Financial Times

Worsening crisis hurts Sri Lanka credit rating
SINGAPORE — Standard & Poor’s Ratings Services last week revised its outlook on Sri Lanka to negative from stable. At the same time, Standard & Poors affirmed its “B+” long-term foreign currency and “BB-“ local currency sovereign credit ratings on Sri Lanka. The “B” short-term foreign and local currency sovereign credit ratings were also affirmed.

The outlook revision reflects Standard & Poor'’ concerns that the recent sharp escalation in hostilities between the Sri Lankan government and the Liberation Tigers of Tamil Eelam (LTTE) could precipitate the complete collapse of the truce in effect since 2002, resulting in a return to war.

"A resumption of full-scale hostilities could have negative implications for the country’s already stressed fiscal and debt position, and likely impair its previously adequate level of external balances," said Standard & Poor's credit analyst Agost Benard.

“The ratings on Sri Lanka are vulnerable due to the country's high government debt, ongoing large fiscal deficits, and the threat to external viability should a return to all-out war result in reduced growth and investor confidence and necessitate higher government expenditure," added Mr. Benard.

Sri Lanka’s fiscal flexibility is seriously hampered by its debt level of an estimated 92 per cent of 2005 GDP (excluding the debt of non-financial public companies) and attendant debt service burden of about 38 percent of general government revenues.

At an estimated 602 per cent, the debt-to-revenue ratio underscores the high level of indebtedness and the relatively low fiscal resource base to service it.
A return to full-scale war threatens to cause further deterioration in these ratios, increasing the country’s vulnerability.

The statement said resumption of all-out hostilities would put additional pressure on government expenditures, which remain burdened by a large public sector, loss-making enterprises, and extensive subsidies. Revenue collection, already one of the weakest among rated sovereigns at 15.4 percent of GDP, would also likely deteriorate as economic growth and investor confidence falter. Taken together, these factors could further exacerbate fiscal deficits that are routinely at 8-10 percent of GDP annually, with adverse implications for Sri Lanka’s debt.

In addition, the country’s external liquidity could come under pressure if war causes reduced foreign exchange inflows from tourism and tourism-related investment, and if export earnings are hurt as a result of damage to infrastructure or attacks on export industry facilities. Moreover, foreign aid could also potentially diminish, as a significant part of disbursements has been conditional on progress in the peace process.

The negative outlook could revert to stable if substantial and tangible progress is achieved in maintaining the official cease-fire, so that infringements are materially reduced, with a view to commencing talks on a final peace settlement. Conversely, resumption of full-scale war and fiscal slippage would exert downward pressure on the ratings.

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