Why Sri Lanka’s economic outlook is looking less rosy

Sri Lanka's deal with the International Monetary Fund (IMF) may have averted a crisis, but the bailout may undermine a key source of strength: the country's impressive economic growth rate.

The deeply indebted country inked an agreement for a $1.5 billion bailout, announced Friday, as it faced heavy fund outflows and overseas debt payments amid declining foreign-exchange reserves, which could have caused a balance of payments crisis.

Foreign-exchange reserves fell by a third from late 2014 to $6.2 billion at the end of March, Reuters reported. Meanwhile, credit rating company Moody's Investors Service, in a report last week before the IMF deal, noted that general government debt was around 76 percent of gross domestic product (GDP) in 2015, up 71.6 percent from five years earlier.

"Without an IMF loan, Sri Lanka would have been in a precarious position," Krystal Tan, an Asia economist at Capital Economics, said in a note Saturday, noting that foreign exchange reserves only covered around 80 percent of short-term external debt.

She estimated the bailout would boost reserves to around 108 percent of short-term debt, a bit above the minimum of 100 percent recommended by many economists.

But the deal is likely to come with costs.

"Growth is likely to slow further over the next couple of years," Tan said. She forecasts the economy will grow at just 4.5 percent this year and next, compared with an average of 6.4 percent between 2010-15.

In a report Tuesday, the IMF has also cut its projections for Sri Lanka's economic growth, now forecasting 2016 and 2017 at 5.0 percent each, down around 1.5 percentage points from October World Economic Outlook forecasts.

Despite its financial wobbles, economic growth in Sri Lanka has been impressive in recent years.

Fitch Ratings, which rates Sri Lanka at B+, noted in February that median growth for 'B' and 'BB' rated countries is around 4.6% and 3.9% respectively.

But the country's economy may lose a key support.

"While the IMF deal should prevent a crisis in the short-term, policy will need to be tightened to ensure Sri Lanka does not find itself in the same mess again," Tan said, noting the agreement is contingent on plans to narrow the fiscal deficit.

That's no small feat: Sri Lanka has now pledged to cut its fiscal deficit to 3.5 percent of GDP from 7.4 percent of GDP in 2015, which itself was well above a 4.4 percent target, and up from 2014's 5.7 percent, Tan noted.

In a March note, Standard & Poor's said that government investment was a key factor underpinning economic growth; it affirmed Sri Lanka's B+ rating, but cut the outlook to negative from stable. At the time, S&P said it expected real per capital GDP growth of 5.5 percent over 2016-19, which it estimated was equivalent to 6.2 percent real GDP growth.