Sri Lanka’s Path to Economic Recovery: Moody's Review - Summary

 

Moody's Ratings has announced a potential upgrade of Sri Lanka’s long-term foreign currency issuer rating from Ca to Caa1, reflecting significant improvements in the country's financial and economic landscape. This decision follows the government's recent debt restructuring measures and its compliance with reforms aligned with the International Monetary Fund (IMF).

Key Developments Driving the Review

1. Debt Restructuring and New Issuances:
• Sri Lanka issued new USD-denominated bonds, including macro-linked bonds (MLBs), governance-linked bonds (GLBs), and step-up and past-due interest (PDI) bonds. These new issuances replace existing bonds under default, providing relief and streamlining repayments.
• The MLBs link payments to GDP outcomes, introducing conditional adjustments to principal and interest.
2. Improved Fiscal Dynamics:
• Sri Lanka's fiscal deficit is narrowing, projected to fall to 5-6% of GDP in 2025-26, down from 7% in 2024.
• Revenue measures, such as tax hikes and improved tax administration, expanded government revenue from 8.3% of GDP in 2021-22 to 14% in 2024.
3. Strengthened Foreign Reserves:
• Foreign exchange reserves surged from $1.6 billion in 2022 to $6.4 billion in October 2024, now covering 3.5 months of imports. This is expected to increase further, alleviating external vulnerability.
4. Reform Commitments and Governance:
• The government has demonstrated commitment to structural reforms under IMF guidance, though political changes pose challenges.
• Governance improvements are enhancing policy credibility.

Challenges Ahead

Despite progress, significant hurdles remain:

• Debt affordability is weak, with interest payments absorbing 40-50% of government revenue.
• The debt-to-GDP ratio, although declining, will remain high compared to global peers, projected to fall below 90% by 2026.
• Political and social constraints may impede further fiscal consolidation and reform efforts.

Environmental, Social, and Governance (ESG) Factors

Sri Lanka's ESG risks contribute to its credit constraints:

• Environmental challenges, including climate vulnerabilities, affect rural incomes and inflation.
• Social pressures stem from limited infrastructure and social services in rural areas, despite strides in education access.
• Governance improvements, though underway, remain fragile, influenced by political dynamics.

Outlook

A successful conclusion of the debt exchange could result in an upgrade to Caa1, reflecting a balance between credit improvements and persistent constraints. This development signifies a turning point for Sri Lanka as it continues its journey toward fiscal stability and economic recovery.