US embassy cable - 05COLOMBO1812

UNCLAS SECTION 01 OF 02 COLOMBO 001812 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR SA/INS M. GOWER, AND C. SIM; MCC FOR D. NASSIRY 
AND E. BURKE 
 
E.O 12958: N/A 
TAGS: ECON, EFIN, CE 
SUBJECT:  CONTINUED IMPROVEMENT IN SRI LANKA?S GROWTH, 
DESPITE INFLATION, VIOLENCE AND UPCOMING ELECTIONS 
 
Ref:  Colombo 1492 
 
1.  (U) Summary:   Since the last economic update (reftel), 
the Central Bank of Sri Lanka has released second quarter 
GDP data which shows a 6 percent annualized growth rate in 
the second quarter.  The growth rate for the first half of 
2005 is estimated at 5.1 percent.  Exports have also been a 
strong contributor to growth.  The Central Bank expects the 
economy to post a growth rate of 5 to 5.5 percent in 2005, 
in line with post tsunami forecasts.  However, fiscal and 
monetary developments need to be watched during the rest of 
the year.  Government fiscal control will be difficult this 
year, given high oil prices, continuing subsidies, tsunami 
reconstruction and populist programs on the eve of the 
budget and presidential elections.  Inflation remains a 
major cause for concern.  Garment exporters expect continued 
growth in the wake of US safeguards on China, but worry about 
the post-2008 removal of safeguards.  Upcoming presidential 
elections present the populace with a fairly distinct choice 
on the country's economic policies.  End Summary 
 
2.  (U) Sri Lanka?s economy grew by 6 percent in the second 
quarter, recovering strongly from the tsunami damage. 
Growth came mainly from service and manufacturing sectors, 
while performance in the agriculture sector was mixed as 
the tsunami-damaged fisheries sector declined.  In the 
services sector, telecommunications, ports and aviation 
continued to contribute strongly to growth.  The 
manufacturing sector grew 6.5 percent aided by strong 
exports.  The construction sector expanded 5.8 percent 
boosted by tsunami reconstruction and other infrastructure 
projects.  In the agricultural sector, tea, rubber and 
paddy production recorded strong growth rates.  According 
to the Central Bank, paddy production has increased by 20 
percent in the main ?Maha? cultivation season to a new 
record level.  These trends are expected to continue in the 
second half, with all sectors contributing to growth. 
 
3.  (U) On the external front, according to latest data, 
exports have increased by about 13 percent in the first 
eight months of the year, the result of continued growth in 
the garment sector.  Imports grew by 11.3 percent during 
this period (primarily the result of increased oil prices). 
The trade deficit rose 7.7 percent to USD 1.6 billion.  The 
Balance of Payments recorded a surplus of around USD 190 
million for the first eight months as the higher trade 
deficit was offset by higher worker remittances (up 22 
percent), official aid, and debt relief.  According to 
official data, tourist arrivals have increased 4.6 percent 
through August.  Most of those arrivals consist of business 
travelers, transit visitors, and tsunami relief workers, 
however, prompting resort owners to complain of low 
occupancy in the tourism hotel sector.  Income from port 
services has also remained strong.  Gross official reserves 
at USD 1.24 billion in August 2005 were sufficient to cover 
3.3 months of imports. 
 
4.  (U) However, fiscal and monetary aggregates have 
deteriorated.  Sri Lanka's inflation rate touched 12.7 
percent in September and money supply increased 
significantly.  Money supply growth continues at around 
20 percent, mainly due to an increase in both public 
and private sector credit.  The IMF expects inflation 
to rise further this year, as aid inflows for tsunami 
reconstruction and oil prices boost inflationary pressures. 
The Central Bank and the Treasury disagree and the Central 
Bank kept interest rates unchanged in October, hoping 
earlier rate hikes (150 basis point since November 2004) 
would help to gradually curb monetary expansion and tame 
inflationary expectations.  Currently, the Central Bank 
repurchase rate and reverse repurchase rates are at 8.5 
percent and 10 percent respectively.  The bank intends to 
conduct more aggressive open market operations to control 
monetary and credit expansion. 
 
5.  (SBU) The government will present its FY 2006 budget to 
Parliament on November 8.  While the opposition has asked 
the government to wait and allow the new President to 
pursue his own agenda, the Government is likely to present 
the budget as planned.  Treasury Secretary P.B. Jayasundera 
told the Ambassador recently that he had asked the Attorney 
General about the possibility of deferring the budget 
presentation until after the elections.  The AG reportedly 
told P.B. that since the Government remains in power until 
the elections, and since Parliament continues to sit, the 
Government should present a budget.  The budget could give 
the Government the opportunity to highlight the Prime 
Minister?s Presidential Election Manifesto, which will 
reportedly include continued subsidies for the agricultural 
sector, increased government employment opportunities and 
expanded welfare benefits, but it will also have to balance 
those promises against its efforts to keep fiscal 
discipline, tame inflation and pursue a sovereign rating. 
 
6.  (U) The 2006 budget will also give an indication of the 
final fiscal outcome in 2005.  The Government targeted a 
deficit of 7.5 percent of GDP in 2005.  Since then, 
official projections have been revised to a deficit of 8.2 
percent to accommodate tsunami expenditure.  The broader 
public sector deficit would be larger if losses in state 
enterprises, especially the state owned petroleum and 
electrical utility, are counted. 
 
7.  (U) In September, the government obtained parliamentary 
approval for a supplementary budget estimate of Rs. 58.6 
billion (USD 586 million) to finance additional expenditure 
on tsunami related development work in 2005.  Part of the 
expenditure is being funded through foreign aid and the 
balance through government funds.  The government also 
plans to raise USD 100 million through an international 
bond issue opened to its expatriate work force 
(approximately one million Sri Lankans live and work 
abroad) in November.  These funds will be used to finance 
key infrastructure projects. 
 
8. (SBU) Comment: While inflation remains a key concern, 
the economy?s growth remains remarkably buoyant, given the 
uncertainty surrounding the presidential elections and 
recent events that have called into question the strength 
of the ceasefire with the Tamil Tigers.  We have heard from 
garment manufacturers that continued growth is likely, so 
long as the US continues to maintain safeguards on Chinese 
textile and apparel products, yet there is much hand- 
wringing in the industry about what happens after 2008 
(when the US agreement with China on China?s WTO accession 
removes the safeguard provision).  The electorate in Sri 
Lanka faces a fairly distinct choice between the two 
candidates in the upcoming elections, and despite lots of 
populist promises on both sides, one side (the opposition 
United National Party) clearly favors a private-sector 
driven market approach, while the Sri Lanka Freedom Party 
candidate, Prime Minister Mahinda Rajapakse, favors more 
government intervention and direction in the economy.  We 
will report on the two campaigns? economic programs septel, 
but we expect both to promise significant benefits 
(subsidies, price controls, etc) without much explanation 
of either related budget cuts, or significant revenue 
enhancements.  End Comment 
LUNSTEAD