Moody's cut the credit rating of the Maldives on Wednesday and warned another was possible in the coming months due to the growing danger of a full-blown debt crisis and what would be the first ever default on an Islamic sovereign bond.

"The decision to downgrade is driven by our assessment that default risks have risen materially," Moody's said as it lowered the country's rating to Caa2 and immediately placed it "on review" for a follow-up downgrade.

That process usually takes up to three months. Moody's warned the Maldives' "fragile external liquidity position will likely worsen further without near-term financing", especially with "significant external debt obligations coming due within the next 12-18 months."

Previously rated CAA-1, the Maldives maintained its earlier rating until 27 June. However, rising economic challenges have led to Moody’s re-evaluation. The downgrade mirrors actions taken by Fitch, which recently lowered the Maldives’ rating to CC, also reflecting concerns over a potential default.

Analysts warn that the implications of these downgrades are serious, as the Maldives will likely face increased difficulty in securing funds from international markets, with borrowing expected to come at higher interest rates. They also noted that investor confidence is expected to decline, making it more challenging to attract foreign investment into the country during these uncertain times.

While the government is working on securing some external financing, comprehensive financing to meet sizeable forthcoming maturities remains uncertain while large twin deficits compound pressures on reserves, and implementation of much needed fiscal reforms continue to see delays, the statement said.

Excess domestic liquidity weighs further on limited reserves as the Maldives Monetary Authority (MMA) commits additional foreign exchange resources to maintain the peg to the US dollar, Moody’s noted.

Moody’s downgrade assessment also identified governance weaknesses in the ability of institutions to swiftly adopt measures that decisively mitigate external vulnerability risks. Limited capacity to reduce excess domestic liquidity also speaks to weaker monetary policy effectiveness, which has led to sustained pressures on the peg and foreign exchange reserves, the company detailed.

“The decision to place the ratings under review is driven by our view that Maldives’ fragile external liquidity position will likely worsen further without near term financing. The rating review will focus on assessing whether the sovereign is able to secure external financing – mainly from bilateral sources – to shore up foreign exchange reserves. In turn, this would buy time for the implementation of announced fiscal and monetary measures to raise foreign currency revenue and reduce external liquidity pressures, thereby avoiding default for the foreseeable future,” the statement said.