Sri Lanka’s credit rating upgraded to ‘CCC+’ by Fitch, signaling improved economic stability and debt restructuring success.
In a significant move that marks a milestone in Sri Lanka’s financial recovery, Fitch Ratings has upgraded the country’s Long-Term Foreign-Currency Issuer Default Rating (IDR) from ‘RD’ (Restricted Default) to ‘CCC+’. This upgrade, released on December 20, 2024, signals the successful restructuring of Sri Lanka’s debt, as well as improvements in its macroeconomic outlook. Despite this positive shift, the road to sustained economic stability remains challenging, as the country navigates fiscal reforms, inflation control, and political changes. This article explores the implications of the rating upgrade, the steps taken in debt restructuring, and the potential risks Sri Lanka faces moving forward.
Sri Lanka Officially Ends Debt Default with Fitch Rating Upgrade
Sri Lanka has officially ended its debt default, marking a pivotal moment in its economic recovery, according to a statement from the Finance Ministry on December 20, 2024. The announcement follows Fitch Ratings’ decision to upgrade Sri Lanka’s long-term credit rating from CCC- to CCC+, reflecting a significant reduction in the risk of further defaults on local currency debt.
This upgrade comes after the completion of the international sovereign bond restructuring process, which has been a key part of Sri Lanka’s efforts to stabilize its economy. The completion of this restructuring, coupled with an improved outlook for macroeconomic indicators, has helped rebuild confidence in the country’s financial system.
The Finance Ministry emphasized that the economic crisis, which led to the country’s default, was primarily the result of poor policy decisions. Top bureaucrat Mahinda Siriwardana remarked that the crisis could have been avoided had early warnings been heeded and there had been timely engagement with the International Monetary Fund (IMF). Despite the positive developments in the debt restructuring and macroeconomic indicators, Siriwardana acknowledged that the painful legacy of the crisis remains, as the public continues to feel the effects of the economic downturn.
The statement also underscored the importance of learning from past mistakes. “The collapse of the economy happens rapidly, but the recovery is painful,” Siriwardana warned. He called for a commitment to avoiding future policy errors to prevent a repeat of the crisis. The recovery, though marked by milestones, must not be taken for granted, he added.
Since the onset of the crisis in 2022, Sri Lanka has undergone a turbulent period with severe shortages of essential goods, including fuel and cooking gas, widespread power cuts, and a foreign exchange crisis. Over the course of this time, Sri Lanka has seen changes in leadership, with three different presidents and finance ministers at the helm. However, officials like Siriwardana and Central Bank Governor Nandalal Weerasinghe played a pivotal role in navigating the recovery process from its inception.
The successful completion of debt restructuring, along with the upgrading of Sri Lanka’s credit rating, highlights the progress made, but the road ahead remains challenging. Despite the improvements in the country’s financial standing, Sri Lanka must continue its fiscal reforms and manage its debt sustainability to ensure long-term stability.
As part of its ongoing recovery, Sri Lanka has made progress in its negotiations with the IMF. On December 20, President Anura Kumara Dissanayake, also the Finance Minister, announced that the government had successfully secured flexibility in the IMF’s state revenue tax regime, a key element of his election promises. The adjustment in tax policy, including raising the threshold for pay-as-you-earn (PAYE) taxes and offering VAT exemptions for retirees, is aimed at easing the burden on citizens while still maintaining fiscal discipline.
This follows the country’s successful third review under the IMF’s $2.9 billion Extended Fund Facility (EFF), with the fourth tranche of the bailout expected soon. The government’s efforts to restructure its external debt, including a $14.2 billion agreement, are crucial steps toward meeting the IMF’s debt sustainability targets. The National People’s Power (NPP) government, under Dissanayake’s leadership, has continued to support the IMF-backed reforms despite its previous criticisms of the bailout conditions, including high taxes and cost recovery-based utility tariffs.
The IMF’s backing of Sri Lanka’s recovery process, alongside successful debt restructuring, offers hope for continued progress in the coming years. However, the political and economic landscape remains dynamic, and Sri Lanka will need to maintain a delicate balance of fiscal discipline, governance reforms, and economic growth to ensure a stable future.
