Standard and Poor’s Ratings Services (S&P) has down graded Sri Lanka’s rating from stable to negative citing concerns about the country’s fiscal and debt positions and its ability to meet external payment obligations.

"Standard & Poor’s believes the military defeat of the separatist LTTE will not alleviate near-term pressure on external liquidity, nor is it likely to reverse the country’s unfavorable fiscal trajectory," the rating agency said in a statement.

The rating agency also raises concerns about the delay in the US$ 1.9 billion standby facility. The Central Bank, however, is confident the loan will come through.

"An IMF agreement and subsequent bilateral loans remain essential to avoiding potential external payment difficulties, while meaningful deficit and debt reduction will require substantive fiscal reforms to expand the revenue base and rationalize expenditure," S&P said.

Analysts say with the war on terror over, the government should turn its attention to achieving a degree of that elusive fiscal discipline. That foreign currency inflows will increase is a given and the foreign exchange market is also bustling with positive sentiments driving the rate to as low as 113.50 until state agents intervened to stabilize the rate at 115 for the benefit of the export sector.

"S&P’s rating is crucial when it comes to commercial borrowings. But if we can get investments from friendly countries and other agencies, and if the Diaspora chips in, S&P’s ratings may not affect us. However, we need to see more discipline on the fiscal side," and analyst said.

However, the rating agency said it would revise its rating when things improve.

The full text of S&P’s statement follows:

SINGAPORE (Standard & Poor’s) May 21, 2009—Standard & Poor’s Ratings Services today revised the outlook on Sri Lanka to negative from stable. At the same time, Standard & Poor’s affirmed its ‘B’ long-term foreign currency sovereign credit rating and ‘B+’ long-term local currency rating on Sri Lanka. The short-term rating was also affirmed at ‘B’.

In parallel, Standard & Poor’s also affirmed the following: (1) transfer and convertibility assessment on Sri Lanka at ‘B+’; and (2) the ratings on Sri Lanka’s senior unsecured debt at ‘B’, for foreign currency, and ‘B+’, for local currency debt.

"The negative outlook reflects our opinion that underlying pressures on Sri Lanka’s external liquidity position have intensified, while the timing and implementation of a potentially stabilizing IMF loan agreement is uncertain," said Standard & Poor’s credit analyst Agost Benard.

The outlook reflects Standard & Poor’s view that further erosion of external liquidity or delays in securing an IMF loan would result in a rating downgrade. The sovereign ratings could stabilize at the current level once an IMF agreement is reached and indications emerge that program targets are being substantially met.

Standard & Poor’s believes the military defeat of the separatist LTTE will not alleviate near-term pressure on external liquidity, nor is it likely to reverse the country’s unfavorable fiscal trajectory.

An IMF agreement and subsequent bilateral loans remain essential to avoiding potential external payment difficulties, while meaningful deficit and debt reduction will require substantive fiscal reforms to expand the revenue base and rationalize expenditure.

Information on foreign exchange reserves at the end of March showed a 26.8% decline in gross official reserves since the beginning of the year, even as the trade deficit narrowed significantly in the quarter. This implies further deterioration in Sri Lanka’s ratio of foreign debt service to reserves (foreign currency debt service payments to official reserves), which rose to 39.8% in 2008 from 29.4% in 2007, and its ratio of commercial foreign currency debt to reserves, which rose to 95% from 68%.

Notwithstanding the expected moderation of the current account deficit from a record 9.3% of GDP in 2008 to our projected 5.8% this year, Sri Lanka’s gross external financing needs are likely to remain high at about 130% of current account receipts plus usable reserves—above the ‘B’ median and all peers.

In addition to the immediate concern over external liquidity, sovereign creditworthiness continues to be constrained by ongoing large fiscal deficits, which in our view, are due to an inadequate revenue base and inflexible expenditure structure. The 2008 fiscal deficit of 8% of GDP is a reversal of modest consolidation over the recent years. In addition, revenue growth of an estimated 14.6% against nominal GDP growth of a reported 23.2% underscores the weak revenue generation.

"Indications on revenue and expenditure trends year to date, together with slowing growth and falling imports, promise little prospect, if any, of improvement in the fiscal trajectory," Mr. Benard said. Standard & Poor’s believes that unless strong policy measures are applied on the expenditure and revenue front, the general government fiscal deficit will remain high at 7%-8% of GDP in the foreseeable future.