Moody's affirmed Sri Lanka's 'B1' sovereign bond rating with the stable outlook on 23 July, citing strong growth potential of the South Asian island nation, but said the weakness of government finances overshadows the rating.
A sustained decline in its deficit, debt and borrowing costs would be seen as credit positive, Moody's said.
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.
The build-up in official international reserves is reducing the country's near-term vulnerability to external financial shocks, the rating agency said.
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, the agency said, adding that the 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," Moody's said.