Fitch Ratings gave the nation a BB- rating, which are three notches lower than investment grade, but with a long-term stable outlook.
The dual ratings highlights the high level of government indebtedness and weak revenue mobilisation, together with political and security concerns, which stem from a fractious political environment and the unresolved issue of a peace settlement with Tamil separatists.
Standard & Poor's believes these are the principal sources of risk for the Sri Lankan economy, with each having the potential to exacerbate the country's fiscal woes and public-sector indebtedness and slow economic progress.
"The dynamics of Sri Lanka's political economy makes for an environment in which public-sector, economic, and fiscal reforms are difficult to accomplish and are prone to setbacks and reversals" said Standard & Poor's credit analyst Agost Benard.
Sri Lanka had also signed up Moody's Investor Services for a sovereign rating. Their rating classification was not announced, though markets were keenly expecting it.
Good Mood
The government, however, was quite upbeat of its 'speculative' grade ranking, when President Mahinda Rajapakse referred to it while presenting his maiden budget on Thursday packed with subsidies for lower income groups and higher corporate and income taxes.
"This places us (Sri Lanka) at a respectable beginning with the universe of rated sovereigns. These positive developments will be further consolidate," President Mahinda Rajapakse told legislators while outlining the government 2006 budget.
Financial analysts expect the government to use the credit ratings to sell its maiden bonds in the international markets next year and also set a benchmark for local companies.
"This is good," said Channa Amaratunga, economist and chief investment officer of Boston Asset Management. "The key thing now is how Sri Lanka plans to use its rating to tap international markets and raise cheaper funds to ease the pressure on the local debt market.
Heavy Indebtness
Sri Lanka's relatively high external leverage of 65percent of GDP (US$13 billion, 142 percent of current account receipts) is mitigated by the concessional nature of nearly all of its debt, which have low interest rates, long grace periods, and a substantial grant element.
Hence, public-sector external debt poses negligible risk for external liquidity, entailing a moderate servicing burden of about nine percent of current account receipts.
"If you look at our expenditure, the bulk of it is spent on interest costs to service local debt. This will ease the pressure and perhaps allow top Sri Lankan corporates to tap the international market for funds as well," said Amaratunga.
Despite a long-running conflict with Tiger rebels, "Sri Lanka has proved resilient to adverse shocks over a long period of time, its institutions are strong and it has an unblemished debt service record," Fitch Ratings said.
"Peace and politics hold the key to Sri Lanka's future," senior Fitch director Paul Rawkins said in a statement.
The island is also seeking to recover from last December's tsunami that killed 31,000 people and displaced nearly a million.
Peace Dividend
Treasury Secretary P B Jayasundara said the government is banking on continued peace to boost growth and help pay for subsidies.
An end to a ceasefire between security forces and the Tamil Tiger rebels would put "downward pressure" on Sri Lanka's rating.
"The absence of an enduring peace continues to hang over the country, intruding into the everyday business of government and the longer-term commitment to economic reform," Fitch said.
It added that weak coalition governments and public debt concerns have weighed down Sri Lanka's US$ 20 billion economy which relies heavily on remittances from overseas workers and exports of garments and tea.
The sovereign rating came against the backdrop of escalating violence in the northeast and heightened fears that Sri Lanka could slip back into civil war.
Sri Lanka's nearly four-year-long ceasefire with the Tamil Tiger rebels has improved the economic and business climate.
Jayasundara said government revenue and spending plans for 2006 will be aimed at achieving eight percent growth. The Central Bank has forecast growth of 5.0 to 5.5 percent this financial year.
-Mel Gunasekera: mel@vanguardlk.com