Reform and growth would ease constraints for Sri Lanka – Moody’s

Whilst noting that financial weaknesses as a key rating constrain, Moody’s said yesterday reform and growth as well as Government’s financial strength will help improve the situation.

Moody’s Investors Service noted that that the Government of Sri Lanka’s B1 rating and positive outlook for its foreign-currency obligations was based on an assessment of the country’s low economic and government financial strengths, moderate institutional strengths and moderate susceptibility to event risks.  

The country’s economic scale and diversity, and per capita income level, are in line with most single B-rated sovereigns. However, a peace dividend in the form of a pick-up in economic growth, if sustained, should translate into greater credit strength. The pace and permanence of an improvement in credit fundamentals will also be determined by the success of ongoing structural and fiscal reforms.

The methodological assessment was contained in Moody’s latest annual report on Sri Lanka which sees financial weaknesses as a key rating constraint. This arises from the legacy of large budget deficits from the civil war years which ended in 2009, and which have contributed to a large government debt overhang.

Sri Lanka’s fiscal space and flexibility are constrained, in comparison to most other sovereigns, and could prove vulnerable to shocks, although contingent liabilities from state enterprises and the banking sector are currently remote.

However, Moody’s assessment of government financial strength would improve if the favorable trend in debt dynamics proves ongoing, the recently enacted fiscal reforms continue to perform well, and if strong economic growth is sustained and the external balance of payments strengthen over time.

Looking ahead, in view of Sri Lanka’s shallow capital markets and relatively modest level of gross domestic savings, Moody’s will continue to place credit emphasis on an improvement in fiscal management.

The report notes that the positive outlook announced in July 2011 was prompted by an increasingly evident peace dividend, as reflected in greater macroeconomic and financial stability, a policy orientation of fiscal reform and economic growth, supported by a successful IMF program, and a reduction in political event risk following the end of the civil war in 2009.

However, a deepening current account deficit and lower-than-expected foreign exchange reserve level projected for the end of 2011 suggests that external vulnerability event risk has not yet receded to a low level and remains moderate.

With a population of 20 million and a $50 billion economy in 2010, Sri Lanka is wealthier than all its neighbors in the Indian subcontinent by per-capita income. Yet Sri Lanka’s $5,040 per capita income, on a purchasing power basis (as of 2010), is slightly lower than the Ba3- to B2-peer median of $5,152.

Another noteworthy point is an unblemished track record of debt-servicing. Except for a voluntary relaxation of payment terms by the Paris Club in 2005 on account of the tsunami in December 2004 -- which affected $227 million in principal and interest payments out of the then-external debt stock of $13 billion -- Sri Lanka has never restructured, or defaulted on sovereign debt.

In combination with a relatively low level of per capita income overall, its political Voice and Accountability governance indicator points to a heightened susceptibility to domestic political event risk, says the Moody’s report. The reintegration of the Tamil minority in the war-torn northeast region is progressing, but the process of political reconciliation is at an early stage.