Moody’s raised Sri Lanka’s sovereign rating outlook to Positive from Stable over the weekend, projecting sustainable growth rates of around 8-9 percent over the medium term on the back of a “peace dividend that has accrued to the economy and the security environment”–part of which stems from the tangible addition of the country’s now-bloated armed forces (which tripled in number during the recent civil war) from security and service work to “development work” (which certainly beats them having to address tough questions from pesky panelists).  Per some observers Sri Lanka still faces “a number of challenges including high fiscal deficit, lack of infrastructure (though the aforementioned military can help address that) and high dependence on short-term foreign financing”–though we quibble which much of that premise and agree with Barclays that a closer examination suggests an imminent, one-notch upgrade in the sovereign rating later this year to low BB, given “strengthening external balances, rising investment and progress on fiscal consolidation.”  Indeed, while the trade deficit will likely continue to deteriorate this year given commodity prices, the trend not only looks to be stemming but hitherto supportive remittances and FDI flows continue to keep the overall balance of payments in an advancing surplus.  Analysts note, for instance, that despite tensions in the Middle East (which accounts for the bulk of remittances) inflows were up 28% y/y in Q1 while FDI inflows, meanwhile, were up 160% y/y during the same period and look directly correlated to tourist arrivals (up 50% in 2010) and overall tourist revenues which, while currently roughly 1% of GDP “could easily double over the coming two to three years.”  Turning to the fiscal story the government appears committed enough to capping current expenditures at roughly 7% of GDP, while tax-simplification measures contained in the latest budget should augment revenue collection and lower the oft-cited public debt to GDP measure under 80%, a development which, coupled with the state’s plan to raise 4x the amount (versus last year) of its financing from domestic sources (up to ~78% projected) in lieu of external ones, should go a long way in addressing an admittedly large and growing debt overhang and determining its ultimate sovereign credit status.  Finally, per monetary policy sticky core inflation numbers to date given in part this spring’s fuel price hike and electricity tariff adjustment as well as ever-mounting FX reserves ($USD7.1bn in early June versus the low of $USD1.3bn in early 2009) will likely see the central bank (CBSL) willing to accept a stronger LKR as the primary normalization tool (assuming annual inflation remains somewhat muted and hovering around 8.0-8.5%), thus keeping policy rates (since January’s 50bp cut repo and reverse repo rates sit at 7% and 8.5%, respectively) unchanged and post-war growth rates that much more unfettered.  In sum, Sri Lanka is poised to outperform emerging-Asia peers as its post-war paradigm continues to unfold.

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