Overview of Fitch Ratings’ Upgrade for Sri Lanka
Fitch Ratings, a global leader in credit ratings, recently raised Sri Lanka’s Long-Term Foreign-Currency IDR to ‘CCC+’, an upgrade from the ‘RD’ status. The ‘RD’ status reflected a period of sovereign default, where Sri Lanka struggled to meet its debt obligations. The upgrade indicates that the country has made substantial progress in restoring its financial stability, reducing the risk of future defaults.
The Local-Currency IDR was also upgraded to ‘CCC+’ from ‘CCC-’, aligning it with the Foreign-Currency IDR. This reflects a reduced likelihood of another default on local-currency debt. Fitch attributed this improvement to the completion of Sri Lanka’s international sovereign bond restructuring and its efforts to stabilize key macroeconomic indicators, such as inflation and GDP growth.
This upgrade is a significant milestone for Sri Lanka, signaling that the country is regaining the confidence of international creditors and investors. However, it’s important to note that Fitch does not assign an outlook to countries rated ‘CCC+’ or below, indicating that Sri Lanka’s financial situation remains precarious, with substantial risks ahead.
Key Changes in Credit Ratings
Upgrade from ‘RD’ to ‘CCC+’ for Foreign-Currency IDR
The most significant aspect of the Fitch upgrade is the shift from ‘RD’ to ‘CCC+’ for Sri Lanka’s Foreign-Currency IDR. The ‘RD’ rating was assigned during a period of default, when Sri Lanka was unable to meet its external debt obligations. The upgrade reflects that Sri Lanka has made significant strides in addressing its debt issues through negotiations with international creditors. As a result, the risk of default on foreign-currency debt has been considerably reduced.
Local-Currency IDR Raised to Match Foreign-Currency IDR
Fitch also raised Sri Lanka’s Local-Currency IDR to ‘CCC+’ from ‘CCC-’. This change was made to align the Local-Currency rating with the Foreign-Currency IDR. The upgrade indicates that Sri Lanka is less likely to default on its local-currency debt, following a successful debt restructuring that has improved its ability to manage domestic liabilities.
Debt Restructuring Measures
One of the key drivers behind the rating upgrade is Sri Lanka’s ongoing debt restructuring efforts. Over the past year, the country has made significant strides in addressing its debt challenges, particularly with its international creditors.
Domestic Debt Optimization in 2023
In September 2023, Sri Lanka completed a major domestic debt optimization, which involved the restructuring of treasury bills and provisional advances held by the Central Bank of Sri Lanka. These instruments were exchanged for new treasury bonds and bills, reducing the immediate debt burden. This domestic restructuring was an essential part of Sri Lanka’s strategy to stabilize its financial situation and was closely linked to the broader international debt restructuring process.
Bond Restructuring and New Debt Instruments
Sri Lanka’s bond restructuring was a critical component of its debt optimization strategy. Under the restructuring, 11 international sovereign bonds were exchanged for a mix of new instruments, including four macro-linked bonds, one governance-linked bond, and a PDI bond. These new debt instruments are designed to alleviate the country’s immediate financial stress while providing long-term solutions to its debt challenges.
Fitch highlighted that bondholders had the option to choose between local alternatives governed by domestic law, including rupee-denominated bonds and a US-dollar bond with step-up coupon payments. These restructuring measures helped secure a 98% participation rate from bondholders, signaling broad support for Sri Lanka’s financial recovery plan.
Economic Recovery Trends
Sri Lanka’s economy has shown signs of recovery following a period of severe contraction. The country faced a sharp economic downturn in 2022 and 2023, with GDP shrinking by 7.4% and 2.2%, respectively. However, there are encouraging signs of recovery, particularly in industrial and service sectors.
GDP Growth Projections for 2024-2026
Fitch forecasts that Sri Lanka’s economy will recover with real GDP growth projected to reach 4.1% in 2024. Growth is expected to average 3.6% from 2025 to 2026, driven by improvements in industrial output and a steady recovery in services. The industrial sector, in particular, has shown resilience, with a strong 11.1% growth in Q3 2024.
