulting in the exchange of all past international bond issuances except $ 268 million of its July 2022 bond.

The successful exchange concludes the restructuring of Sri Lanka’s international bonds and reduces the default risk on new and future issuances. Before the restructuring of international bonds, Sri Lanka had already reached agreements with its main bilateral creditors, which include Paris Club members and India (together with the Official Creditor Committee), as well as China and the China Development Bank.

The agreements have either come into effect or will do so in the coming weeks. The Government also restructured part of its domestic debt from July to September 2023 in its Domestic Debt Optimisation (DDO) initiative. 

The DDO covered the local currency debt held by the Central Bank of Sri Lanka (CBSL) and superannuation funds, as well as the US Dollar-denominated Sri Lanka Development Bonds (SLDBs) and Foreign Currency Banking Units (FCBUs) held by domestic investors including banks. 

Moody’s takes SL to ‘Caa1’ status 

Following the completion of the bond exchange, Moody’s Ratings and Fitch Ratings upgraded Sri Lanka’s credit rating.

The decision to upgrade the issuer rating to ‘Caa1’ by Moody’s was driven by the conclusion of the restructuring of Sri Lanka’s international bonds held by private sector creditors. 

Accordingly, at ‘Caa1,’ Sri Lanka’s credit profile reflects the reduction in external vulnerability and Government liquidity risk, as well as prospects for fiscal and debt sustainability, albeit from a weak starting point, which are underpinned by ongoing reforms under the Government’s programmes with development partners including the International Monetary Fund (IMF). 

It said that willingness and capacity to implement reforms speak to Sri Lanka’s governance and also underpin the rating action. However, these credit supports are balanced against still weak debt affordability and a high debt burden compared to peers, which limit the Government’s fiscal flexibility and capacity to address underlying social challenges. 

Moody’s said that Sri Lanka’s credit fundamentals had improved over the past two years, aided by effective policy adjustments that had led to a stabilisation of the macroeconomic environment, as well as debt restructuring and ongoing reforms under the Government’s programmes with the IMF and other development partners. 

It said that external vulnerability and Government liquidity risk had both declined from elevated levels while restructuring had also had a limited impact on the banking sector, reflecting Sri Lanka’s wider domestic investor base compared to peers. 

Moreover, it said that foreign exchange reserves had quadrupled since the default, as sizeable financing inflows from development partners, the suspension of external debt repayments to bilateral and commercial creditors, an improvement in current account dynamics, and substantial purchases of foreign exchange by the CBSL had helped Sri Lanka rebuild its foreign exchange buffers.

As of the end of November, foreign exchange reserves (excluding gold and special drawing rights) amounted to $ 6.4 billion, up from $ 1.6 billion in April 2022, sufficient to cover slightly more than three months of total goods and services imports over the next year. 

“We project that foreign exchange reserves will rise to cover more than four months of imports and all of the country’s external debt due by the end of 2026 and over the following 2-3 years,” Moody’s said.

It also noted that the higher level of foreign exchange buffers would be anchored by supportive balance of payments dynamics, including further external financing inflows from official and private sector sources, as well as expectations that the current account would be largely in balance or in a small deficit over the next 2-3 years. 

At the same time, it noted that Sri Lanka’s external repayment profile would remain benign at less than 2% of Gross Domestic Product (GDP) annually over the next few years even as debt repayments fully resumed post-restructuring, adding that it expected the Government’s gross financing needs to fall to an average of around 15% of GDP – still sizeable but materially lower than before the sovereign defaulted. 

Besides the reduction in liquidity risks, Sri Lanka’s fiscal and debt dynamics are also improving, albeit from a weak starting point. 

“We expect Sri Lanka’s fiscal deficit to narrow to 5-6% of GDP in 2025-’26, compared to our estimate of 7% of GDP for 2024 and an average deficit of 11% of GDP in 2021-’22 around the time of the default,” Moody’s said, adding that the reduction in the deficit had been driven by revenue measures that had significantly widened the Government’s revenue base from 8.3% of GDP in 2021-’22 to its estimate of around 14% of GDP in 2024. 

