Moody’s Investors Service on Tuesday downgraded Sri Lanka’s outlook to negative from stable after affirming the government of Sri Lanka’s foreign currency issuer and senior unsecured sovereign ratings at B1. The rating issuer said two key drivers which underpin the change in outlook to negative from stable the expectation of a further weakening in some of Sri Lanka’s fiscal metrics in an environment of subdued GDP growth which could lead to renewed balance of payments pressure and the possibility that the effectiveness of the fiscal reforms envisaged by the government may be lower than expected, which could further weaken fiscal and economic performance.

“The negative outlook signals that an upgrade is unlikely. Evidence of effective implementation of fiscal reforms leading to significant and lasting improvements in tax collection would be positive. Such an improvement, coupled with reforms of macroeconomic policy that lead to more stable external financing conditions, would support a return of the rating outlook to stable,” the rating agency said.

It however stated that Sri Lanka’s B1 rating is supported by the economy’s robust growth potential and higher income levels than similarly-rated sovereigns.

“With the effective implementation of some of the fiscal policy measures and other structural reforms planned under the IMF programme, the government would be able to tap a significant potential revenue base,” the agency projected.

Explaining the rationale for assigning a negative outlook, the agency cautioned that weakening in fiscal metrics could lead to renewed liquidity and external pressure.
“The first driver of the negative outlook on Sri Lanka’s B1 ratings is our expectation that the government’s debt burden will increase further, from high levels, which could intensify external vulnerabilities and refinancing risks.”

“If there was a further marked deterioration in fiscal metrics combined with heightened balance of payment pressures, Sri Lanka’s overall credit metrics would weaken compared to other B1-rated sovereigns. Moody’s expects a more moderate reduction in budget deficits than outlined in the projections published as part of the International Monetary Fund’s (IMF) Extended Fund Facility (EFF). This reflects the difficulties in rapidly raising revenues after years of decline in the efficiency of tax collection and administration. We forecast that the budget deficit will narrow to slightly under 5% of GDP by 2020, from 7.4% in 2015 and compared with 3.5% projected by the IMF as part of the EFF.”

The agency noted that in addition, a number of state-owned enterprises are under financial stress, pointing to sizeable contingent liability risk for the government. Some of these risks have already crystallised with the government taking responsibility for SriLankan airlines’ (unrated) liabilities, worth Rs. 461 billion or around 4% of GDP. These liabilities will inflate government debt, at least temporarily.

“We assume that the government will retain responsibility for some of these liabilities.
With nominal GDP growth slower than in the last decade, persistent sizeable deficits will raise the government’s debt burden. We expect government debt to rise to just under 80% of GDP and subsequently fall to around 75% by the end of the decade, above the IMF’s projections (68.2% in 2020) and debt levels of similarly rated sovereigns,” Moody’s said adding that with persistent elevated government debt and large borrowing requirements, including for external and foreign currency debt financing, latent liquidity and external risks will remain and could escalate in an environment of global financial uncertainty.

Sri Lanka’s gross reserves declined to $5.6 billion in May 2016, equivalent to 3.6 months of imports, from $7.3 billion six months earlier. Gross reserves include foreign currency reserves which decreased to $4.7 billion in May, from $6.5 billion last November. At these levels, foreign currency reserves are equivalent to around 3 months of imports, a low coverage, and only partially cover external debt due over the year.

“Funding from the IMF and other international agencies will likely not fully finance the balance of the current account and foreign direct investment. The negative outlook captures the risk that without a sustained resumption of portfolio inflows which slowed significantly last year and continued access to international funding sources, foreign exchange reserves could fall further and balance of payment pressures would heighten,” the agency said.