OREANDA-NEWS. Fitch Ratings has affirmed Sri Lanka's Long-Term Foreign and Local Currency Issuer Default Ratings at 'BB-'. The issue ratings on Sri Lanka's senior unsecured foreign and local currency bonds are also affirmed at 'BB-'. The Outlooks on the Long-Term IDRs are Stable. The Country Ceiling is affirmed at 'BB-' and the Short-Term Foreign Currency IDR at 'B'.

KEY RATING DRIVERS
The affirmation of Sri Lanka's sovereign ratings with Stable Outlooks reflects the following key factors:

- Orderly and peaceful political transition. Sri Lanka enjoyed a smooth political transition following presidential elections in January 2015, reinforcing perceptions of a functioning democracy with relatively strong institutions by 'BB' standards. However, uncertainties remain about the timing and outcome of parliamentary elections, and the implications for effective policymaking in the future.

- Favourable GDP growth. Sri Lanka continues to post strong economic growth of 7.5% (five-year average), far exceeding the 'BB' median of 3.9%. However, with low foreign direct investment, growth is heavily dependent on external borrowing, while the government's "pro-growth" bias has constrained improvements in Sri Lanka's fiscal and current account deficits and weakened policy coherence and credibility. Recent monetary easing and continued strong credit growth lend further support to this view.

- Weak balance of payments. Falling oil prices should play to Sri Lanka's advantage, helping to contain the current account deficit, as should strong remittances and tourism, while net non-resident inflows into the domestic debt market have remained positive. Even so, heavy external debt repayments have led to a drawdown of international reserves from USD10bn at end-April 2014 to less than USD7bn at end-March 2015, raising concerns about external liquidity, particularly in the face of expected monetary tightening by the US Federal Reserve.

- External Borrowing Strategy. Fitch expects that Sri Lanka will succeed in rebuilding international reserves to USD10bn by the end of 2015 through a combination of renewed borrowing on international capital markets, the exercise of foreign currency swaps with the Indian and Chinese central banks, and onshore borrowing through Sri Lanka Development Bonds. Nonetheless, there are risks that may derail this strategy, including a potential rise in domestic political uncertainty and an adverse shift in investor sentiment, which led Sri Lanka to abort plans to borrow in international capital markets in 1Q15.

- Public finances remain a credit weakness. Sri Lanka's fiscal metrics are a standout relative to the 'BB' category, notwithstanding a reduction in general government deficits to around 5% in 2014 from 8% of GDP in 2010. Narrower government deficits have contributed to a fall in public debt, despite a weaker Sri Lanka rupee, which drives up the local currency component of external public debt. Still, gross general government debt remains high at about 75% of GDP at end-2014 and Fitch believes that fiscal consolidation could stall in 2015-16 as expenditure rises and revenues remain lacklustre. An interim 2015 budget contained a number of one-off measures that have hurt business confidence and did little to address the lack of a medium-term fiscal framework.

Sri Lanka's ratings are supported by the following factors:
- A clean external debt servicing record, which stands out among 'BB' peers.
- Levels of basic human development, including education, health and literacy, are relatively high, as indicated by a favourable UN Human Development Index score. Among sovereigns rated by Fitch, Sri Lanka falls in the 61st percentile, which is much higher than the 'BB' median of 41.

RATING SENSITIVITIES

The Outlook remains Stable. Fitch's current assessment therefore does not anticipate developments with a high likelihood of leading to a rating change.

The main factors that individually or collectively could trigger a negative rating action are:

- Increase in external vulnerability driven by a sharp decline in FX reserves due to, for instance, reduced international market access and/or sudden reversal in portfolio inflows.
- Deterioration in policy coherence and credibility leading to a widening of macroeconomic imbalances and a loss of investor confidence
- A deterioration in public finances that leads to wider fiscal deficits and increases in debt

The main factors that individually or collectively could trigger a positive rating action are:

- Predictable and robust policy framework following upcoming parliamentary elections that is consistent with stable and low inflation, is in line with peers, and leads to a prolonged period of real GDP growth.
- Sustained smaller current account deficits with higher levels of non-debt capital inflows (foreign direct investment) and an increase in foreign exchange reserves
- Improvement in Sri Lanka's public finances underpinned by a credible medium-term fiscal consolidation strategy including a broadening in the general government revenue base.

KEY ASSUMPTIONS

- There is no renewal in the civil conflict that previously lasted 26 years and ended in 2009.
- Global economic assumptions are consistent with Fitch's Global Economic Outlook.