“These revenue measures include raising the Value-Added Tax (VAT) and corporate income tax rates, lowering the personal income tax-free allowance, and strengthening tax administration,” Moody’s said.

Fitch takes SL to ‘CCC+’ status

Meanwhile, Fitch Ratings upgraded Sri Lanka’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘CCC+’ from ‘RD’ (Restricted Default).

It said that Sri Lanka’s foreign currency debt restructuring offered substantial upfront debt repayment relief, with no foreign currency bond maturities until 2029. The amortisation on the Macro-Linked Bonds (MLBs), which have low coupon rates until 2032, starts from 2029 while Governance-Linked Bond (GLB) amortisation begins in 2034 and the US Dollar step-up bonds start amortisation in 2029.

“We expect foreign exchange reserves to reach $ 8.7 billion by 2026, also reflecting debt relief over the period,” Fitch said.

It also said that the debt restructuring had reduced the Government’s debt service burden and liquidity risks, but general Government debt/GDP and the interest/revenue ratio were likely to stay high in the medium term. 

The restructuring under Fitch’s baseline assumptions lowers general Government debt/GDP to about 90% by 2028, while Fitch forecasts the interest/revenue ratio to decline to 42%, still well above the ‘CCC’ median of 16%. 

“This is, however, a large drop from the 67% in 2021, prior to the sovereign default. Sri Lanka has a weak long-term revenue raising record, but the Government implemented several major tax measures to boost revenue collection and achieve debt sustainability,” it added.

Fitch expects general Government revenue/GDP to exceed 15% by 2026, from 11% in 2023, broadly in line with IMF programme projections. 

Noting that Sri Lanka’s September Presidential Election had been won by the Leader of the Opposition National People’s Power (NPP), which subsequently secured a majority of over two-thirds in the legislature, Fitch said that it expected the new Government to support progress on reforms. 

The new Government has said it will continue to implement the 48-month IMF Extended Fund Facility (EFF), which began in March 2023. Sri Lanka has made major progress on the programme under the previous Government. 

Fitch also notes that Sri Lanka’s economy is recovering after a contraction in 2022 and 2023. In seasonally adjusted terms, real GDP growth in Q3 2024 recovered to 5.2%, after contracting by 7.4% in 2022 and 2.2% in 2023. This was driven by an 11.1% pick-up in industrial growth, while services grew by about 2.8%.

“We expect growth to recover to 4.1% in 2024 and average 3.6% over 2025-2026,” it added.

Further, it said that the CBSL’s policy measures had largely reversed a rise in inflation, which peaked in September 2022 at 67.2% (seasonally adjusted). Inflation continues to decline, falling to -2.1% Year-on-Year (YoY) in November. 

The CBSL has eased monetary policy significantly, reducing the Standing Deposit Facility Rate (SDFR) by a cumulative 800 bp since June 2023.

Fitch expects further easing over 2025-2026, in line with its expectation that underlying inflationary pressure will remain muted and the CBSL will meet its medium-term inflation target of 5%.

Upside and downside risks for continuing upgrades

On the upside, Moody’s noted that the Government’s commitment to and continued implementation of reforms may strengthen its credit profile beyond current assumptions to a level consistent with a higher rating. In particular, the Government has exceeded its revenue targets under its IMF programme and is targeting further increases in revenue over the coming years. 

“While we believe the social backdrop remains challenging, significant revenue increases can contribute to material improvements in debt affordability and reduction in debt burden beyond our expectations,” Moody’s said.

On the downside, the agency said that the still narrow Government revenue base and limited fiscal space, combined with the reliance on external financing, posed asymmetric risks to the credit profile. Although it expects global growth to remain steady, which will support continued recovery of Sri Lanka’s economy, it notes that any slowdown in global growth affecting the demand for the country’s exports could result in balance of payments imbalances and threaten the recovery and reform momentum.

