In a recent turn of events on September 14, 2023, Fitch Ratings took a significant step by downgrading Sri Lanka’s Long-Term Local-Currency Issuer Default Rating from ‘C’ to ‘RD’. This move came in response to the completion of a complex treasury bond exchange program, part of a broader domestic debt optimization effort. It’s worth noting that the exchange of treasury bills held by the Central Bank of Sri Lanka (CBSL) is still a work in progress.
In a reassuring statement, Fitch expressed its confidence, stating, “We do not believe the completion of the first phase of the restructuring of the sovereign’s local-currency obligations is likely to trigger a loss of depositor confidence in the banking system, leading to a widespread default within the financial system, including for non-bank financial institutions (NBFIs). As such, we expect the banks to continue to service their local-currency obligations, given their better funding and liquidity profiles relative to that of the sovereign.”
However, Fitch has kept the Rating Watch Negative (RWN) status for Sri Lanka’s banks and NBFIs. This move reflects an acknowledgment of the potential risks that may impact their creditworthiness in comparison to other entities on the Sri Lankan national ratings scale. These near-term risks are primarily associated with the aftermath of the sovereign’s debt restructuring and the ongoing constraints in accessing wholesale foreign-currency funding.
Fitch also highlights the need for further clarity in the sovereign debt restructuring process, especially regarding foreign-currency debt. Such clarity could signal a reduction in the challenges that have been affecting the banking sector over the past few quarters, potentially leading to the resolution of the RWN status with an affirmation of the bank ratings.
While local banks have been spared from the rupee debt restructuring, it’s important to recognize the persisting challenges in the broader economic landscape. The anticipated economic contraction and volatile economic variables continue to pose challenges. These factors may exert downward pressure on individual credit profiles, especially for NBFIs, which are often more exposed to cyclically sensitive segments of the economy.
Fitch concludes by underlining the significance of reassessing the sovereign credit profile after the completion of the debt exchange with CBSL, as it will inevitably influence the ratings of banks and NBFIs. The interconnectivity between these institutions and the sovereign’s financial health remains a critical factor.
As the domestic debt optimization program nears its conclusion, there is still a cloud of uncertainty looming over the completion of the foreign-currency sovereign debt restructuring. Any uncertainties in this domain could impact the banking sector, with potential ripple effects on NBFIs, given the banks’ exposure to defaulted foreign-currency sovereign bonds, despite their relatively small share of sector assets (3.6% of assets at the end of the first half of 2023).