Moody’s says positive outlook on Sri Lanka’s B1 rating hinges on policy performance

Moody’s Investors Service says that the outlook for Sri Lanka’s B1 rating is positive, but it hinges on the effective management of macroeconomic challenges.

According to a new Moody’s report titled, “Credit Analysis: Sri Lanka,” the B1 rating reflects Sovereign Bond Methodology scores of “low” economic and government financial strengths, “moderate” institutional strength, and “moderate” susceptibility to risks from financial, economic, and political events.

Sri Lanka’s strong growth trend supports the rating, but the economy has faced a number of challenges over the past year.

GDP growth rose to 8% in 2010 and 8.3% in 2011, following the end of the civil conflict in May 2009. However, some aspects of the ‘peace dividend’ appear to be waning--namely, the reductions in inflation and in government funding costs. Therefore, sustaining strong growth and price stability will entail steady and effective macroeconomic management and further improvement in the investment environment.

Developments in the country’s balance of payments position will be central to the rating outlook. Policies taken earlier this year have limited downward pressures on the external accounts which emerged in late 2011. While reserves have stabilised recently, a slowdown in exports suggests that Sri Lanka’s vulnerability to external risks has not significantly receded.

Renewal of the International Monetary Fund’s stand-by agreement with Sri Lanka, which ended earlier this year, would be positive for the country’s external payments position, although the prospects and size of a fresh loan are uncertain

In addition, fiscal space and flexibility are limited, given Sri Lanka’s high government debt and refinancing needs. However, the steady moderation in the budget deficit to 6.2% targeted for 2012 from a peak of 9.9% in 2009, and a budgeted deficit of 5.8% in 2013 underscores the government’s commitment to and success in fiscal consolidation.

The stability of the current Government limits helps to ensure policy continuity. Continued progress in the reconciliation with the Tamil minority would also ensure social stability and boost economic growth in the Sri Lankan economy. However, Sri Lanka’s ‘moderate’ susceptibility to event risk reflects latent political risks in a country which only recently emerged from a long civil war.

Moody’s report is an annual update to the markets and does not constitute a rating action.