"Additional rating constraints include the country's fundamental fiscal weaknesses, and the attendant high government debt and interest burdens.
"Political institutions that lack transparency and independence are a further rating weakness."
But the ratings were supported by strong growth prospects and limiting inflation to single digits, the agency said. Inflation may moderate as the rupee stabilizes.
Standard & Poor's credit analyst Takahira Ogawa said external liquidity remained week with gross external reserves at three months of current account payments.
The full statement is reproduced below: -
Sri Lanka Ratings Affirmed At 'B+/B'; Outlook Remains Stable
SINGAPORE (Standard & Poor's) March 1, 2013--Standard & Poor's Ratings Services today affirmed its 'B+' long-term and 'B' short-term sovereign credit ratings on Sri Lanka. The outlook remains stable. We also affirmed the recovery rating at '4'. The transfer and convertibility (T&C) assessment is unchanged at 'B+'.
We affirmed the ratings to reflect our view of Sri Lanka's weak external liquidity, a moderately high and increasing net external liability position. Additional rating constraints include the country's fundamental fiscal weaknesses, and the attendant high government debt and interest burdens. Political institutions that lack transparency and independence are a further rating weakness.
Support for the ratings comes from Sri Lanka's robust growth prospects and the government's moderate progress in addressing a number of its structural weaknesses through fiscal measures and success in limiting inflation to single digits.
"Sri Lanka's external liquidity remains weak," said Standard & Poor's credit analyst Takahira Ogawa. "This is despite the government and the central bank having shifted their monetary and exchange rate policies to control the pace of credit expansion and reduce the country's trade and current account deficits over the past year. We estimate its gross international reserves will stay at three months' coverage of current account payments in 2013."
Although the Sri Lankan government has started to implement some of its planned fiscal reforms, progress has been slow so far. Further reforms could gradually improve the country's competitiveness as well as reduce fiscal burdens, Mr. Ogawa said.
A narrow tax base, the debt burden from a long civil conflict and the reconstruction, extensive subsidies, and a bloated public sector have contributed to a fiscal deficit of 8% of GDP on average over the past decade. The increase in government debt often exceeded the deficit because of currency depreciation.
Although Sri Lanka's inflation edged up to 9.8% in January 2013, we believe it will ease slowly this year, as the rupee stabilizes. Inflation has been in single digits since 2009. The rupee depreciation, price increases for electricity and fuel, drought, and floods pushed prices higher in 2012.
"In our view, the country's growth prospects are favorable. We expect investment to climb toward 30% of GDP on continued reconstruction and other public investments," Mr. Ogawa said.
The stable outlook reflects our view that the country has strong medium-term prospects, with per capita GDP growth of more than 6%, and an improving fiscal profile. We balance these strengths against its vulnerable external liquidity and high fiscal and external debt. The outlook also reflects our view that the country will keep the pace of credit expansion in check, which will help to contain the country's external imbalances.
We may lower the rating if the stabilizing external liquidity situation falters, or if Sri Lanka's growth and revenue prospects diminish markedly. Conversely, we may raise the rating if economic reforms reduce fiscal and external vulnerabilities and broaden the still-narrow economic profile.