Moody's said foreign reserves have stabilized at 6.9 billion US dollars and the rupee was no longer being pegged tightly to the US dollar.
But foreign liabilities of banks have doubled to 3.4 billion US dollars by February 2012 from July 2011 which could "lead to pressure on the external payments position, if creditor sentiment deteriorates," Moody's said.
"The second driver behind the rating action is a slowdown in the pace of fiscal consolidation," Moody's said.
"While progress has been made in reducing both debt and deficits, much of this consolidation took place between 2009 and 2011, and since then, the pace of improvement has slowed," Moody's said.
"As a result, Sri Lanka's debt burden remains considerably higher than the 44% of GDP median in 2012 for Sri Lanka's B-Caa rating peers."
Budget deficits have fallen from 9.9 percent in 2009 to 6.4 percent in 2012 and national debt has fallen from 86 percent of GDP to 79 percent.
Related to the debt level was slowing economic growth. After growing 8.1 percent in 2010 and 2011, economic growth had since slowed.
"Looking ahead, the government projects highly favorable macroeconomic developments," the rating agency said.
"By 2015, it expects growth to accelerate to 8.3 percent, the current account deficit to diminish to 1.4 percent of GDP, and official foreign reserves to surpass $10 billion, in large part as a result of a substantial increase in foreign direct investment.
"However, Moody's also believes that internal policy challenges, and global economic headwinds and financial cross-currents will make achieving such targets challenging."
Moody's said a said a "sustainable rise in official foreign exchange reserves" and reduction of its external vulnerability indicator below 100 percent, higher growth and lower deficits would help upgrade the rating.
A shift away from debt financing to foreign direct invest would help the rating.
A worsening of political stability and reconciliation after the end of a civil war that would hurt investor confidence or worsening deficits would trigger a downgrade.
The full statement is reproduced below
Rating Action: Moody's changes outlook on Sri Lanka's sovereign rating to Stable
Singapore, July 02, 2013 -- Moody's Investors Service today changed the outlook on Sri Lanka's B1 foreign currency sovereign rating from positive to stable, and affirmed its B1 foreign currency government bond rating.
The action was prompted by:
1) The stabilization in the external payments position, following the sizable loss of foreign reserves in 2011, but without enough improvement to support a positive rating action at this time; and
2) The pause in the decline in the government's very high debt burden, as ongoing large deficits impede a reduction that would be credit positive.
The first driver underlying Moody's decision to affirm Sri Lanka's B1 rating and revise its outlook from positive to stable is a decline in the strength of the external payments position in the past two years. In defending the currency in the face of a sharply widening current account deficit, reserves fell from a high of $8.1 billion in July 2011 to a low of $5.5 billion in February 2012. In addition, the rapid rise in banks' net foreign liability position since July 2011 -- involving an almost doubling to $3.4 billion as of February 2013 -- could lead to pressure on the external payments position, if creditor sentiment deteriorates, or if the current account deficit widens.
Nevertheless, since late last year there has been a stabilization of the external payments position. The government has taken remedial measures, including abandoning the de facto currency peg to the dollar, tightening monetary policy, and raising tariffs on imports. These measures have reduced the current account deficit somewhat, and official foreign exchange reserves have stabilized, standing at $6.9 billion as of April 2013.
However, these reserves remain considerably below the peak achieved when the outlook was changed to positive in July 2011.
The second driver behind the rating action is a slowdown in the pace of fiscal consolidation. The fiscal deficit has narrowed from a peak of 9.9% of GDP in 2009 to 6.4% in 2012. The debt/GDP ratio has also been on a generally declining trajectory, falling from 86% of GDP in 2009, the year the civil war ended, to 78% of GDP in 2011, although it edged higher to 79% of GDP in 2012 due to currency depreciation.
While progress has been made in reducing both debt and deficits, much of this consolidation took place between 2009 and 2011, and since then, the pace of improvement has slowed. As a result, Sri Lanka's debt burden remains considerably higher than the 44% of GDP median in 2012 for Sri Lanka's B-Caa rating peers.
Related to the near stall in debt reduction is the slowdown in economic growth. Real GDP grew an average of 8.1% between 2010 and 2011. However, this rate did not prove to be sustainable and the policy framework allowed an over-heating of the economy in late 2011, as manifested in a sharp widening in the current account deficit and a rise in inflation. Through 2013 and 2014, Moody's expects growth will remain in the 6% to 7% range, and pose less of a risk in terms of possible overheating pressures.
Looking ahead, the government projects highly favorable macroeconomic developments. By 2015, it expects growth to accelerate to 8.3%, the current account deficit to diminish to 1.4% of GDP, and official foreign reserves to surpass $10 billion, in large part as a result of a substantial increase in foreign direct investment. However, Moody's also believes that internal policy challenges, and global economic headwinds and financial cross-currents will make achieving such targets challenging.
FUTURE RATING TRIGGERS
Upward pressure on the rating would come from:
• A strengthening of the external payments position, as reflected in a sustainable rise in official foreign exchange reserves and reduction in the external vulnerability indicator well below 100%. A shift away from external debt financing towards greater reliance on foreign direct investment (FDI) could be a key element of such improvement, or from
• The maintenance of relatively strong GDP growth -- coupled with a steady reduction in fiscal deficits -- to the extent that the government debt burden declines at a faster pace to narrow the wide divergence from its peers and, more importantly, to reduce the high government debt-service burden. On the other hand, triggers for a downward rating action would include:
• A reversal in progress on fiscal consolidation,
• A substantial worsening of the country's external balance and foreign currency liquidity position, or
• A reversal in post-war political stability and reconciliation, which would undermine investor confidence and both fiscal and economic performance.
GDP per capita (PPP basis, US$): 5,582 (2011 Actual) (also known as Per Capita Income) Real GDP growth (% change): 6.4% (2012 Actual) (also known as GDP Growth)
Inflation Rate (CPI, % change Dec/Dec): 9.2% (2012 Actual)
Gen. Gov. Financial Balance/GDP: -6.4% (2012 Actual) (also known as Fiscal Balance)
Current Account Balance/GDP: -6.6% (2012 Actual) (also known as External Balance)
External debt/GDP: 56.7% (2012 Actual)
Level of economic development: Low level of economic resilience
Default history: No default events (on bonds or loans) have been recorded since 1983.
On 27 June 2013, a rating committee was called to discuss the rating of the Sri Lanka, Government of. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have materially decreased. The issuer's fiscal or financial strength, including its debt profile, has not materially changed. External payments position has weakened over the past two years Other views raised included: The issuer's institutional strength/ framework, have not materially changed. The issuer has become less susceptible to event risks.