"The outlook on the rating on Sri Lanka could revert to stable with more robust initiatives to further fiscal consolidation, or if tangible progress were achieved in a final peace settlement with the Tamil separatists," said S&P's credit analyst Agost Benard.
"A resumption of full-scale war and fiscal slippage, however, would exert downward pressure on the rating," Bernard said.
The rating also reflects the high level of the government's "indebtedness and weak revenue mobilization, together with security concerns posed by the unresolved conflict with Tamil separatists," the risk evaluator said.
"These factors are balanced against the economy's demonstrated resilience and favorable medium-term growth prospects, as well as the benign terms of its external debt, which impose minimal stress on external liquidity," Benard.
Sri Lanka's limited fiscal flexibility due to weak public finances and a narrow tax base is a significant constraint on its credit rating.
Although recent tax rises caused a notable increase in the tax-to-GDP ratio to an estimated 15.5 percent in 2006 from 13.1 percent in 2003, the country's tax base remains fundamentally deficient.
"Sri Lanka's revenue and expenditure rigidities prevent a more robust pace of fiscal consolidation, which is needed for improved debt sustainability. The attendant fiscal gaps in turn fuel the inflationary impetus via the government's partial monetisation of its deficits," said Benard.
The high level of public indebtedness resulting from perennial large fiscal deficits (averaging 8.7 percent of GDP for the past ten years excluding grants) is an additional constraint on the ratings.
A lack of political will and the divergent policies of successive governments hampered consolidation efforts in the past.
General government debt stood at an estimated 90 percent of GDP in 2006, and the interest burden on this debt at close to 30 percent of general government revenues further restricts fiscal flexibility.
The debt-to-revenues ratio at an estimated 470 percent is more than double that of the median for similarly rated countries, and highlights Sri Lanka's high level of indebtedness and the relatively low fiscal resource base to service it, the statement adds.