Moody's Investors Service has changed the outlook on Sri Lanka's B1 foreign currency sovereign rating to positive from stable.
The key drivers for the decision are:
1. An increasingly evident peace dividend reflected in greater macroeconomic and financial stability;
2. A policy orientation of fiscal reform and economic growth, supported by a successful IMF program;
3. An improving external payments position; and
4. A reduction in political event risk following the end of the civil war in 2009.
RATIONALE FOR THE OUTLOOK CHANGE TO POSITIVE
After the long-running civil war ended two years ago, Sri Lanka has started to reap a peace dividend that has accrued to the economy and the security environment. The economy is expected to grow sustainably at around 8 to 9 percent over the medium-term as confidence is further bolstered and investment picks up.
Greater macroeconomic stability is seen in a downward trend in inflation from very high levels evident during the civil war. The re-integration of the northeastern part of the country formerly controlled by the separatist Tamil movement is helping to raise food supply.
Although the government budget has not directly gained from the end of the conflict as defense mobilization remains high, a benefit is being realized by the sharp tightening in yields on government bonds. Nevertheless, the budget deficit is gradually declining in line with annual targets set out in the government's IMF program.
External vulnerabilities are also expected to ease in the near term. Relatively moderate current account deficits should continue to be easily financed, in part by rising inflows of foreign direct investment, as reflected in small balance of payment surpluses that have led to a steady rise in foreign exchange reserves. Merchandise export performance and tourism receipts have been especially buoyant early this year. In addition, Sri Lanka is rapidly building up its port cargo capacity, exploiting its strategic location astride the main shipping lane between the Middle East, South Asia, and Southeast Asia.
The main challenge facing the government is the reduction of its large debt overhang and the consequently large debt servicing costs. Among non-investment grade credits, only Lebanon, Jamaica, Ireland, and Portugal surpass Sri Lanka in terms of general government debt as a share of GDP. On a net present value basis, however, the debt burden is lower owing to a considerable share of concessional debt. Nonetheless, Sri Lanka is well-placed to grow out of its debt given its robust outlook for growth.
Re-integration of the Tamil minority in the war-torn northeast region is progressing, namely in the provision of humanitarian assistance and supporting development projects. However, the process of political reconciliation is at an early stage and will need to advance further to ease persisting concerns about political risk. As such, Moody's assessment of event risk remains somewhat elevated, but at a moderate level in our global bond methodology framework.
FUTURE RATING TRIGGERS
Continued deficit reduction as targeted by the government coupled with the containment of inflation amidst sustained high rates of growth would be credit positive developments over the 12-18 month rating horizon. Such developments would lead to a steady reduction in the government's debt burden and would enlarge the government's fiscal space to cope with future contingencies or shocks.
In other words, a longer track record in effective policy management by the post-civil war government would be viewed as credit positive. (Source : moodys.com)