Fitch Ratings has revised the Outlook Sri Lanka’s Long-term foreign and local currency Issuer Default Ratings (IDRs) to Stable from Negative. At the same time, the agency has affirmed the Long-term foreign and local currency IDRs and the Country Ceiling at ‘B+’, and the Short-term IDR at ‘B’.

"The revision to Sri Lanka’s Outlook reflects positive changes in sovereign credit fundamentals following the end of the 26-year civil war, the approval of a USD2.6bn IMF agreement and the return of private sector capital inflows," says James McCormack, Head of Asia Sovereigns at Fitch. "Official foreign exchange reserves were USD4.3bn at end-September, which is a record high, and are expected to exceed USD5bn by year-end, providing a substantial lift to the sovereign’s external financial position," added McCormack.

In Fitch’s view, there is a real opportunity for economic renewal as part of the post-war transformation of Sri Lanka. The agency believes that, with the fighting having ended, it is much more likely that a durable political consensus can be reached on constitutional change and other measures to allow for the sharing of power among different ethnic groups and across different levels of government. A more settled political backdrop should, in turn, allow policymakers to focus more on economic issues, including construction and development in areas directly affected by the war, some of which has already begun. In fact, the economic ‘peace dividend’ should extend to the entire economy, as the labour force effectively expands, and costs such as transportation and insurance decline. Concurrent foreigncurrency inflows from international donors, investors and the Sri Lankan diaspora are expected to supplement domestic resources available for investment spending. Increased tourism receipts offer additional potential foreign-currency income, and tourist arrivals have increased sharply on a year-on year basis in recent months.

The current IMF programme calls for the fiscal deficit to fall to 7.0% of GDP in 2009 from 7.7% of GDP in 2008. It is to decline further by 1pp of GDP in both 2010 and 2011. Based on historical fiscal performance and the clear need to increase government spending as part of reconstruction efforts, Fitch considers the current fiscal targets to be ambitious, even after taking into account the anticipated increase in donor funding.

From a ratings perspective, however, the agreed targets with the IMF are less important than the emergence of a sustainable medium-term fiscal framework with a credible strategy for raising government revenue. Once interest payments on debt are accounted for, Sri Lankan government revenue is forecast by Fitch to be only 10% of GDP in 2009, among the lowest of all rated sovereigns.

A presidential commission has been established to report on ways to increase tax collection, and the government has already begun to scale back exemptions granted under the Board of Investment Act, confirming the authorities’ commitment to raising the revenue/GDP ratio. However, Fitch is concerned that spending will accelerate more quickly. Reductions in the deficit are needed to bring government debt ratios more in line with Sri Lanka’s rating peers. Fitch forecasts Sri Lankan government debt will reach 82.7% of GDP at end-2009, compared with the ‘B’ median of 30.4% and the ‘BB’ median of 37.3%.