This growth is expected to continue as Sri Lanka implements reforms and works towards stabilizing its economy. However, the growth outlook remains sensitive to global economic conditions and domestic policy adjustments.
Impact of Industrial and Service Sector Performance
The industrial sector’s recovery is a promising sign, particularly as it experienced significant growth in 2024. This is crucial for Sri Lanka, which relies heavily on manufacturing and exports for its economic growth. The service sector has also seen positive trends, contributing to the overall economic recovery. However, challenges remain in the agricultural sector, which continues to face difficulties.
Fiscal and Financial Reforms
Sri Lanka’s fiscal and financial situation remains one of the most critical factors in determining its creditworthiness. The country has implemented several key reforms, particularly in the areas of tax policy and fiscal consolidation.
Tax Measures and Fiscal Policy Adjustments
To address its fiscal deficits, Sri Lanka has introduced major tax reforms aimed at boosting revenue collection. These include increases in VAT, income taxes, and other key levies, which are expected to raise government revenue to over 15% of GDP by 2026, up from 11% in 2023. These reforms are in line with the projections of the International Monetary Fund (IMF), which has been providing financial support to Sri Lanka.
IMF Program Implementation and Sustainability Goals
Sri Lanka’s IMF program, which began in March 2023, plays a crucial role in the country’s recovery efforts. The program is designed to help Sri Lanka implement structural reforms, stabilize its economy, and achieve debt sustainability. Fitch expects the new government, following the September 2024 election, to continue supporting the IMF-backed reforms.
Banking and Monetary Policy
The banking sector has improved significantly since Sri Lanka’s financial crisis. The country’s financial institutions are regaining stability, with lower systemic risks and improved profitability.
Improved Banking Sector Resilience
Economic reforms and the restructuring of external debt have reduced pressure on Sri Lanka’s banking system. Asset quality stress has peaked, and declining credit costs have led to higher profitability for banks. This is a key factor in restoring confidence in Sri Lanka’s financial system.
Inflation Control and Monetary Easing Strategies
Inflation has been a major concern for Sri Lanka, particularly after it peaked at 67.2% in September 2022. However, the Central Bank has successfully managed to reverse this inflationary surge through monetary easing, with a cumulative 800 basis point reduction in the standing deposit facility rate since June 2023. Inflation fell to -2.1% year-over-year in November 2024, and the central bank is expected to maintain a target inflation rate of 5% over the medium term.
Long-Term Projections and Risks
While Sri Lanka has made significant progress, there are still several long-term challenges that could hinder its economic recovery.
Forecasts for Debt-to-GDP Ratios
Fitch expects Sri Lanka’s debt-to-GDP ratio to fall to about 90% by 2028, which would be a significant improvement from its pre-default level of 110%. However, the interest-to-revenue ratio is expected to remain high, at 42%, which is still above the ‘CCC’ median of 16%. This suggests that the country’s debt burden will remain a concern in the medium term.
Potential Risks and Vulnerabilities
Sri Lanka remains vulnerable to external shocks, including fluctuations in global commodity prices, changes in international trade dynamics, and shifts in foreign investment. Additionally, the government’s ability to maintain fiscal discipline and raise sufficient revenue remains a critical risk factor.
Political Stability and Governance
The political landscape in Sri Lanka has shifted with the September 2024 presidential election, which saw the opposition National People’s Power party secure a two-thirds majority. Fitch believes that the new government will continue to support the ongoing reforms, including the IMF program.
ESG Considerations and Governance Scores
Sri Lanka faces challenges in terms of political stability and governance. The country has an ESG Relevance Score of ‘5’ for political stability, rule of law, and corruption control, indicating areas of concern for international investors. However, the government’s commitment to implementing reforms under the IMF program provides some reassurance.
