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Moody’s Ratings has announced a potential upgrade of Sri Lanka’s long-term foreign currency issuer rating from Ca to Caa1, signaling substantial improvements in the nation’s financial and economic outlook. The decision follows recent debt restructuring efforts and the government’s compliance with International Monetary Fund (IMF)-backed reforms.
Key Drivers of the Review
Sri Lanka’s positive credit trajectory is driven by several developments:
Debt Restructuring and New
Bond Issuances
The government has issued new USD-denominated bonds, including macro-linked
bonds (MLBs), governance-linked bonds (GLBs), and step-up and
past-due interest (PDI) bonds. These issuances replace bonds previously
under default, easing repayment burdens.
Macro-linked bonds introduce GDP-based adjustments to principal and interest payments, offering conditional relief tied to economic performance.
Fiscal Improvements
The fiscal deficit is narrowing significantly, projected to decrease to 5-6%
of GDP by 2025-26, down from 7% in 2024. Enhanced revenue
collection, driven by tax hikes and improved administration, has
increased government revenue from 8.3% of GDP in 2021-22 to 14% in
2024.
Foreign Reserves Growth
Sri Lanka’s foreign exchange reserves have surged from $1.6 billion
in 2022 to $6.4 billion in October 2024, now covering 3.5 months
of imports. This increase reduces external vulnerability and strengthens
the country’s financial stability.
Structural Reforms and
Governance
Under IMF guidance, the government has shown strong commitment to structural
reforms, enhancing fiscal policy credibility. Efforts to improve governance
are also contributing to long-term stability, although political changes remain
a potential risk.
Challenges Ahead
Despite this progress, Sri Lanka faces significant hurdles:
- Debt Affordability: Interest payments continue to absorb 40-50% of government revenue, limiting fiscal flexibility.
- High Debt Levels: The debt-to-GDP ratio, while declining, remains elevated. It is projected to fall below 90% by 2026, still high compared to global peers.
- Political and Social Constraints: Fiscal consolidation and reforms may face resistance due to political and social pressures, especially in addressing infrastructure and social service gaps.
Environmental, Social, and Governance (ESG) Considerations
Moody’s highlighted Sri Lanka’s ESG challenges, which contribute to credit constraints:
- Environmental Risks: Climate vulnerabilities impact rural incomes and inflation, affecting economic stability.
- Social Pressures: While strides have been made in education access, rural areas face limited infrastructure and social services.
- Governance Fragility: Ongoing improvements in governance are crucial but remain sensitive to political dynamics.
Outlook
A successful conclusion of the debt exchange process could lead to a rating upgrade to Caa1, reflecting a balance between economic progress and ongoing challenges. This potential upgrade marks a turning point for Sri Lanka as it continues its path toward fiscal stability and economic recovery.
Conclusion
Moody’s review underscores the significant strides Sri Lanka has made in rebuilding its economic foundation. While challenges persist, the progress in fiscal reforms, debt restructuring, and foreign reserves management highlights the nation’s resilience and potential for sustained recovery.
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