US embassy cable - 04COLOMBO1702

UNCLAS SECTION 01 OF 03 COLOMBO 001702 
 
SIPDIS 
 
E.O 12958: N/A 
TAGS: ECON, CE, ECONOMICS 
SUBJECT:  Sri Lankan Economy Continues to Grow Despite 
Confusion Over Policies 
 
1.  (U) SUMMARY:  The Sri Lankan economy grew by 5.2% in 
the second quarter, following 6.2% growth in the first 
quarter.  Consequently, first half GDP growth is estimated 
around 5.7% and the Central Bank is optimistic of 5 to 5.5% 
overall growth in 2004.  The Bank attributes the growth 
this year to the continuation of economic momentum 
following the signing of the ceasefire agreement.  The 
economy, however, faces several challenges:  high oil 
bills, drought in agricultural districts, deficit in the 
Balance of Payments, inflationary pressures, subsidy costs, 
stalemate in the peace front and economic uncertainty.  The 
GSL seems to be coming around to the realization that 
fiscal restraint is needed, and is making some efforts to 
curb subsidies, but its prospects for long-term success on 
this front are poor.  End Summary. 
 
GDP Growth Continues 
-------------------- 
 
2. (U) The Sri Lankan economy grew by 5.2 percent in the 
second quarter, down from 6.2 percent in the first quarter. 
Second quarter growth was fueled by a strong services 
sector, which grew by 7.1 percent.  Within services, 
telecommunications, port services, import trading and 
banking did well.  The agriculture sector declined 
slightly.  Tea, rubber and coconuts increased, but rice 
recorded a 12 percent decline due to drought.  Growth in 
factory output slowed to 3 percent from 9 percent in 2003. 
 
External sector 
--------------- 
 
3.  (U) As the oil bill soared and aid flows slowed, the 
BOP recorded a USD 223 million deficit in the first half of 
2004 from a USD 187 million surplus for the same period in 
2003.  On the bright side, exports gained from continuing 
global economic recovery and rose by 10 percent. Tourism, 
foreign inward remittances and shipping also recorded 
healthy growth and partly offset the huge trade deficit, 
caused by a 21 percent rise in imports.  The trade deficit 
increased to USD 1.1 billion in the first half of 2004 
(2004H1) from 0.7 billion in 2003H1.  The oil bill was $539 
million in 2004H1 compared with $375 million in 2003H1. 
The treasury expects it to rise further to about $1.2 
billion by year-end.  Import of machinery and other 
investment goods also increased.  The current account 
deficit was $428 million compared with a deficit of $1.5 
million in 2003. 
 
4. (U) Capital inflows have slowed.  Government borrowing 
declined to $284 million in 2004H1 compared to $315 million 
in 2003H1, as IMF and WB have withheld program loans to Sri 
Lanka while the new Government pursues its development 
plan.  To cover the shortfall, the government hopes to 
borrow up to US$400 million through dollar bond issues in 
2004.  The Central Bank said that FDI inflows remained at 
last year's levels -- around $100 million.  Outflows have 
increased due to a large investment abroad by a local bank. 
Portfolio investment saw a drastic drop to just US $6 
million as investors sought greater clarity in government 
policy on the economic and peace fronts.  The worsening BOP 
situation resulted in official reserves declining to $2.1 
billion by June from $2.3 billion in December 2003.  Total 
reserves declined to $3.1 billion from $3.2 billion, 
providing 5.2 months of import cover. 
 
5. (U) The Central Bank recently said that a small BOP 
surplus for the second half of 2004 could be expected if 
privatization proceeds from the sale of a petroleum retail 
unit and program loans flow in and oil returns to below $40 
a barrel - neither of which appears likely at this point. 
Without such changes, the BOP deficit for the full year 
could exceed $200 million. 
 
Exchange rate, interest rate and inflation 
------------------------------------------ 
 
6. (U) Exchange rates, interest rates and prices are under 
severe pressure due to BOP deficit, government subsidies 
and price hikes.  The government has, however, been able to 
temporarily keep a tight rein through state intervention in 
both money and exchange markets.  Despite Central Bank 
intervention, in which the bank sold USD 235-300 million, 
the rupee depreciated by 6.2 percent by the end of August. 
The news of an increased BOP deficit has further weakened 
the rupee.  It is currently trading at around 104 rupees to 
the dollar. 
 
