By Uditha Jayasinghe

COLOMBO (Reuters) -The International Monetary Fund did not reach a staff-level agreement with Sri Lanka in its first review under a $2.9 billion bailout package, due to a potential shortfall in government revenue generation, the Fund said on Wednesday.

Speaking after a two-week visit to the country, IMF delegation head Peter Breuer said a second tranche of about $330 million under a lending programme would only be released after the IMF reaches a staff-level agreement, and there was no fixed timeline on when that would take place.

"Sri Lanka has made commendable progress in implementing difficult but much-needed reforms. These efforts are bearing fruit as the economy is showing tentative signs of stabilisation," the IMF said in a statement.

"The team will continue its discussions in the context of the First Review with the goal of reaching a staff-level agreement in the near term."

The IMF delegation said despite early signs of stabilisation, full economic recovery is not yet assured and growth momentum remains subdued.

In the last six months Sri Lanka has seen its runaway inflation drop to 1.3% in September, its currency appreciate by about 12% and foreign exchange reserves improve.

But the island has struggled to improve its revenue with additional measures likely to be taken in the upcoming budget in mid-November.

Despite revenue mobilisation having improved relative to last year, the IMF said revenue was expected to fall short of initial projections by nearly 15% by year end.

"While partially due to economic factors, the onus of fiscal adjustment would fall on public expenditure if there were no efforts to recoup this shortfall. This could weaken the government's ability to provide essential public services and undermine the path to debt sustainability."

Sri Lanka's international bonds were unmoved by the news, trading slightly higher on the day.

The bonds are still in deeply distressed territory, trading between 46-48 cents to the dollar, Tradeweb data showed.

The global lender said Sri Lanka would need to strengthen tax administration, remove tax exemptions and actively eliminate tax evasion to increase revenues and signal better governance.

Sri Lanka accepted offers to exchange about $10 billion worth of defaulted local debt for new bonds, taking it a step towards meeting debt restructuring requirements ahead of the IMF review.

Sri Lanka has also held multiple rounds of talks with bondholders and bilateral creditors including Japan, China and India to reach an agreement to rework its foreign debt after suspending repayments in May last year.

The island's debt restructuring is also being discussed at a meeting of the Institute of International Finance and Paris Club scheduled for later in the day, according to the agenda seen by Reuters.

(Writing by Swati Bhat, additional reporting by Karin Strohecker and Jorgelina do Rosario in London; editing by Sudipto Ganguly)