Sri Lanka's inflation is now running at 17.3 percent as monetary policy was not tight enough to contain expansionary fiscal policy.
Fitch said the outlook on the rating was lowered to negative in April 2006 after an internal conflict with the separatist Tamil Tigers intensified, because it could lower growth, undermine economic stability and affect Sri Lanka's ability to repay debt.
If the war worsened and hit government finances and the economy harder, Fitch warned that it will have to downgrade Sri Lanka's sovereign rating.
Standard & Poor's has already given Sri Lanka a rating a notch below at B+ but recently lifted the outlook to stable.
Fitch said better budgets were needed if Sri Lanka was going to make it a habit to borrow commercially abroad.
"Fitch opines that concerted fiscal consolidation is required to reduce the vulnerability of the economy and the public finances to adverse shocks and to smooth the transition to less concessional sources of fiscal and external funding," the agency said.
Fitch says it does not believe that the opposition United National Party would "wilfully default" on the bond as it had threatened to do, should it come to power in the future.
The UNP has publicly challenged the legality and the economic rationale for the bond issue and has threatened to disavow the debt and withhold payments on the bond, while the government has said that it was properly authorised.
"…Fitch currently judges that any future UNP administration would not wilfully default," the rating agency said.
Sri Lanka is hoping to raise 500 million dollars in international markets and has appointed HSBC, JPMorgan and Barclays Capital as lead managers for the issuance.
Fitch said Sri Lanka's economy has shown "remarkable resilience" over a long period of time, having negative growth once at the height of the war in 2001.
Economic growth was 7.4 percent last year, the highest in two decades with higher domestic investment and record foreign remittances of 8 percent of gross domestic product (GDP).
In 2007 growth has slowed to 6 percent and inflation had risen to 17 percent driving yields on government debt to similar levels.
Fitch says that Sri Lanka has an unblemished debt service record - a rare trait among sub-investment grade sovereigns. In 2006 public debt had fallen slightly.
"Nonetheless, public debt remains high by the standards of rating peers at 93 percent of GDP and interest payments absorb almost 30 percent of government revenues, notwithstanding the concessional nature of much external public debt," Fitch said.
Fitch said if the war affected growth and delayed trimming the budget deficit (including grants) which was 7.3 percent of GDP last year, the government may not be able to reduce national debt to 76 percent of GDP by 2010 as planned.
High levels of human capital development, good governance, reasonably strong institutions and a liberal economic climate, were in Sri Lanka's favour, while the war remained against the country.
Fitch said the outlook on the rating could be lifted to stable from negative if inflation was brought down, budgets became better and the risk of war to government finances reduced.
Updated