7. (U) As of the end of September, the Central Bank 
maintained its interest rates, despite rising inflation and 
exchange rate pressures.  T-bill rates, which increased by 
about 200 basis points through July 2004, have started to 
decline in the last few auctions as state institutions 
increased buying, reportedly on instructions from the 
Finance Ministry.  The current 3 month T-bill rate is about 
7 percent compared with 7.26 percent a year ago.  The 
average prime-lending rate is around 9.68 percent compared 
with 9.32 percent a year ago. 
 
8. (U) The money supply expanded by about 18 percent in 
July as both private and public sector credit grew.  The 
Central Bank has expressed concern about the high growth in 
public sector credit due to subsidies on petroleum, wheat 
and several other services.  The Bank said that the impact 
could be mitigated by revising prices, which would also 
support interest and exchange rate stability. 
 
9. (U) Inflation has once again become a major concern to 
the Government and policy makers.  Average inflation as 
measured by the Colombo Consumer Price Index (CCPI) was 5.4 
percent in September.  A much faster rate of inflation was 
indicated in the point-to-point change (September 
2004/September 2003) in the index, which rose by 11.6 
percent as the full effect of recent price hikes began to 
be captured by the index.  Prices have been rising as a 
result of oil price hikes, depreciation of the rupee, and 
lower agricultural supplies due to a drought.  Inflationary 
pressures will rise further in the coming months due to 
price hikes on petroleum, transport, and electricity 
announced in late September. 
 
Government fiscal operations 
---------------------------- 
 
10. (U) On the fiscal front, the GSL Treasury maintains 
that the budget deficit for 2004 will be 8%, despite 
subsidy costs and increased government recruitment.  The 
treasury has said that subsidies up to Rs 8 billion could 
be accommodated within a deficit of 8 percent of GDP. 
According to reports, subsidies on petroleum alone have 
amounted to about Rs 7.5 billion (USD 75 million) so far 
this year.  The government has begun to gradually raise the 
price of petroleum products (gasoline and diesel), 
electricity, and public bus transport.  Even with prices 
recently allowed to rise on diesel, kerosene, and wheat 
flour, these products are still subsidized.  Sri Lanka has 
sought, with only marginal success, OPEC assistance 
(concessionary financing through the OPEC fund) to ease the 
pressure on government finances.  Some of the price 
increases requested by the private sector (such as bus 
fares, wheat flour, cooking gas) are under intense debate. 
 
11. (U) The Central Bank expects investment will continue 
to achieve a higher growth in the medium term.  Future 
investment will depend on several factors affecting 
consumer and investor confidence: political stability, a 
resumption of, and progress in, the peace talks, 
improvements in macroeconomic management, greater fiscal 
control, improved clarity in economic policy, reduced price 
distortions, improved infrastructure, structural reforms, 
and effective utilization of donor assistance. 
 
Comment 
------- 
 
12. (SBU) While the picture is not dire on the economic 
front, it could be far better, particularly with exports 
surging as they are.  It appears that monetary policy is 
looser than might be expected despite increasing interest 
rates and a weakening rupee.  While the depreciating rupee 
should be good for Sri Lankan exports, much of its effect 
is offset by the increasing cost of imported inputs for the 
export sector.  The losses of IMF and World Bank budgetary 
support magnify the balance of payments problem even more. 
 
13. (SBU) Continued floundering and a failure of the 
Government to speak with one voice on matters of economic 
policy will continue to send the wrong signals to markets 
and potential investors.  During upcoming TIFA talks in 
Washington, USG interlocutors will hear from the GSL that 
they intend to "stay the course" on economic reform.  This 
is only partially true.  The current Government has taken 
privatization off the table and cuts to subsidies are just 
now beginning to be considered, as continuing price 
increases bring home the reality of the nation's fiscal 
situation.  The GSL has begun to change its tone, with the 
President recently commenting that subsidies are no longer 
sustainable and should not be expected to continue. 
Whether this rhetoric will translate into concrete action 
on the fiscal front is questionable.  The President's 
coalition remains tethered to a socialist firebrand party 
(JVP) with keen interests in seeing continued payouts for 
its constituent base in the rural, poor southern regions. 
LUNSTEAD