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By : Kenneth De Zilwa

Moody’s Credit Rating Agency on the 23^rd of November 2018 announced that they have downgraded Sri Lanka’s sovereign credit by one notch from B1 to B2. Many political statements have been made of this downgrade.Let us examine what it really means to Sri Lanka.

Table-1-Credit rating range From Aaa to Ca

Source: Econsult & moody’s

Each country is rated based on their governments likelihood to default on their external borrowing obligations.  The credit rating therefore looks at the default probability  of the state. In doing so Credit rating agencies take into account GDP growth, per capita growth, monetary conditions, fiscal deficits, external debt burden and a host of other quantitative and qualitative data in arriving at the credit rating political risk is also one such variable.

Moody’s have an established rating score which is Aaa which indicated the highest quality of credit  with a  probability of default of 0.03 percent while speculative grading’s are from Ba1- Ba3 with a probability of default 2.60 percent.  The lowest credit score is classified as High risk or Highly  Speculative obligations which are rated by Moody’s as B1, B2 and B3 (probability of default 9.58 percent).  With the lowest and most riskiest being Carated sovereign credits (two year default probability of 35.9 percent).

Sri Lanka Credit Rating B1 to B2

In this regard Sri Lanka was already rated as a high speculative country B1 (stable) since July 2013 and later the rating  outlook downgraded from stable to negative rating reaffirmed in 2016, 2017 and 2018 . Therefore Sri Lanka  a B1 credit was below investment grade to begin with the outlook changing from ‘stable’ in 2013 to ‘negative’ from June 2016. (Source: countryeconomy.com).  The corrective action plan could have reversed this outcome; however, the trajectory was unadjusted.

Moody’s appears to place a higher weight on GDP growth, inflation, growth in per capita income in order to achieve a higher grade rating, while lower inflation and lower external debt also consistently relate to higher ratings.

Therefore the overall credit rating of Sri Lanka in terms of its high risk rating has become more pronounced as the external debt and external foreign reserves situation has decreased since 2014 with warnings not heeded by persons responsible for managing the external debt. Added to this our external Foreign exchange reserves too has continued to decline and has declined by 30pct from USD 9.9 billion in April  2018 to 7.0 billion as at November 2018

Chart-1-External Debt Maturities

Source: Econsult & moody’s

Putting the Impact into perspective

The credit rating impact thus must be seen as a testimony of the shift in the economic model which has seen a shift to consumption demand which is supplied by external sources, thus this has lead to the trade deficit widen to USD 14 billion. Non-consumer import  demand during the past three year have witnessed an increase by 47pct growing from  USD 1,700 million to  USD 2,500 million over the period 2012-2014, 2015-2017 With the rupee depreciation rapidly to stem the imbalance in the overall current account.

Therefore the reason for the downgrade is three fold a) Sri Lanka’s growing debt to GDP ratio which had increased from 71% of GDP in 2014 to 85% of GDP as at 2018 June and b) its deteriorating external finances and c) the deterioration in GDP growth from 9% in 2012 to 3.1% in 2017 and also a stagnant per capital growth over the past 3 years.

Internal

Chart-2-All Share Index and USD/LKR price behavior

Source: Reuters

In fact the financial markets had already factored the credit downgrade of Sri Lanka since June this year  (Chart-3) as depicted in the Colombo Stock Exchange All Share Index breaking the 6000 mark (Yellow line) and the flight of foreign bond holders from the government debt securities market which resulted in the Rupee depreciating by 15% on year to date basis  (Purple line) therefore it is not professionally correct to underpin the downgrade to the last two weeks of political swings

External

Chart-3- Sri Lanka Sovereign Bond secondary market behavior

Source: Econsult & moody’s

The deterioration in the country’s external finances also had a significant bearing the ability raise finance as the 2025 USD Bond with a coupon of 6.875pct witnessed a sell off in the secondary market. The sell off of the Sovereign bond (ISIN 85227SAQ9) was witnessed since January 2018 but exacerbated during the past one month, reaching a yield of 9.04pct

This negative sentiment has thus prevented Sri Lanka tapping the Euro bond markets for refinancing its external maturities. This can pose a short term stress condition.

