Sri Lanka ratings upgraded to ‘BB-‘ - Fitch

Fitch Ratings has upgraded Sri Lanka’s Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) to ‘BB-’ from ‘B+’. The Outlooks on both ratings are Stable. At the same time, the agency upgraded the Country Ceiling to ‘BB-’ from ‘B+’ and affirmed the Short-Term Foreign-Currency IDR at ‘B’.

“The upgrade reflects the stabilization and recovery of the economy under the country’s IMF programme and increased efforts to address the chronic budget deficit position,” said Art Woo, Director in Fitch’s Asia Sovereign Ratings group. Real GDP grew an impressive 8% in 2010, up from a 3.5% rise in 2009 as Sri Lanka’s post-war economic transformation, particularly the integration of the war-torn northern and eastern provinces, continued to gain traction. In tandem, the current account position has held up well, with a deficit of 2.9% of GDP in 2010, compared with the peak shortfall of 9.5% in 2008. Moreover, the positive economic momentum extended into 2011: GDP rose 7.9% yoy in the first quarter due in part to strong demand for exports, particularly garments and textiles. As a consequence, Fitch forecasts real GDP to grow 7.5%-8% in 2011 and 2012.

Consumer price inflation, which has historically proven to be both high and volatile, has been relatively well behaved, rising 7.5% yoy in H111, compared with a 6.2% rise in 2010. The benign outcome is especially encouraging given that the domestic agriculture sector suffered a sharp downturn in output earlier in the year and global food and energy prices remain elevated. Fitch forecasts CPI to be 7.5% in 2011 and 6.8% in 2012.

Sri Lanka has also made some important headway in consolidating its fiscal deficit, which is one of the sovereign’s key rating weaknesses, particularly when compared with ‘BB’ rating category peers. The

budget deficit was brought down to 8% of GDP in 2010, from 9.9% in 2009. Moreover, many recommendations by the Presidential Commission on Taxation, which was formed in mid-2009 to review the country’s tax system, were implemented in the 2011 budget. This should enable the authorities to achieve, or at least come close to, the budget deficit targets of 6.8% of GDP for 2011 and 5.2% for 2012.

If Sri Lanka is able to continue consolidating the fiscal position, its public debt dynamics should be placed on a more sustainable path. Fitch notes that Sri Lanka’s public debt-to-GDP ratio stood at 82% of GDP in 2010, which is well above the ‘B’ and ‘BB’ peer rating group medians of 40% and 41% respectively.

Weak external finances also weigh on Sri Lanka’s ratings. Net external debt was 30% of GDP in 2010, which is well above the ‘B’ and ‘BB’ range medians of 9.4% and 7.4% respectively. However, official foreign exchange reserves have recovered to USD7.2bn in April 2011, from a trough of USD1.3bn in March 2009 before Sri Lanka entered into a USD2.6bn stand-by arrangement with the IMF. The ability to attract non-debt capital inflows, specifically foreign direct investment (FDI), would not only help reduce Sri Lanka’s reliance on external debt but could also improve the overall competitiveness of the economy. However, FDI following the end of the civil war has been surprisingly weak, totalling just USD478m (or 1% of GDP) in 2010.

Fitch would view the authorities’ ability to continue consolidating the budget deficit, by both enhancing the tax revenue base and rationalising expenditures, and in tandem lowering the level of public debt as supportive for Sri Lanka’s ratings. A sustained period of strong economic growth, particularly if accompanied by an improvement in the investment climate and private sector capital spending, would also be supportive for the ratings. In contrast, continued double-digit inflation or deterioration in political stability would put downward pressure on Sri Lanka’s ratings.