Moody’s which started rating Sri Lanka (SL) in 2010, downgraded SL’s Credit Rating to B2 (Stable) from B1(Negative) on November 20th 2018. As usual, the other two rating agencies, (Fitch and S&P), which started rating SL in 2007, also downgraded correspondingly on December 3 and 4, from B+ (Stable) to B (Stable). Moody’s started with B1 (stable) in 2010, improved to B1 (positive) in 2011 and downgraded to B1 (Negative) in 2016. The Other two ratings agencies also downgraded in 2009, upgraded in 2010 and 2011, and downgraded in 2016. Therefore, the present downgrade, a further downgrade of one notch since 2016, is not a surprise, and could have been avoided.
What is a Credit Rating?
A Credit Rating is an external judgment on the ability/capacity to repay debt by a borrower in the future, and is generally valid for one year. The borrower’s performance in business, finance and industry is generally assessed. Rating is not a mathematical formula-based number, but a judgement/view expressed after review of available data and experiences of other countries/borrowers.
In Government/Country rating, factors such as fiscal performance (revenue, budget deficit and borrowing), debt profile and repayment burden, the country’s macroeconomic performance such as growth, Balance of Payments, foreign reserves, investor and business confidence, and political stability are assessed because government debt and repayment depend on fiscal discipline and the country’s macro-economy to generate tax revenue. Rating agencies also assess a country’s performance as compared to peer countries (similar economies).
The Rating Agency receives information through reports from country authorities and discussions held with the authorities and the Business community. In SL, the Central Bank (CB) as the debt manager and financial adviser to the government, handles all correspondence.
Credit Rating classes
Moody’s credit rating for long-term bonds consists of 21 ratings denoted from “Aaa”, (the highest credit quality), to “C”, (default/bankruptcy). Fitch and S&P also have similar ratings of 24 with different notations, (i.e., AAA to D). The investment grade is the 10th level and above,( i.e. “Baa3” for Moody’s and BBB- for the other two. The balance ratings from Ba1 and BB- and below, are “speculative” or “junk” bonds (non-investment grades) - that means, various vulnerabilities exist as to bond repayment.
B category in all three ratings has three ratings, B1, B2 and B3 for Moody’s and B+, B and B- for the other two, which are 14th, 15th and 16th levels. Accordingly, Sri Lanka has been downgraded to the 15th level from the 14th level. If Sri Lanka wishes to move to the minimum investment rating, it has to move up by five levels/notches. (India (Baa2/BBB) is six notches above Sri Lanka).
Under each rating, “positive” or “stable”or “negative” is added as the outlook/flavour. When a rating is changed, the rating itself, or the flavour, or both, may be changed.
All three Bs express the same view, i.e., the borrower is more vulnerable, but it currently has the capacity to repay debt/bonds whereas adverse business, financial, or economic conditions will likely impair the borrower’s capacity or willingness to repay. Therefore, rating change is an early signal of possible change in the credit quality that the borrower can/should take objectively, and work for improvement.
There are many countries in the ‘B’ rating category, for example, in Moody’s 27 countries’ Band, 8 countries are in B2. (including Argentina, Cambodia, Bahrain, Nicaragua, Papua New Guinea, Suriname and Tunisia). Greece, a well-known debt and fiscal crisis country, is B3. Pakistan is also B3. The European Commission last week declined to approve the Italian Budget for 2019 due to its high deficit, although the Italian credit rating is investment grade (Moody’s Baa2, six notches above SL’s rating). Only Venezuela is ‘C’/’D’.
Experiences of country-downgrades
Country-downgrades are attributed to four main factors, i.e., poor Macroeconomic performance, adverse fiscal deterioration, political vulnerabilities and various adverse shocks such as currency turmoil and collapse of commodity prices. In 2016, there were 16 country-downgrades done by Fitch, 21 by S&P, and 25 by Moody’s. Political factors have caused downgrades of many countries, e.g., Brazil and Russia in 2015 and South Africa in early 2016.
In Brazil, political unrest over a massive corruption scandal that ultimately resulted in the impeachment of the then President, was the cause. In South Africa, the political unrest created by the Cabinet reshuffle and the change of Finance Ministers (several times) by the then President, caused the downgrade. In June 2016, the UK was downgraded two notches by S&P (from AAA to AA), one notch by Fitch (from AA+ to AA) and Moody’s twice, from Aa1 (Stable) to Aa1 (Negative) and from Aa1 (Negative) to Aa2 (Stable) in June 2016 and September 2017, due to vulnerabilities envisaged from Brexit (Britain to exit from the EU) decision in June 2016 and these ratings prevail up to now, as Brexit is not yet settled.
Rating agencies are quite familiar with how political and economic vulnerabilities would spread, and the underlying early warnings. They downgrade countries only after a lengthy review of information and discussions with the authorities and investors. Generally, all three rating agencies follow changes one after another with a short time lag.
Adverse Effects of Downgrade
Credit Rating is one of the services in finance/credit markets, to assist trade in bonds/debt. The lenders and borrowers find it easier to follow recognised credit ratings, rather than making individual credit risk assessments. Credit risk is a major factor that determines the interest rate charged from the borrower. In Finance, the higher the risk, the higher is the return/interest rate. Therefore, creditors immediately charge higher interest rates on all new borrowings and roll-overs after a downgrade, and vice versa. In a country-downgrade, private interest rates which carry varying risk premia on Government Bond interest rates/credit risk, also rise. Therefore, a general increase in the cost of funds due to credit downgrade, will become a burden to the country’s economy.
