Fitch Ratings-London/Singapore-08 October 2007: Fitch Ratings has said today that it will assign the Democratic Socialist Republic of Sri Lanka’s forthcoming debut sovereign bond a rating of ‘BB- (BB minus)’. This rating is in line with Sri Lanka’s ‘BB-’ Long-term foreign currency Issuer Default rating (IDR) which is on Negative Outlook.

Fitch assigned Sri Lanka Long-term IDRs of ‘BB-’ in December 2005. The Outlook on Sri Lanka’s
Sovereign Ratings was subsequently revised from Stable to Negative in April 2006, in response to a renewed outbreak of violence between government security forces and the Liberation Tigers of Tamil
Eelam (LTTE), which seeks a separate state. “Fitch judged this turn of events to be a material deterioration in the domestic security situation with potentially adverse consequences for growth, economic stability and sovereign creditworthiness” says Paul Rawkins, Senior Director in Fitch’s Sovereign rating team in London.

Sri Lanka’s economy has displayed a remarkable resilience to shocks over a long period of time, sustaining negative growth only once in recent times, at the height of the last outbreak of hostilities in
2001. Last year, the economy expanded at 7.4%, its fastest rate for more than two decades, underpinned by rising domestic and foreign investment and record inflows of remittances (equivalent to around 8% of GDP). More recently, however, growth has slowed to around 6% and inflation has risen sharply to 17% year-on-year (from 10% in H106), driving up yields on government paper to similar levels.

“Steering inflation back down to single digits will be essential for sustaining strong economic growth and containing the government’s debt service costs” says Mr Rawkins.

Fitch says that Sri Lanka has an unblemished debt service record - a rare trait among sub-investment grade sovereigns - while public debt declined slightly in 2006. Nonetheless, public debt remains high by the standards of rating peers at 93% of GDP and interest payments absorb almost 30% of government revenues, notwithstanding the concessional nature of much external public debt. 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. Should the security situation adversely affect economic growth and delay planned reductions in the budget deficit from last year’s level of 7.3% of GDP (including grants), the government’s target of reducing public debt to 76% of GDP by 2010 could be at risk.

The main opposition party, the United National Party (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, should it come to power at some time in the future. The government has stated that the bond has been properly authorised and Fitch currently judges that any future UNP administration would not wilfully default.

The ratings are underpinned by high levels of human capital development, good governance, reasonably strong institutions and a liberal economic climate. Fitch believes that these attributes should stand the country in good stead over the medium term. In the near term, however, “a further deterioration in the security situation to the point where it adversely affects Sri Lanka’s credit fundamentals could lead to a downgrade of the Sovereign Ratings” says Mr Rawkins.

Conversely, the Outlook could revert to Stable if there are clear signs of fiscal consolidation, a reduction in inflation and, in Fitch’s judgement, a material diminution in the risk to sovereign creditworthiness from the conflict.

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