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* Sri Lanka's economy shows strong growth potential, but government finances remain weak - Moody's
Thu, Jul 24, 2014, 12:39 am SL Time, ColomboPage News Desk, Sri Lanka.

July 23, Singapore: Moody's Investors Service affirmed Sri Lanka's 'B1' sovereign bond rating with the stable outlook today, citing strong growth potential of the island nation, but said the weakness of government finances is a rating constraint.

However, a sustained decline in its deficit, debt and borrowing costs would be seen as credit positive, Moody's said.

Moody's notes that real GDP growth is likely to remain in the 6.5%-7.0% range over the medium term, supported by infrastructure investment. However, the success of efforts to encourage private investment will be key to achieving the Central Bank of Sri Lanka's real GDP growth target of 8.4% by 2017.

With the credit analysis Moody's examined the country in four categories: economic strength, which is assessed as "moderate (+)"; institutional strength "low (+)"; fiscal strength "very low (-)"; and susceptibility to event risk "moderate (-)".

Sri Lanka's real GDP growth is likely to remain in the 6.5-7.0% range over the medium term, supported by infrastructure investment, the rating agency said, but added that the success of efforts to encourage private investment will be key to achieving the central bank growth target of 8.4% by 2017.

"Currently, favourable supply-side developments, such as a ramp-up in agricultural production from the northern and eastern areas, are helping to contain inflation to the mid-single digit range."

"Furthermore, a reduction in the current-account deficit, coupled with global bond issuances, has helped to replenish official foreign-exchange reserves, which saw a sizable loss in 2011 when the balance of payments came under strain," Moody's said.

Moody's assesses Sri Lanka's government financial profile and says that while rapid economic growth has helped to reduce the government deficit and debt service expenditure since the end of the civil war in 2009, the public debt burden remains high.

According to Moody's as a share of GDP, government debt fell considerably between 2009 and 2011, but the pace of reduction has since slowed and debt is higher than most similarly rated peers. Debt affordability is also constrained: interest payments as a share of revenues are among the highest of all countries that Moody's rates.

"However, these risks are somewhat mitigated by relatively long tenors and a captive investor base. Should the recent moderation in treasury yields be sustained, interest expenditure would fall, easing a key financing constraint."

Contingent risks from state-owned enterprises are also abating. While government subsidies have contributed to large losses in state-owned enterprises (SOEs) - particularly in the aviation and energy space - 2013 did see a turnaround in the performance of the Ceylon Electricity Board and the Ceylon Petroleum Corporation, resulting in a significant moderation in aggregate losses among SOEs, the rating agency said.

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