While it also provides Sri Lankan risk takers with the opportunity to buy the Sri Lanka credit at a discounted value, and factor in high yields as part of their investment portfolios

The process of Sri Lankan policy reforms of liberalisation since 1977 has been predominantly unilateral. These reforms were undertaken in a global context of multilateral trade and tariff reforms under the guidance of international organizations like GATT and WTO. In addition, Sri Lanka joined in the efforts of liberalisation at regional level, e.g. the South Asia Free Trade Agreement (SAFTA) under SAARC initiatives. Multilateral and even regional trade negotiations however, have proved very slow and cumbersome. Bilateral and preferential trade agreements have become attractive globally, as well as in Sri Lanka.

The first experience of post-independence Sri Lanka in bilateral trade agreements was the well-known Rubber-Rice Pact of 1951 between Sri Lanka (then Ceylon) and the People’s Republic of China. It was a simple bilateral bartering agreement which provided a win-win solution to the two participating countries. The recent Sri Lankan interest in pursuing bilateral and preferential trade agreements can be traced to the 1990s. Three FTAs have been signed and implemented since then. The India-Sri Lanka Free Trade Agreement (ISFTA) was signed in 1998 and entered into force in March 2000. The Pakistan-Sri Lanka Free Trade Agreement (PSLFTA) came into force in June 2005. The Sri Lanka Singapore Free Trade Agreement (SLSFTA) was signed and made effective in 2018.

The ISFTA and PSLFTA are simple agreements covering the trade of goods between the respective partner countries. The SLSFTA in contrast, is a comprehensive agreement covering trade in goods, sanitary and phy-to-sanitary measures, and technical barriers to trade, customs procedures and trade facilitation, trade in services, telecommunications, E-commerce, government procurement, foreign investment, competition, intellectual property rights, transparency rules and matters of economic and technical cooperation. Sri Lanka may choose to negotiate its future FTAs in the same format as that of the SLSFTA. The new FTAs would then be comprehensive/deep agreements. Such ‘deep’ FTAs influence border-related policies as well as beyond-the-border policies. Liberalization through bilateral FTAs is being given priority with multiple objectives.

Several issues must be raised on this declared approach of expanding the policy scope of FTAs. A fundamental issue is that FTAs, particularly comprehensive FTAs, restrict the policy autonomy of the government to a significant extent. In today’s global institutional and organizational structure the policy autonomy of a small country is no doubt extremely limited. It may be for good reasons that the policy makers in Sri Lanka opt to get their policy autonomy further constrained by a series of FTAs. Here the opinion makers in the country seem to demand the following. The reasons for signing an FTA ought to be transparently shared with the public. Adequate research ought to be conducted to establish that any envisaged FTA would generate net positive benefits to Sri Lanka. Further the feasibility of the envisaged FTA should be carefully examined without rushing into signing. The planned FTAs are to be signed with countries with greater experience and equipped with better institutions. If adequate care is not taken, the signing of an FTA could produce extensive adverse effects on the country’s development efforts.

”From an overall point of view, Sri Lanka, as it stands today, is in an extremely weak competitive position in the global economic set up”

There are many needed domestic economic reforms. Some of these could lead to further liberalization. At the same time, there could also be critical intervention by the state in some fields. Before envisaging any more FTAs, priority must be accorded to domestic policy reforms based on a coherent national development framework and a widely-accepted national foreign trade policy.

There is another danger in the current declared policy of moving toward two more FTAs and a comprehensive agreement with India, in addition to the three FTAs currently in force. FTAs are not the best way to improve Sri Lanka’s competitiveness or productivity which is constrained by various structural and institutional factors. None of these factors can be resolved by entering into FTAs. In addition, operating a number of FTAs with different countries, involving multiple Rules of Origin, can make the foreign trade system extremely complicated, distorted and cumbersome.

Sri Lanka does not yet have a firmly established institutionalised procedure within which international trade agreements, particularly those so-called comprehensive agreements, can be negotiated and implemented. Strong legal, regulatory and institutional frameworks are needed if the national interest is to be safeguarded in the process of negotiation and implementation of bilateral preferential FTAs. Entered into without due care, bilateral trade agreements could turn out to be, in the long run, contractual traps with obligations, without worthwhile advantages to gain.

BY: ECONSULT