By W A Wijewardena –
Sacking of a Government and harvesting a credit downgrade
Moody’s Investors Service, in a recent ratings change, downgraded Sri Lanka’s sovereign debt from B1 to B2, while improving the country’s economic Outlook from Negative to Stable.
Its prompt move to revise Sri Lanka’s rating status is understandable, since rating agencies had been blamed for not warning the investors in time before Greece bonds became worthless in 2009. The other two rating agencies, Standards and Poor’s and Fitch Ratings, are yet to come up with their own analysis of the country’s changed debt profile after President Maithripala Sirisena on 26 October summarily sacked his three-year-long companion in power, Prime Minister Ranil Wickremesinghe, and appointed his arch enemy, the former President Mahinda Rajapaksa, in his place.
The economic fallout of this rash action was analysed by me in a previous article in this series in which I argued that the economy was to be the casualty unless the man-made constitutional crisis was resolved quickly. Yet, the crisis lingered on moving from bad to worse in each passing day without any sign of a sound resolution in sight.
This made investors in Sri Lanka’s sovereign debt nervous and anxious. For instance, the Sri Lanka government sovereign bonds that are to mature in January and April 2019 witnessed a rate jump from around 5.5-5.8% to around 9-10.8% within a week. This is quite contrary to the behaviour of bonds which have a tendency for market prices to converge to face values when the maturity date comes closer. What it implied was that the holders of these bonds have attempted to quit them by dumping them in the market wholesale. Hence, Moody’s has fulfilled its obligation to investors by coming up with a revision in rating and faulting the rating agency for doing so may not be in order.
Two components of rating results
The rating results pertaining to a sovereign borrower have two components. One is an ‘alpha-numerical value’ it assigns to a country indicating the probability of a sovereign borrower defaulting a particular borrowing. The other is the subjective assessment about the short to medium term outlook of the economy, whether it is healthy, stable or unhealthy.
An alpha-numerical value to denote the probability of credit default
In the case of Moody’s, the alpha-numerical values with low default risk have ranged from Aaa denoting the best to Baa3 denoting passable. These are known as investment or prime grade borrowings. Those assigned from Ba1 to C carry a high default risk and are normally known in the market as speculative or non-investment grade borrowings. In the market terminology, these bonds are derisively known as ‘junk bonds’ or simply ‘junkies’.
Since the profit is the degree of risk which an investor would take, there is a demand for these junkies too. The only difference is that the investors will expect a higher profit or yield to compensate for the higher risk they are taking. This additional profit they are expecting is called the ‘risk-premium’ and it changes from 4% at best to even 10% at worst.
Sri Lanka had been rated at B1 earlier by Moody’s or its equivalent at B+ by Standards and Poor’s and Fitch Rating. This was four notches below the investment grade borrowings and, hence, were categorised as junkies. Since the risks were high, the risk premium which investors put on Sri Lanka was about 4-4.5% over the rate which a best borrower at Aaa would have got. With the downgrading from B1 to B2, this risk premium will jump at least by about half a per cent or in market terminology by about 50 basis points.
Since the risk premium in the case of bonds to mature in 2019 has already jumped to about 8%, the risk is that Sri Lanka would not be able to issue sovereign bonds in the market for less than 10% immediately. That is why a Sri Lankan Government official in a recent press briefing had opined that it was not time for the country to go to the international sovereign debt market immediately and would look for funding from elsewhere.
Subjective assessment of economic outlook
The second component of a debt rating, the country’s economic outlook, is a subjective assessment of the state of the economy based on what the assessor has read about its plans, developments and actual achievements. This subjective assessment can be one of the three positions, Positive, Stable or Negative.
This can be compared with the opinion expressed by a physician on a patient based on the latter’s reaction to the medication administered to him. If the physician opines that the condition of the patient is negative, his health conditions are fast deteriorating, he does not answer to medication and he needs to have special care in an intensive care unit for otherwise it is not possible to save his life. It is a hopeless case. If the condition is stable, he has improved a lot, can be transferred from the Intensive Care Unit to the ward and will, with good medication, have the chance of recovering fully. If it is positive, he has recovered, answered well to medication and could be discharged from the hospital with only follow-up wellness treatments.
