President Mahinda Rajapaksa, re-elected with a stronger mandate, had a "unique opportunity" to "implement comprehensive fiscal and public sector reforms," which is the key to cutting public sector deficits and debt ratios, S & P said.

But the reform agenda was "likely to concentrate mainly on addressing fiscal revenues," while there may be new spending.

"[P]re-election promises of public sector wage increases and large infrastructure spending programs are likely to strain government coffers further, potentially endangering program targets under the IMF-sanctioned fiscal adjustment program," S & P said in a comment on Asian sovereigns it rates.

"The final recommendations of a Tax Commission expected toward mid-year will be key, as they will serve as the basis for increasing the country's low revenue ratios."

S & P has given Sri Lanka a speculative 'B' rating. The outlook on the rating was raised to 'positive' from 'stable' after a deal was signed with the IMF to fix government finances. Deficit spending stemming from a bloated public sector is the main drag on the economy.

But ratings could be cut if a deal with the IMF ends.

"The ratings on Sri Lanka could be raised on evidence of continued implementation of the IMF program, including progress in expanding revenue-generation capacity following the Tax Commission's recommendations," S & P said.

"The outlook, however, could be revised back to stable in the event of substantial deviation from the IMF program or early termination of it, or if expectations of recovery in growth prospects and revenue improvements disappoint."

Economic analysts have pointed out that Sri Lanka's fiscal strains spill-over to debt monetization (money printing) by the central bank, which quickly translates itself to inflation and currency depreciation through the country's pegged exchange rate regime.

Sri Lanka's inflation had bottomed out at 0.7 percent in September 2009, and had risen to 4.8 percent by December. Core inflation was also going up. In January inflation hit 6.5 percent.

"The economy fared well during last year's global slowdown with GDP growth of an estimated 3.5 percent," S & P said.

"Yet, the overall policy emphasis appears firmly set on growth and reconstruction needs, illustrated by the apparent lack of urgency to stem emerging price pressures."

S & P said the trade deficit has halved compared with the year before and the current account deficit has narrowed to 3 percent of gross domestic product from 9.5 percent in 2009.

Foreign reserves were at 5.2 billion US dollars. External liquidity could improve further as reconstruction aid and foreign investment comes but could be tempered by rising import costs.

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