"However, some aspects of the 'peace dividend' appear to be waning--namely, the reductions in inflation and in government funding costs," Moody's said.
"Therefore, sustaining strong growth and price stability will entail steady and effective macroeconomic management and further improvement in the investment environment."
Sri Lanka ran into a balance of payments crisis from mid 2011, after the state used large volumes of bank credit to manipulate energy tariffs and printed money to keep interest rates down, eventually triggering currency depreciation and a spike in inflation.
Moody's said a package of measures to raise tariffs, float the currency and raise interest rates had helped stabilize the economy and foreign reserves. But a slowdown in exports showed that external risks to the economy were continuing.
A new agreement with the IMF, which was still uncertain would be positive for Sri Lanka, the report said.
The Moody's report titled, 'Credit Analysis: Sri Lanka', gives scores of low' for economic and government financial strengths, "moderate" institutional strength, and "moderate" susceptibility to risks from financial, economic, and political events.Sri Lanka’s institutional strength score assesses governance strengths, a strong payments record and the government’s commitment to data transparency, Moody's said.
Rule of Law
World Bank's Governance Indicators (WGI) given strength to the assessment with score similar to India on government effectiveness and rule of law, though the indicators have started to slip.
"This is particularly evident in the Control of Corruption (where its score has fallen from the 40th percentile in 2008 to the 28th percentile in 2011) and the Rule of Law (from 44th percentile to 42nd percentile)," the report said.
Two head of Sri Lanka's Securities and Exchange Commission had been ousted.
"While the World Bank’s assessment of Sri Lanka’s regulatory quality is somewhat more favorable than its B-rated peers, turnover at the Securities and Exchange Commission (SEC) raises concerns over the effectiveness and independence of regulation in Sri Lanka’s capital market," Moody's said.
"In the past year, two SEC chairpersons have resigned over contentious market regulation issues.
"In addition, the parliament’s initiation of impeachment proceedings against the chief justice is a sign of growing tension between judiciary and the government."
Helping the country was however a strong debt repayment record. Except for a voluntary repayment delay by western lender after a 2004 tsunami Sri Lanka has never defaulted or re-structured debt.
Sri Lanka did not yet subscribe to IMF's Special Data Dissemination Standards, (the SDDS, the IMF’s most stringent standards), but intends to adopt these standards by 2013. Data are "generally of good quality and timely" Moody's said.
Budget deficits were large but had fallen to 6.2 percent in 2012 and the state was targeting 5.8 percent in 2013.
Deficit spending and state enterprise losses were creating a low savings rate. State revenues as a share of GDP was low compared to some other countries.
"While the projected consolidation in 2013 is encouraging, as in the past, implementation will be key," the report said.
"To this end, achieving targets looks difficult, given that assumptions are based on (a) an ambitious 19.2 percent increase in revenues (vs. a 14.6% average increase between 2001-11).."
There could be a 0.6 percent slippage in the target if growth slows to 6.5 percent of gross domestic product from a projected 7.5 percent, Moody's said.
The debt to GDP ratio of 80 percent, though still high compared to peers, have come down from earlier highs. Interest payments were also taking up a large share of revenues.
Sri Lanka had moderate political risks, with the current administration being stable.
"On the one hand, the highly centralized political power can drive economic development through a strong degree of policy continuity, and allow the government to implement difficult reforms," the report said.
"But on the other, it could also contain latent risks to political voice and government accountability, and hence social stability.
"Political uncertainty is inherent given Sri Lanka’s recent emergence from a long civil war.
"The ongoing process of re-integration of the Tamil minority in the North and the East is unfinished political task, as the three-decade long civil war ended only three years ago."