Fitch Ratings has raised Sri Lanka’s Long-Term Issuer Default Ratings (IDRs) from ‘CCC+’ to ‘B-’, while maintaining a Stable Outlook.
This rating upgrade is attributed to the successful implementation of macroeconomic stabilization strategies and structural reforms, which have alleviated external financing risks and enhanced the country’s resilience to economic shocks. These improvements are evident in the significant progress made in fiscal and external balances, alongside a gradual increase in foreign exchange reserves. The government’s commitment to fiscal discipline and efforts to enhance revenue generation are expected to sustain primary surpluses, contributing to a decline in the debt-to-GDP ratio and mitigating the chances of renewed external imbalances.
Despite the positive changes, Sri Lanka’s credit profile is still challenged by high government debt relative to GDP and debt service ratios when compared to similar-rated countries, even after recent restructuring and macroeconomic adjustments. The country’s foreign exchange reserves remain limited, particularly in light of an anticipated increase in external debt service obligations over the next five years.
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A comprehensive list of the rating actions is included at the conclusion of this commentary.
Key Rating Factors
Revenue Growth Fuels Primary Surpluses: Projections indicate a robust primary surplus of 2.6% of GDP for 2026, down from a historic high of 5.4% in 2025, driven by persistent revenue growth. This aligns with an overall deficit increase to 4.1% of GDP in 2026 from 2.3% in 2025. The rise in revenue is a result of tax reforms and a temporary spike in import duties due to increased demand for imported vehicles. This revenue growth is expected to offset rising reconstruction costs following Cyclone Ditwah in 2025 and targeted energy support initiatives.
We anticipate that primary surpluses will remain above 2% of GDP in the coming years, supported by consistent revenue and controlled expenditures. Although revenue growth may slow with a decrease in auto imports, ongoing revenue mobilization efforts should maintain collections near 16% of GDP. The Public Financial Management Act of 2024 restricts non-interest spending to 13% of GDP until 2031, promoting fiscal discipline, despite the cap being breached in 2026 for cyclone recovery efforts. As elections approach in 2029, the potential for fiscal slippage may increase, even in the context of reforms.
Ongoing Fiscal Challenges; Gradual Improvement: Government debt and the ratio of interest to revenue remain elevated compared to peers, although there are signs of gradual improvement. We project a decrease in debt to 92.9% of GDP in 2026, down from 96.7% in 2025, with a further decline expected over the next five years to the low-80% range. The interest-to-revenue ratio is forecasted to decline to 41.0% in 2026 from 45.6% in 2025, and a peak of 76.3% in 2023, yet it remains significantly above the ‘B’ median of 12.7%. Limited fiscal space necessitates compliance with established fiscal frameworks to ensure sustainability continues.
Energy Price Surge Affects Current Account: Anticipated high energy costs are expected to shift the current account into a deficit of 1.2% of GDP in 2026, following three years of an average surplus of 1.5%. The ongoing US-Iran conflict has escalated the energy import costs and temporarily impacted tourism revenues. Nevertheless, remittances are steadily increasing, which helps counterbalance these challenges. The risks remain significant due to uncertainties related to the US-Iran situation and Sri Lanka’s status as a net importer of energy and fertilizers. As the situation stabilizes in 2027, a return to a near-balanced current account is expected.
Satisfactory Near-Term Financing Conditions: Continued support from the IMF and other multilateral organizations is providing stable external financing to alleviate immediate current account pressures. This assistance, alongside the adoption of more flexible exchange rate policies, will enable the country to bolster its foreign exchange reserves, projected to reach USD 7.7 billion (equivalent to 2.9 months of current external payments) by the end of 2026. However, the external shock has limited the extent of reserve accumulation, with risks skewed towards the downside.
Increasing Debt Repayments: External financial buffers remain thin, and external debt repayments are expected to rise in the upcoming five years, particularly post-2028, which could heighten vulnerability to external shocks or policy missteps. The government is contemplating re-entering the international bond markets in 2027. The current IMF Extended Fund Facility program concludes in March 2027, with potential for a subsequent facility to help reinforce policy frameworks and provide financial support.
Resilient Economic Growth: Despite recent challenges from Cyclone Ditwah and geopolitical tensions, Sri Lanka’s economy has shown resilience; however, we project GDP growth to moderate to 4.1% in 2026 from an average of 5.0% in the preceding two years. There are downside risks associated with the country’s energy dependencies. Over the medium term, GDP growth is expected to exceed 4%. Obstacles remain in attracting foreign direct investment, improving exports, and revitalizing state-owned enterprises, but sustained reform efforts could yield positive results.
