"A resumption of full scale hostilities could have negative implications for the country's already stressed fiscal and debt position, and likely impair its previously adequate level of external balances," S&Ps credit analyst Agost Benard said.
Sri Lanka has a speculative grade B+ rating from S&P, four notches below investment grade. Fitch Ratings Inc also assigned a BB- rating, which is three notches lower than the lowest investment grade rating of BBB-.
At the same time, S&P affirmed its B+ long-term foreign currency rating and BB- local currency sovereign credit ratings. Its B short-term foreign and local currency sovereign credit ratings were also affirmed
Credit ratings are used by fund managers to determine investment risk and the amount of interest payments they demand.
A negative credit outlook would also increase Sri Lanka's cost of raising funds in the international markets.
"Investors may want a premium on bonds, which may push the cost of borrowing up. But a downgrade will have an immediate impact on the cost of debt," explains Channa Amaratunga, Economist at Boston Asset Management.
Sri Lanka plans to sell up to a billion dollars in bonds maturing in 7-10 years later this year, treasury secretary P B Jayasundara said. The government has already hired Citibank Sri Lanka, a unit of Citigroup Inc., to structure the issue.
"We are currently looking at various options, to raise funds at the cheapest possible way," Jayasundara told reporters Wednesday adding that the government hopes to use part of the proceeds to retire some expensive 400 million dollar loans borrowed by Japan in the early 1980s.
S&Ps statement comes as the Sri Lankan government launched air, sea and land attacks against suspected Tamil Tiger positions in the northeast since the rebels were blamed for a suicide bombing on Tuesday in Colombo targeting army chief Sarath Fonseka.
At least 80 people have died in bombings in the past two weeks while Tamil rebels say 70 civilians have been killed by pro-government militia or security forces, a charge denied by the military.
"The outlook could revert to stable if substantial and tangible progress is achieved in maintaining the official cease- fire," says Benard.
Sri Lanka is targeting economic growth in excess of seven percent this year, fueled by growth in the telecommunications sector and higher revenues from shipping clothes and tea, Jayasundera said adding that growth for the first quarter or 2006 should top 6.5 percent.
The government is confident of keeping to the target despite the upsurge in violence and increasing shaky truce pact.
"We will continue to push our economic program despite challenges," Deputy Finance Minister Ranjith Siyambalapitiya said.
"We will not stop because we have faced challenges before."