Fitch Ratings has affirmed Sri Lanka’s foreign- and local-currency IDRs at ‘BB-’. The outlook for both ratings is stable. The Country Ceiling has also been affirmed at ‘BB-’ and the short-term foreign currency IDR at ‘B’, according to a report from the agency.

“The ratings reflect Fitch’s view that the authorities have taken the appropriate action to correct recent pressure on the balance of payments and place it on a more sustainable trajectory. Given the weakened state of Sri Lanka’s external finances and a heavy external debt refinancing schedule through to 2013, the authorities’ ability to persist with policies that address existing macroeconomic imbalances and improving external liquidity is crucial,” Director in Fitch’s Asia-Pacific Sovereign Ratings Group, Philip McNicholas said.

The pace of deterioration in external buffers, rather than their level, was the main focus of a report from Fitch.

“The level of foreign exchange (FX) reserves meets with international conventions and does not indicate an immediate risk of substantial balance of payments stress. However, Fitch believes the rapid depletion of FX reserves in H211 has heightened the vulnerability of the Sri Lankan sovereign credit profile to a spike in global risk aversion,” the report stated.

The report further stated that Fitch views the resumption of the IMF tranche disbursements following the implementation of policy measures aimed at macroeconomic rebalancing as a positive development, alongside the tightened monetary conditions themselves, all of which could lead the country along a more sustainable GDP growth trajectory over the long term.

“Although Sri Lanka was able to record real GDP growth over 8% for the second consecutive year in 2011, such economic performance, coupled with policy missteps, resulted in the current account deficit rapidly widening to 7.8% of the GDP from 2.2% in 2010. This, in conjunction with deterioration in the external economic environment and limited currency flexibility, led to balance of payment pressures and in turn a sharp depletion of foreign exchange (FX) reserves to USD 5.8 billion (3.4 months of imports) in January 2012 from USD 8.1 billion (equivalent to 5.7 months of imports) in July 2011.”

“In the near-term, certain policy measures have resulted in adverse risks to both growth and inflation that have the potential to impact policy consistency. Due to the authorities' pro-growth bias and the fragile balance of payments, Fitch believes developments in the coming months warrant close monitoring,” the report stated. It noted that the government has been able to rationalise expenditure and continue consolidation efforts, despite lower-than-expected fiscal revenues resulting in a narrowing of the fiscal deficit (including grants) to 6.9% of the GDP in 2011 from 8% in 2010 and public debt declined to 78.5% of the GDP from 81.9%.

“Further simplification of the tax system could bolster measures announced in previous budgets and aid in the attraction of greater foreign direct investment inflow,” the report added. Successful implementation and persistent application of policies aimed at improving external liquidity, including further monetary tightening if required, would support the ratings; however, this would require a concerted effort to persist with fiscal consolidation, by both enhancing the tax revenue base and rationalising expenditure, in tandem with lowering public debt would be supportive of Sri Lanka's ratings, according to the agency.

However, the report cautioned that a reversal of policy measures leading to further balance of payment pressure would be negative for the ratings. “Further FX reserve depletion, resulting from domestic policy or an external shock would likely have the same effect. Deterioration in public debt and budget deficit ratios owing to revenue shortfalls and/or failure to rationalise expenditure would also be negative for the ratings,” the report stated.

The report also disclosed that the Central Bank of Sri Lanka currently maintains a 10% equity stake in Fitch Ratings Lanka Ltd.