Rising Inflation: Projected headline inflation is expected to average 6.3% in 2026, an increase from -0.5% in 2025, driven by global energy shocks and the El Nino phenomenon impacting domestic price levels. In response to inflation concerns, the Central Bank of Sri Lanka (CBSL) raised its policy rate by 100 basis points in May to 8.75%. Further rate hikes are not anticipated. It is believed that current price pressures are temporary, and inflation is expected to decline to just below the CBSL’s target of 5% by the next year.
Governance and ESG Factors: Sri Lanka has a medium ranking of 39.6 on the World Bank Governance Indicators (WBGI), indicating a recent history of peaceful political transitions, moderate political participation rights, reasonable institutional capacity, established rule of law, and a moderate corruption level.
RATING SENSITIVITIES
Potential Negative Rating Triggers:
- Public Finances: Any reduction in fiscal discipline or weakened revenue collection efforts could lead to lower primary balances and slow the decline of government debt-to-GDP ratios.
- External Finances: Renewed external liquidity issues characterized by an inability to enhance foreign exchange reserves and a resurgence of significant current account deficits could prompt a downgrade.
Potential Positive Rating Triggers:
- Public Finances: A significant reduction in government debt-to-GDP and interest-to-revenue ratios, supported by effective implementation of a credible medium-term fiscal consolidation and debt management strategy, improved revenue generation, and accelerated economic growth could lead to an upgrade.
- External: A considerable and sustainable increase in foreign exchange reserves, potentially driven by enhanced remittance flows or improved export performance, could also have a positive impact.
Sovereign Rating Model (SRM) and Qualitative Adjustments:
Fitch’s proprietary Sovereign Rating Model assigns Sri Lanka a score corresponding to a ‘B-’ rating on the Long-Term Foreign-Currency (LT FC) IDR scale, an upgrade from ‘CCC+’ in the previous review. The sovereign rating committee did not modify the SRM output in determining the final LT FC IDR.
The SRM is a proprietary multiple regression rating model incorporating 18 variables based on three-year centered averages and one year of forecasts to generate a score equivalent to a LT FC IDR. The Qualitative Overlay (QO) serves as a forward-looking qualitative framework that allows adjustments to the SRM output to finalize the rating based on factors not fully quantifiable or reflected within the SRM.
Debt Instruments and Rating Drivers:
The ratings for senior unsecured long-term debt align with the corresponding Long-Term IDR, reflecting Fitch’s expectation of average recovery prospects in a default scenario. These debt instruments have been assigned a Recovery Rating of ‘RR4’.
Country Ceiling:
Sri Lanka’s Country Ceiling stands at ‘B-’, aligned with the LT FC IDR, indicating no significant constraints or incentives that would impede the private sector’s ability to convert local currency into foreign currency or transfer proceeds to non-resident creditors for debt service payments.
Fitch’s Country Ceiling Model generated a baseline uplift of zero notches above the IDR, with no qualitative adjustments applied by the rating committee.
References for Key Drivers:
The primary sources of information utilized in this analysis are detailed in the applicable criteria.
Climate Vulnerability Assessment:
Our Climate Vulnerability Screener did not identify any significant risks for Sri Lanka.
ESG Considerations:
Sri Lanka holds an ESG Relevance Score of ‘5’ for Political Stability and Rights, as these World Bank Governance Indicators carry significant weight in Fitch’s SRM and are crucial for rating determination. With a percentile rank below 50 in this indicator, it negatively affects the credit profile. Additionally, the country scores ‘5’ for Rule of Law, Institutional and Regulatory Quality, and Control of Corruption, again reflecting a detrimental impact on its credit standing due to low percentile ranks in these areas.
For Human Rights and Political Freedoms, Sri Lanka has an ESG Relevance Score of ‘4’, indicating relevance to the rating and a negative impact on the credit profile. Similarly, the score of ‘4’ for Creditor Rights highlights the importance of debt service willingness, especially following recent public debt restructuring in 2024, further affecting the credit profile.
The highest level of ESG credit relevance is a score of ‘3’, unless otherwise stated in this section. This score signifies that ESG issues are credit-neutral or have minimal credit impact due to their nature or management. Fitch’s ESG Relevance Scores are not direct inputs in the rating process but are observations regarding the significance of ESG factors in the rating decision. For additional information on Fitch’s ESG Relevance Scores, please visit www.fitchratings.com/topics/esg/products#esg-relevance-scores.
Source: Financial Chronicle Biz English | Sri Lanka Business News.
