Sri Lanka is still vulnerable to external shocks given, lower than expected year-end foreign exchange reserves and needs lasting reforms to better its credit rating, Moody's, a rating agency has said.
The island must further reduce government debt and budget deficits while a rapid and lasting improvement in credit strength depends on how successful ongoing reforms are, Moody's Investors Service said in a credit report.
Sri Lanka's B1 rating and positive outlook for its foreign-currency obligations is based on an assessment of the country's low economic and government financial strengths, moderate institutional strengths and moderate susceptibility to event risks, it said.The report notes that the positive outlook announced in July 2011 was prompted by an increasingly evident peace dividend, after the end of a 30-year ethnic war in 2009.
This was seen 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 war, the rating agency said.
"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," it said.
Moody's assessment of government financial strength would improve if it continues to reduce debt, recently enacted fiscal reforms continue to perform well, and if strong economic growth is sustained and the external balance of payments strengthen over time.
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," said Moody's annual report on Sri Lanka.
The country's economic scale and diversity, and per capita income level, are in line with most single B-rated sovereigns.
The rating agency said it sees financial weaknesses as a key rating constraint arising from the legacy of large budget deficits from the civil war years, 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, Moody's said.
Moody's will continue to place credit emphasis on an improvement in fiscal management in future because of Sri Lanka's shallow capital markets and relatively modest level of gross domestic savings.
It noted that with a population of 20 million and a 50 billion US dollar 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 dollar per capita income, on a purchasing power basis (as of 2010), is slightly lower than the Ba3- to B2-peer median of 5,152 dollars," Moody's said.
However, the rating agency praised Sri Lanka's debt service record saying: "Another noteworthy point is an unblemished track record of debt-servicing."
Sri Lanka has never restructured, or defaulted on sovereign debt, except for a voluntary relaxation of payment terms by the Paris Club in 2005 on account of the tsunami in December 2004, Moody's said.
This affected 227 million dollars in principal and interest payments out of the then-external debt stock of 13 billion dollars.
However, the rating agency also noted that Sri Lanka's political risk has not come down to low levels with no sign yet of a permanent solution to the ethnic conflict which gave rise to violence.
"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," said 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."
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