In the case of an economy, changing from Negative to Stable means that the economic patient of Sri Lanka has answered to past medication and could recover completely provided proper curative treatments are administered to him. It is out of danger and could be transferred to the ward for normal treatments. It is indeed a good sign for Sri Lanka’s ailing economy.
Subjective assessment is based on evidence
In the past 10 year period since Sri Lanka was subject to international credit rating, the country had never been in the Positive category. It had hovered between Stable and Negative positions, moving from one to the other quite frequently.
As I mentioned earlier, this is a subjective assessment based on evidence. The evidence is gathered by rating agencies from a variety of sources, namely, plans of the country, published and unpublished data, interviews with public officials, political leaders, officials in international agencies like IMF, World Bank, ADB or UN System and private sector think tanks and thought leaders. All the evidence gathered is screened, assessed and synthesised to form a single opinion on the country: whether the economy shows good signs, remain at an acceptable level or has moved into worse conditions.
Once again, if this subjective assessment is not to the liking of the authorities, all they can do is to change the behaviour so that those who provide information on the country will paint a favourable picture about the prevailing economic status. Fighting a war with the rating agency on that count will prove unproductive.
The man-made political crisis is the culprit
Moody’s has reasoned out the downgrading from B1 to B2 as follows: ‘The decision to downgrade the rating to B2 is driven by Moody’s view that ongoing tightening in external and domestic financing conditions and low reserve adequacy, exacerbated most recently by a political crisis which seems likely to have a lasting impact on policy even if ostensibly resolved quickly, have heightened refinancing risks beyond levels anticipated when the rating agency affirmed the rating at B1 with a Negative outlook in July. Moody’s projections include a slower pace of fiscal consolidation than assumed in July to reflect disruption to fiscal policy implementation in a period of political turmoil.’
The crisis will have a lasting impact on the economy
The main culprit has been the political crisis which has worsened the country’s ability to raise new funds to meet its prevailing debt servicing obligations. This crisis is the handiwork of the President, as many analysts had pointed out, by taking a hasty decision to fire a government based on his personal vendetta against its Head and appointing a government which does not command majority in Parliament.
The inability of the government appointed by the President to show its majority in Parliament has been demonstrated by a score of defeats it has suffered in the House in the last 10-day period: two no-confidence motions, one policy statement and a further one involving the composition of the Selection Committee in Parliament. As the world saw it, the members of the President’s government had resorted to unruly behaviour within the House, walked out of it without facing a vote and resolved themselves to the tactic of briefing the media on what they were planning to do to gain power in Parliament.
Moody’s feels that even if this crisis is resolved by using ‘ostensible’ tactics, it will have lasting impact on the country’s decision making processes. In other words, in the opinion of Moody’s, the country’s ability to get out of the present economic crisis is not within sight due to the man-made political crisis.
Credit downgrade is a slap for the President
Moody’s has also noted that the prevailing political crisis has weakened Sri Lanka’s ability to implement a full-scale economic reform program which it had promised the IMF when the country sought its assistance in 2016 under an Extended Fund Facility or EFF.
Says Moody’s: ‘A steady and credible implementation of planned fiscal and economic reforms would improve Sri Lanka’s ability to sustain investor confidence through the upcoming period of large debt maturities. However, the likelihood of the government pursuing its reform agenda on the previously planned schedule has fallen following recent political events that have interrupted the reform momentum. Moody’s does not expect the current political crisis to be fully resolved rapidly, and the crisis is in any event likely to leave its mark on the pace and content of the reform program. Even if past episodes of political disruption have not changed the broad direction of reforms in Sri Lanka, delays in the pace of reform will at a minimum limit the government’s ability to respond to changing market conditions.’
The important reading here is that the current political crisis will not be resolved quickly and even if it is resolved, it would affect both the speed and the coverage of the reform program. In other words, they would be too slow as well as too short. Hence, the downgrade of the country’s credit rating from B1 to B2 is a slap for the President.
