Deterioration in the security situation, delays in the public sector reforms and loose fiscal management will put downward pressure on the ratings they said.
Like rating agencies government budgets also have a medium term outlook while serving as a tool for policy implementation.
A budget is always more than a mere statement of how government plans to spend the money it raises through taxation.
It is more importantly an indicator of how economic plans will be implemented in the medium term, in other words it is a policy statement.
In the medium term government here wants to rationalize spending while increasing revenue according to a pre budget statement made according to the Fiscal Responsibility Act.
It says the: "Primary focus of the fiscal efforts is directed at making continued fiscal consolidation by maintaining a healthy growth in Government revenue and rationalizing recurrent expenditure, while ensuring that public investments in areas critical to support pro-poor growth are not neglected."
Public investment is a cornerstone of high growth especially since government has failed to attract high investment flows from abroad.
Foreign Direct Investment or FDI flows have stagnated around US$ 200 million a year during the last decade.
Experts argue that Sri Lanka needs to raise overall investment to 30 to 35 percent of GDP from the current 25 percent levels if it wants the economy to grow by 8 percent.
Some of this investment will come from the government.
If government invests around 6.8 percent of the GDP equivalent value during the next four years, in line with its budget, it will need at least the equivalent of 23 percent of GDP in investment from the private sector yearly.
The private sector investment figure, including FDI, is ambitious according to analysts and is on the upper end of performance seen in previous years when liberal economic polices were in place.
But a bigger problem could lie in the State’s own investment numbers.
In the past governments have cut public investments when budgets become tough to balance.
This year it is expected to miss an original target of 6.3 percent. It will invest only the equivalent of 5 percent of GDP.
The under investment of Rs. 26 billion is enough to fund construction of two Colombo-Katunayaka expressways.
Higher spending on subsidies and inability to borrow domestically without raising interest rates put a cap on public investment this year.
This year was no exception.
Sri Lankan governments miss public investment targets by around a percent of GDP every year because of revenue overestimates and pork-barrel politics to win regular elections.
Both Fitch and Standard & Poor's in their ratings highlight loose fiscal management.
S&P says: "ratings could improve with progress in fiscal consolidation in accordance with the government's Medium Term Macroeconomic Policy Framework, which aims for a deficit of around 5 percent of GDP by 2008."
The five percent deficit target set for this year by the Fiscal Management Responsibility Act will take three more years than planned to realize.
The current government blames the lax performance on economic mis-management during 2002 and 2003, when UNP was in power, and the double whammy of an oil shock and the Tsunami this year.
But UNP that introduced the Fiscal Responsibility Act in 2002 is skeptical about how the government plans to balance the budget.
"This is a money-printing budget," says Bandula Gunawardana, Former Deputy Finance Minister, UNP.
"Next year they will introduce a 2,000 denomination currency notes. The rupee will depreciate to 105 to 108 to the Dollar and interest rates will go up," he warns.
"Inflation is something people will have to expect if this budget is implemented."
Government printed Rs. 65 billion this year to meet expenses.
Printed money drove up prices and weakened the economy despite a public commitment to keep prices down.
Higher Oil prices would have only caused some inflation if they were passed down.
But commodity subsidies and a higher than ever public sector deficit created pressure.
This year's transfer of Rs. 68 billion, equivalent to 3 percent of GDP, is the highest ever to loss making public institutions and ones that are short of capital.
Analysts say if at least some of these were privatized, those ones could have raised the money outside of the government budget.
If there were no losses in government institutions one percent of GDP or Rs. 22 billion could have been saved.
Dividends for this year, including Rs. 2 billion from the Central Bank, will only bring in Rs. 8 billion around a third of the losses in government run businesses.
President Mahinda Rajapakse, who is also the Finance Minister, says he expects these institutions to do better.
"Mr. Speaker our Government does not believe that privatization is the only strategy for economic reforms," he said during the presentation of budget proposals last week.
"In fact we will not privatize State Owned Enterprises but will improve their performance through management reforms. Our enterprise reforms will be ownership neutral. All SOEs must perform at maximum output capacity and deliver services to the nation in an efficient manner. All SOEs should bring in dividend income. At the least they should not rely on the Treasury for funding. Therefore, all SOEs will be required to enter into performance contracts with the Treasury," he said.
However, these State Owned Enterprises will also be forced to absorb 10,000 people every year for the next few years under plans to create more jobs.
That will add a direct burden to these already overstaffed ventures.
If implemented profitability will suffer.
However, the greatest risk is in defense spending.
The President, who is also the Commander-in-Chief of the armed forces, made no reference to this in his budget speech.
Defense spending at around Rs. 95 billion or 4 percent of GDP is lower than the near 6 percent of GDP seen during years of conflict.
But the amount is a record high for Sri Lanka in absolute terms.
The only reference to defense spending, in the statement under the Fiscal Responsibility Act, says it will be capped at 2.5 percent of GDP over the medium term.
Obviously the government is not planning to go to war at those levels?
"The President doesn’t plan to go to war. So this budget has been prepared on those lines. War is a hypothetical situation, instead we have concentrated on development in all areas of the country," says P B Jayasundara, Treasury Secretary.
However, allocating a record Rs. 95 billion for defense is not in line with medium term policy or the Treasury Secretary's optimism.
Both Fitch and S&P's have already highlighted lack of budgetary space to fight a war.
Fitch Ratings said in a statement "a fresh outbreak of full-scale hostilities would be very damaging for the rating, not least because the public finances are so much weaker than they were and external financial assistance could be put at risk if donors lost confidence in the peace process."
Fitch ratings gave Sri Lanka a BB- rating for its medium term dollar denominated debt while S&P’s gave a rating that was a notch lower at B+.
Both the international rating agencies said the outlook is "stable" in the medium term.
But like Fitch, Standard & Poor’s also warned about the high risk of the conflict escalating.
It said: "any significant delay in fiscal adjustments and reforms in the public sector or a serious deterioration in the security situation would exert downward pressure on the ratings."
A downgrading because of a war, could be disastrous, since Sri Lanka plans to tap the international markets.
Critics say the challenges with public sector reforms; responsible budgeting and progress on the peace process are more pronounced now after years of economic mismanagement.
There is no room to consider fighting another war.
Meanwhile, the deputy finance Minster says the media should not highlight the impractical budget proposals but should focus on the ones the government can implement.
"But we must start from the positive side of the budget," says Ranjith Siyambalapitiya, Deputy Finance Minister.
He was referring to media reports that highlighted negative affects of subsidies and high public sector deficits.
Sri Lanka governments generally miss key budget targets set by them selves.
The budget deficit has averaged around 9 percent a year during the last decade because of populist government spending on subsidies and higher than budgeted losses at public corporations.
Higher than target deficits add to the debt burden while depriving money for investment in key infrastructure like roads, hospitals and schools.
Poorest segments of the population are hurt the most by the lack of investment because provincial infrastructure is the weakest in the country.
-LBR Newsdesk: LBOEmail@vanguardlk.com