According to Fitch Ratings, factors that could, individually or collectively, lead to negative rating action/downgrade include public finances, where an increase in Government debt/GDP, potentially reflecting an inability to further raise revenue, results in wider budget deficits, as well as external finances, where the inability to rebuild foreign exchange reserves weakens debt repayment capacity.

It said that upgrade was possible through the sustained decline in the general Government debt/GDP ratio underpinned by strong implementation of a credible medium-term fiscal consolidation strategy, increase in fiscal revenue, and faster economic growth. 

IMF expects ‘B’ rating by 2027 

Speaking to The Sunday Morning, Frontier Research Head of Macroeconomic Advisory Chayu Damsinghe said that the general expectation of the IMF would be to see Sri Lanka gain a ‘B’ credit rating, where Sri Lanka could issue an International Sovereign Bond (ISB) by the time the IMF programme ends in 2027, given that the programme includes a $ 1.5 billion ISB issuance by 2027 to close the external financing gap.

However, he noted that this did not indicate that the ‘B’ credit rating was the only rating through which Sri Lanka could issue an ISB. “It’s possible for us to raise a bond at a lower rating as well, but that would make it a lot more costly,” he explained.

Regardless, it will depend on how the global financial situation will look like by the end of 2027.

Damsinghe added that improving taxation appeared to be the primary expectation of all relevant stakeholders involved in Sri Lanka’s economic programme for the next three years.

Rating upgrades not solely dependent on IMF prog.

Damsinghe further noted that different credit rating agencies had slightly different definitions for what constituted a rating upgrade.

Noting that Fitch had put Sri Lanka at a ‘CCC+’ while Moody’s had given a ‘Caa1’ rating, he added: “Part of this criterion for rating upgrades is available publicly, such as credit profile, debt level, and fiscal level, but a lot of it is more subjective.”

Accordingly, the three-notch upgrade by Fitch shows that Sri Lanka did not get out of the default in a chaotic manner, but rather that there had been significant macroeconomic progress in the last two years. 

Moreover, Damsinghe said that credit rating upgrades henceforth would not only be considered based on the reforms undertaken through the IMF programme, adding that it would depend on Sri Lanka’s ability to finance its creditors in the future.

“The IMF programme will likely constitute a big part, but it doesn’t have to be just the IMF programme alone,” he said, adding that what mattered was how Sri Lanka conducted its fiscal policy, the country’s economic growth, and external sector performance. 

Further, he said that it would also depend on Environmental, Social, and Governance (ESG) aspects, which were also a part of the IMF programme through the addressing of corruption and governance issues.

He also noted that if Sri Lanka managed to witness some continued external surpluses, which would require growth and imports to remain weak, thus accumulating a significant amount of dollars similar to what happened over the past two years, it would help to continue the rating upgrade. However, he noted that the IMF programme did not expect this. 

Public debt management crucial  

To tackle public debt and avoid the repetition of the 2021-’22 period, the IMF has proposed the establishment of a debt management office to manage public debt more independently and with more transparency.

According to a statement by the Finance Ministry, the key responsibilities of the Public Debt Management Office (PDMO) established earlier this month under the Public Debt Management Act (PDMA) include the management of the debt of the Government, issuance and management of loan guarantees, management of on-lending operations, and recording and reporting of public debt.

“The PDMO will take over all the relevant functions from the CBSL, the Department of External Resources, and the Department of Treasury Operations and will centralise the country’s debt management operations holistically, and will be fully operationalised by January 2026,” the Finance Ministry statement read.

The PDMO will also prepare and publicise the medium-term debt management strategy, annual borrowing plan, and auction calendars for the issuance of Government securities. It will also investigate the negotiation of financial terms and conditions and execution of domestic and external borrowings, other credit arrangements, and Government debt management activities.