Cause of downgrade has been the worsened ‘eyeball fundamentals’
The Central Bank, as usual, has issued a protest statement against the downgrade. The bank has argued that the downgrade has not done justice to the improved macroeconomic fundamentals of the country in the recent past. In fact, as I have presented above, the cause of the downgrade has not been any worsened macroeconomic fundamentals.
Indeed, they have improved slightly with promise to deliver better results in the near to medium term. Inflation has been subdued, exchange rate corrected to reflect better market conditions and the budget on a pre-planned consolidation path. The cause of the downgrade has been the worsened ‘eyeball fundamentals’ as demonstrated by the lingering political crisis with no resolution in sight and a government totally non-functioning due to lack of majority in Parliament. These are visible fundamentals to concerned Sri Lankans as well as foreign investors.
No budget for 2019, no expenditure as well
For example, take the case of the government’s expenditure and revenue programs for 2019. With the prorogation of Parliament and due to the riotous behaviour of parliamentarians, there is no possibility for presenting a budget now in Parliament and get it approved before the end of 2018. Even if a temporary vote on account is presented by the Rajapaksa group, it is unlikely that it will get the sanction of the legislators.
Unless the government spends money, tax people and borrow funds by violating the Constitution, the government services will come to a standstill in 2019. That is because without a budget, it will have no powers to spend money, raise new taxes or borrow money to meet any gap in the revenue. The repayment of debt is also at risk, though some have argued that the governing debt legislations have empowered the Deputy Secretary to Treasury to charge it to the Consolidated Fund, a fictitious account that does not exist in reality.
The fictitious Consolidated Fund
As I have argued in a previous article, the Consolidated Fund which is always overdrawn is simply a summary of the cash-flow of the Treasury and if there are no adequate credits to that cash-flow, no debits can also be made to it. To repay foreign debt, for example, the government has to buy foreign exchange from the Central Bank which has enough of it now by delivering rupee funds.
In the past, if rupee funds are not available, the Central Bank made a temporary arrangement by supplying the same by issuing a Treasury bill to itself. Without Parliamentary sanctions, this also cannot be done in 2019. In the past, the government was a beneficiary of the provisional advances given to it by the Central Bank up to 10% of the estimated revenue of the government for the forthcoming year. Since that revenue was always bigger than the previous year’s revenue, there was always a net gain for the government by way of fresh money.
Without a budget for 2019, this source is also closed for the government. Hence, there is the overdrawn Consolidated Fund and debiting it to generate rupee funds to buy foreign exchange is a farcical exercise. These are the hard ‘eyeball fundamentals’ which Moody’s has used to downgrade the country’s credit rating. Hence, instead of finding fault with Moody’s, a solution has to be sought to overcome the present budgetary impasse.
A pat for the Central Bank for good achievements
Meanwhile, the Central Bank should be happy because the decision to upgrade the country’s economic outlook from Negative to Stable has been due to the positive action taken by the bank to bring about a better set of macroeconomic fundamentals.
Moody’s has justified the upgrade as follows: ‘Over the medium term, planned changes to Sri Lanka’s Monetary Law Act should help the Central Bank anchor inflation expectations and ensure monetary policy independence from fiscal developments. A shift toward market-oriented policy frameworks – including inflation-targeting and floating exchange rate policies – could increase the effectiveness of Sri Lanka’s monetary policy by helping to stabilise the cost of debt at lower levels than in the past and bolster fiscal flexibility’. Thus, the Central Bank should not take offence since it is a pat on its back.
To resolve crisis, go back to pre-26 October state
The way to resolve the crisis, as I have suggested in my previous articles, is for the President to keep a step backward, go back to pre-26 October state after the withdrawal of the support to Wickremesinghe Government by UPFA but before swearing in of Rajapaksa as the premier and allow Parliament to select a government which can present for the time being a vote on account to cover expenses at least for the first three months of 2019.
*W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at firstname.lastname@example.org
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