Therefore, a country’s authorities must professionally deal with Ratings Agencies to protect and improve the ratings if they wish to keep the cost of borrowings/investments low, in a market environment.
Response of SL authorities to downgrades
In response to Moody’s downgrade, the CB, on the following day, hurriedly issued a Press Release to inform the public of its disagreement as the downgrade/new credit rating did not properly reflect the macroeconomic fundamentals of the country, and therefore, was unwarranted. It outlined that Sri Lanka’s macroeconomic position had neither deteriorated nor experienced a macroeconomic policy slippage since Moody’s last rating decision (in July 2018). Also, various new foreign borrowings and funds being arranged so as to sustain SL’s past track record of debt repayment, and measures to strengthen the foreign reserves, were noted. The same press release with only a few changes of words, was repeated on December 4 in response to the downgrade by Fitch and S&P.
However, the CB Press Releases never justified the country’s so-called macroeconomic fundamentals and how they were not reflected in the new ratings. Any moderate person reading the Press Releases will notice the difficulties SL confront in foreign debt repayment funded by new borrowings. A few other authorities also informed the public, through the press, about arrangements being made to borrow and raise other funds to repay forthcoming repayments.
The latest adverse developments in the political and civil administration of the country amply show huge, historic vulnerabilities to both political stability and macroeconomic stability. There is no sign of immediate full settlement of political disputes which have worsened daily after the Moody’s downgrade. Therefore, no sensible person can dispute the new rating downgrades, given the role of Ratings.
The CB does not seem to have understood the meaning of B2 (Positive)/B (Stable). Both B1/B+ and B2/B imply the capacity of the borrower to repay debt, but more vulnerabilities prevail to impair the repayment or willingness to repay in future. Those vulnerabilities are easily understood - from deteriorating political stability and macroeconomic conditions (including the currency turmoil), to being without a legally instituted Cabinet, disruption in Parliamentary proceedings, confusing/aggressive statements by top political leaders, and attempts to make new foreign borrowings to honour the upcoming repayments, including US$ 1,000Mn of Sovereign Bonds in January 2019, whilst the currency continues to depreciate due to lack of foreign reserves with which to intervene.
Learn and act promptly
Rating Agencies are the judges of Credit Risk assessment. Rating is not a mathematical formula, but a judgement. Therefore, blaming the judges is not professional. Either the authorities should withdraw from Ratings-Based market borrowing systems, or make a professional appeal with justifiable story/facts to regain/improve ratings, at the earliest. Without doing so, when an authority like the CB blames judges/Ratings Agencies for not assigning the same rating, international investors will downgrade the SL authorities too.
When the ratings (outlook) were downgraded in 2016, the authorities should have been vigilant of further possible downgrades as political and macroeconomic conditions continued to deteriorate, along with results of the Local Government elections held on February 10th 2018.
In April 2015, I recall having an early hint of a possible downgrade by a Rating Agency based on similar political and economic instabilities developing at that time. I held a few conference calls to discuss the issue, and urgently sent a special fact-filled report, personally drafted by me, to address their concerns. We could save the ratings. Therefore, the SL authorities must do their job for the Nation.
The present system of international market borrowing (Sovereign Bonds) with the help of Ratings and global investment banks, commenced in 2007. Up to now, US$ 13,150 Mn have been raised from sovereign bonds alone. There is about US$ 3,300 Mn of development bonds and more than US$ 1,000 Mn of State bank bond borrowings for the government. Foreign investments in local currency Treasury bills/bonds also require foreign currency back-up. So far only, US$ 1,000 Mn of sovereign bonds have been repaid. Another US$ 1,000 Mn in January and US$ 500 Mn in April come up for repayment. All have to be rapid by new borrowings.
The Sovereign Bond system was intended to develop the SL debt market abroad, in addition to the domestic debt market. Debt market development/deepening is intended to reduce the cost of borrowing and raise the liquidity/demand. However, the CB pursued such foreign borrowings aggressively to strengthen its foreign reserves, to show the world an artificial strength of the country. Funds were spent without any assessment/monitoring of end-use economic benefits.
Therefore, now, both the government and the CB with its foreign reserve and exchange rate management have got into the trap of Ratings, investment banks and their investors. The borrowing system before was direct bilateral borrowings and project loans. The domestic debt market, despite it being the oldest debt market in the country, also has not developed, when recent public concerns on debt issuances and debt burden are examined.
Rating downgrades and other debt market concerns are good early warnings of grave structural problems in SL debt management systems and that debt bubble could burst any moment. Many countries (including the developed) have defaulted on their debt from time to time. Therefore, we have to leave behind the usual complacency and feel-good attitudes of authorities, examine burning debt fundamentals and resolve them now, instead of being happy about further borrowing which will endanger the future of the next generation.
(The writer, a recently retired Public Servant was a Deputy Governor of the Central Bank and a Chairman and member of 6 Public Boards. During his nearly 35 years’ of service in the CB, he also served as Director of Bank Supervision, Secretary to the Monetary Board and Senior Deputy Governor, and authored five Economics and Financial/Banking books published by the CB, and more than 50 published articles.)