Other tasks include:

• Maintenance of relationships for achieving and maintaining access to financial markets
• Coordination of debt operations in relation to cash flow management
• Preparation and execution of debt-related liability management operations
• Assessment of the credit risk and advising on risk mitigation mechanisms of loan guarantees and on-lending operations
• Recording, reporting, dissemination, and publication of public debt, loan guarantees, on-lending, suppliers’ credit, and finance leases
• Servicing the debt of the Government on a timely basis
• Preparation of debt service forecasts

The statement noted that all relevant parties should coordinate with the PDMO to obtain prior written approval of the minister in charge of the subject of Finance for any public issue of debt securities, raising of funds denominated in foreign currency, and issuance of guarantees by a State-Owned Enterprise (SOE) in compliance with Section 26 of the PDMA.

Furthermore, SOEs shall submit to the PDMO all terms and conditions for each of the planned borrowings and a copy of the executed debt contract.

Delay in setting up the PDMO 

Damsinghe noted that there were administrative issues in operationalising the PDMO, as some of the functions belonged to the CBSL while the rest belonged to the Treasury, which was one of the reasons for its establishment to take another 12 months until 2026.

“Bureaucratically, combining those functions is a complicated task since both the administrative and procurement process have to be dealt with,” he added.

He noted that another reason for the delay was technical, involving who had the liability and who had the authority to manage the funds.

According to Damsinghe, the ultimate reason for the delay is the lack of sufficient manpower within the Government to operate such an office at present.

SL needs to follow rating upgrades 

Speaking to the media on Friday (27), University of Colombo (UOC) Department of Economics Professor Priyanga Dunusinghe said that given that Sri Lanka had not followed the rating downgrades properly during the 2020-2022 period, which had led to the crisis, it should not ignore the rating upgrades that were taking place at present. 

He said the current rating upgrades had taken place as a result of decisions and sacrifices the country had made. “It is important to strengthen them further and take them in the right direction after the huge sacrifices we made to come to this place,” he said.

Govt. yet to present clear economic plan

Moreover, Prof. Dunusinghe said that Sri Lanka should at least gain a ‘BBB’ rating to access the international capital market and reduce the interest under which the country would borrow in future.

He noted that in order to attain such a rating, Government fiscal and economic growth should be in a favourable position.

“Thus far, we are not seeing the economic programme of the Government and the actions taken towards such a programme,” he said, adding that what could be seen instead were Government measures to address day-to-day economic issues.

“We don’t see reforms being done to take the economy forward,” he said, adding that investors lacked a complete picture of the Government’s economic policy.

Rating upgrade shows confidence in Govt. path

Speaking to the media on Thursday (26), Deputy Minister of Economic Development Prof. Anil Jayantha Fernando said that for the first time in history, a country which had been in ‘RD’ status had advanced by three notches to a ‘CCC+’ credit rating, which demonstrated the response to the Government’s stability programme.

He said that people had confidence in the Government’s ability to carry forward the stability programme and that they were aware it would take some time to show results. 

“The 2025 Budget will be prepared under the policy theme of ‘A Rich Country – A Beautiful Life,’ including the income and expenses of the Government, showing the direction of the economic reform programme,” the Deputy Minister said. 

Moreover, he added that through the completion of debt restructuring, the Government had managed to complete the first stage of financial stabilisation, noting that through the continuation in the same direction, the results would manifest in people’s income and economic conditions by the end of 2025. 

SMEs to expand the economy 

Further, speaking at the same media briefing, Deputy Minister of Finance and Planning Dr. Harshana Suriyapperuma said that the Government would support Small and Medium-sized Enterprises (SMEs) in order to expand the economy.

He said that the Government had extended the suspension of executing parate rights by the banking sector for another three months until March 2025 for Non-Performing Loans (NPLs) worth over Rs. 25 million obtained by the SMEs, while the Government had also provided a period of 12 months to restructure loans below Rs. 25 million.

He further noted that loans between Rs. 25 million and Rs. 50 million would be given another nine months after the expiration of the suspension of parate rights for them to be restructured.

Moreover, he said that the PDMO would take over the functions performed by the CBSL thus far and that the current work was being undertaken through excellent coordination among departments.