Conclusion
Fitch Ratings’ upgrade of Sri Lanka’s credit rating to ‘CCC+’ is a significant milestone in the country’s ongoing financial recovery. While challenges remain, particularly in terms of fiscal management and external debt, the country is making progress in stabilizing its economy. With continued fiscal reforms, a recovering banking sector, and support from international financial institutions like the IMF, Sri Lanka has the potential to regain its financial stability over the coming years. However, political stability and effective governance will be crucial in ensuring the sustainability of these reforms.
FAQs:
- What is the significance of Sri Lanka’s credit rating upgrade by Fitch?
- The upgrade of Sri Lanka’s long-term credit rating from CCC- to CCC+ by Fitch Ratings signifies the country has officially ended its debt default. It reflects a reduction in the risk of future defaults on local currency debt, signaling improved economic conditions due to successful debt restructuring and positive macroeconomic developments.
- How did Sri Lanka end its debt default?
- Sri Lanka ended its debt default through the completion of the international sovereign bond restructuring, a key component of its economic recovery plan. The successful restructuring and improved macroeconomic indicators played a crucial role in the country’s financial stabilization, leading to the Fitch credit rating upgrade.
- What were the causes of Sri Lanka’s economic crisis?
- The economic crisis that led to Sri Lanka’s debt default was largely attributed to poor policy decisions and failure to heed early warnings. A lack of early engagement with the International Monetary Fund (IMF) and mishandling of the country’s fiscal policies contributed to the crisis.
- How has Sri Lanka’s economy been affected by the crisis?
- The crisis resulted in severe shortages of essential goods, including fuel and cooking gas, as well as long power cuts. The country also faced a foreign exchange crisis that led to a significant decline in living standards for its citizens, triggering widespread public hardship in 2022.
- What steps has the Sri Lankan government taken to recover from the crisis?
- Sri Lanka has made significant strides in economic recovery, including completing the debt restructuring process, securing an IMF bailout package, and implementing fiscal reforms. These measures have led to improvements in macroeconomic indicators and a reduction in the risk of further defaults.
- What is the IMF’s role in Sri Lanka’s recovery process?
- The International Monetary Fund (IMF) has played a crucial role in Sri Lanka’s recovery by providing financial support through a $2.9 billion Extended Fund Facility (EFF). The government has worked with the IMF to implement fiscal and structural reforms to stabilize the economy and secure the fourth tranche of the bailout.
- What tax reforms has the Sri Lankan government implemented?
- The government, under President Anura Kumara Dissanayake’s leadership, has reformed the tax system to raise the tax threshold for higher income earners while easing the tax burden on lower-income citizens and retirees. These changes include raising the pay-as-you-earn (PAYE) tax threshold and offering VAT exemptions for certain groups.
- What is the future outlook for Sri Lanka’s economy?
- While Sri Lanka has made significant progress in its economic recovery, challenges remain. The country must continue to implement fiscal reforms, manage debt sustainability, and attract investment to ensure long-term stability. Continued collaboration with the IMF and other international partners is crucial for maintaining progress.
- Who were the key officials responsible for Sri Lanka’s recovery?
- Key officials involved in Sri Lanka’s recovery process include Finance Ministry bureaucrat Mahinda Siriwardana and Central Bank Governor Nandalal Weerasinghe, both of whom played instrumental roles in guiding the country through the economic crisis and into recovery.
- What were the political changes in Sri Lanka during the crisis?
- Sri Lanka underwent significant political changes during the crisis, including changes in leadership. The country saw three different presidents and finance ministers during the period of economic turmoil, while the government under President Anura Kumara Dissanayake has been implementing key reforms to restore stability.
- Has Sri Lanka fully recovered from the crisis?
- While Sri Lanka has made substantial progress in its recovery, including exiting debt default and improving its credit rating, the country is still dealing with the legacy of the crisis. Economic recovery is ongoing, and the government needs to continue reforms to achieve long-term economic stability.
- What is the debt restructuring agreement with the IMF?
- Sri Lanka reached a debt restructuring agreement involving $14.2 billion in debt, aimed at restoring debt sustainability. This agreement is critical to maintaining the country’s financial stability and meeting IMF targets for fiscal management and economic recovery.