COLOMBO, June 14 (Reuters) - The International Monetary Fund (IMF) said on Tuesday that Sri Lanka's economic outlook is facing risks from the government's inaction on key policies and a significant deterioration in the external environment.
Sri Lanka's finances are in a precarious situation because of high external debt, partly due to heavy infrastructure borrowing under the previous government.
The island nation is also facing a balance of payments crisis due to heavy foreign outflows from government securities.
"Despite positive growth momentum, the Sri Lankan economy is facing challenges due to the difficult external environment and a period of significant political transition," the IMF executive board said in a report after Article IV consultations, where IMF experts assess a country's financial and economic conditions.
But the IMF said Sri Lanka's medium-term prospects appear favorable if current macro-financial imbalances can be addressed.
The IMF earlier this month approved a three-year $1.5 billion loan to support Sri Lanka's economic reform agenda.
The main objectives are reforms aimed at boosting government revenues to reduce the fiscal deficit, improving foreign exchange reserves, reducing public debt and Sri Lanka's risk of debt distress, and improving public financial management.
The IMF has also asked the government to improve the operations of state owned enterprises and support a transition toward flexible inflation targeting with a flexible exchange rate regime.
The global lender also said it expected Sri Lanka's economy to growth 5 percent this year, compared with 4.8 percent in 2015. But the IMF's projection is far below the central bank's estimate of 5.8 percent.
"While the government seeks to undertake sizable fiscal consolidation and tackle high priority structural reforms, growth momentum can be sustained with a solid commitment to reform, a clear direction on macroeconomic policies, and restoration of market confidence."
The $82.2 billion economy's foreign exchange reserves have fallen by more than a third from their peak in late 2014 to $5.6 billion at the end of May, the lowest since February 2012, mainly due to foreign outflows of around $2 billion from government securities.
The IMF said that greater exchange rate flexibility and an exit from central bank intervention in the forex market would help protect and rebuild foreign exchange reserves. (Reporting by Ranga Sirilal and Shihar Aneez; Editing by Kim Coghill)