S&P revises Sri Lanka FC rating outlook to stable from positive

Overview
Sri Lanka’s reserves have fallen to three months coverage of its current account payments as of end 2011 from roughly four months in the middle of 2011.
Given the lower reserves and continued fiscal pressures, we are revising the outlook on our ‘B+’ long-term foreign currency sovereign rating on Sri Lanka to stable from positive.

We are equalising our long-term local currency sovereign rating with the foreign currency sovereign rating at ‘B+’. The outlook is stable.
We are affirming our ‘B+’ long-term foreign currency rating and ‘B’ short-term foreign and local currency ratings on Sri Lanka.
The stable outlook reflects our view that the country’s strong medium-term growth prospects and recent measures to improve its fiscal profile are balanced against vulnerable external liquidity and high fiscal and external debt.
Rating action
On 29 February 2012, Standard & Poor’s Ratings Services revised its outlook on the long-term foreign currency sovereign credit rating on the Democratic Socialist Republic of Sri Lanka to stable from positive. At the same time, Standard & Poor’s affirmed its ‘B+/B’ foreign currency sovereign credit ratings on Sri Lanka. We also lowered the long-term local currency rating to ‘B+’ from ‘BB-’, while affirming the ‘B’ short-term local currency rating. Likewise, the long-term local currency issue rating has been lowered to ‘B+’ from ‘BB-’. The outlook for the long-term local currency rating is stable. We affirmed the recovery rating at ‘4’. The transfer and convertibility (T&C) assessment is unchanged, at ‘B+’.
Rationale
We revised our outlook on the long-term foreign currency rating to reflect the country’s deteriorating external liquidity. We also lowered the long-term local currency rating to the same level with the foreign currency rating to reflect the country’s lack of track record in having a floating exchange rate regime and its still-developing secondary market for debt instruments.
The ratings are constrained by weak external liquidity, moderately high and increasing external debt, fundamental fiscal weaknesses, the attendant high public debt and interest burden, and political institutions that, in some cases, lack transparency and independence. The ratings are supported by improved growth prospects and the government’s moderate progress in addressing a number of its structural weaknesses, through fiscal measures and success in limiting inflation to single digits.
Although the government and the central bank have recently begun to shift their monetary and foreign exchange rate policies to control the pace of credit expansion and import growth, Sri Lanka’s external liquidity has weakened. We estimate its gross international reserves fell to three months’ coverage of current account payments in December 2011.
A narrow tax base, the burden of a civil conflict, extensive subsidies, and a bloated public sector have contributed to the country’s fiscal deficit of 8% of GDP on average over the past decade, with the change in debt often exceeding the deficit because of currency depreciation. We expect the general government deficit to improve to 6.8% of GDP in 2012 from our estimate of 7.1% in 2011, on account of tax measures and expenditure restraint. We project this improvement, combined with an estimated 13.5% growth in nominal GDP, to lower the debt burden to 78% of GDP at the end of 2012 from 81% in 2011. However, despite the reduction, the levels of debt and attendant interest burden still result in the weakest debt score, according to our criteria, and are among the highest in the rating category.
Despite the recent moderation of inflation, the high inflation in the past has constrained investment and raised the general government interest burden to about 40% of general government revenues in recent years.
The ratings reflect the country’s favourable growth prospects, which we believe are partly due to the “peace dividend”- positive effects from the end of the civil war in 2009. We expect investment to edge upward to 30% of GDP, boosting per capita growth to more than 6% per year in the next few years. If the business environment improves and boosts net foreign direct investment above its current pace of about 1% of GDP, we believe stronger growth may be possible in the medium term.
The Sri Lankan administration has started to implement a part of its planned fiscal reforms, helped by the increased political stability. Further reforms could gradually improve the country’s competitiveness as well as fiscal and debt profiles.
The government has not relied on funds from the IMF’s Standby Loan Program since April 2011, despite the program having boosted investor confidence. However, as the government’s shift of its monetary and exchange rate policies since November 2011 indicates, the government might start to subscribe to this facility again, which is likely to help restore a part of the confidence eroded in recent months.
Outlook
The stable outlook reflects our view that the country’s strong medium-term growth prospects of more than 6% of GDP per capita and recent measures to improve the fiscal profile are balanced against vulnerable external liquidity and high fiscal and external debt. We also expect the recently announced monetary and foreign exchange policy to keep the country’s external position from further deterioration. We may raise the rating if there is evidence of progress in addressing the external weaknesses and domestic problems, such as fiscal or structural economic reforms that reduce the vulnerabilities from high debt and interest burdens and the still-narrow economic profile.
Conversely, we may lower the rating if there is substantial further deterioration of the country’s external liquidity, or if Sri Lanka’s growth and revenue prospects fall below our current expectations.