US embassy cable - 02COLOMBO2202

UNCLAS SECTION 01 OF 03 COLOMBO 002202 
 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON, EFIN, ETRD, CE, ECONOMICS 
SUBJECT:  SRI LANKA: A REFORM-MINDED 2003 BUDGET 
 
1.  Summary:  Indicating government commitment to fiscal 
discipline and continued reforms, the 2003 GSL budget 
concentrated on improving the macro economic situation through 
measures to narrow the budget deficit and public debt while 
increasing tax revenue.  The fundamental weakness of the fiscal 
situation remains, however; committed current expenditures 
absorb all of government revenue, require heavy borrowings and 
hold public investment below required levels.  The budget 
foresees an improved macro economic situation and lower interest 
rates (stemming from a lower government deficit) together 
boosting private investment.  In addition, the budget proposed 
to slightly expand tax holidays for investment and further 
liberalize exchange controls.  Significantly, there were no 
populist measures.  The budget was generally well received by 
the business community; the opposition criticized it for a lack 
of relief for the masses.  It represents a credible first step 
toward fiscal stability.  End Summary 
 
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Reign in Macro Economic fundamentals 
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2.  The Minister of Finance, K N Choksy, presenting the GSL 
budget for FY 2003 to Parliament on November 6, said it aims to 
undo the defects of the past and build prosperity for the 
future.  He said "our effort is to reform the economy in 
parallel with the peace process" but warned that a spectacular 
overnight recovery of the economy cannot be expected.  He 
recalled that in the past, the people have judged governments 
and budgets by the number of flowery promises they make.  He 
asked that this government be judged by the results it delivers. 
 
3.  Under the United National Front (UNF) government, the 
economy has already made a partial recovery from -1.3% dip in 
2001.  Growth is projected at 3% in 2002, increasing to 5.5% in 
2003.  Inflation has dropped from 14% in 2001 to about 9% in 
2002.  Considerable progress has been made in reducing the 
budget deficit from 10.9% of GDP in 2001 to 8.9% of GDP in 2002, 
which is just 0.4% off the IMF target.  Deficit control, 
however, has come at the cost of capital expenditure.  The 
current account deficit expanded to 4.3% of GDP in 2002 from a 
planned 3.4%. 
 
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Deficit to drop to 7.5% in 2003 
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4.  The government commitment to strengthening macro economic 
fundamentals was manifested by moves to reduce government 
spending and increase revenue.  GSL hopes a new Fiscal 
Management Law will ensure fiscal prudence and an Economic 
Management Law will help ministries track economic reforms.  The 
2003 budget calls for total spending (and net lending) of Rs. 
438 billion ($4.5 billion), or 24.6% of GDP.  Revenues are 
projected at Rs. 304 billion ($3.2 billion) or 17.1% of GDP, 
implying a budget deficit of Rs. 134 billion ($1.4 billion), or 
7.5% of GDP.  The contraction in the deficit from last year's 
levels, equivalent to about 1.4% of GDP, stems from both an 
increase in revenue and a reduction in current expenditure.  The 
Government still runs a large current account deficit of 2.3% of 
GDP.  The overall deficit is to be financed through foreign 
grants ($94 million), foreign borrowing ($260 million), domestic 
financing ($906 million) and privatization receipts ($145 
million).  In the medium term, the government hopes to further 
improve the fiscal situation by reducing the budget deficit to 
5.6% of GDP by 2005. 
 
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Revenue to rise 16%; exemptions withdrawn 
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5.  Revenue is forecast to increase by 16% in 2003 - a 
reasonable target given the projected GDP growth of 5.5%, 
inflation of 9% and a new, broad-based tax regime.  The Value 
Added Tax (VAT) introduced in August 2002 and import tariffs 
were expanded to cover exempted goods and sectors. A 20% import 
surcharge will remain through 2003, while a 0.1% debit tax on 
bank transactions was extended to all types of bank accounts. 
Certain other tax exemptions were withdrawn.  The government 
expects additional revenue of about Rs 12 billion from the 
expanded tax regime.  Furthermore, new taxes on annual vehicle 
license fees, airline tickets and tourist hotels will fund the 
development of roads, airports and tourism.  Some of these taxes 
have drawn criticism from affected persons and industries. 
 
6.  The budget announced the establishment of a revenue 
authority to coordinate the functions of the various revenue 
collecting agencies.  In addition, tax administration is to 
become more transparent and simplified.  In order to widen the 
tax net, the government offered an amnesty to defaulters and non- 
taxpayers, with the intention of bringing them under a new tax 
regime from April 2003. 
 
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Expenditure to come under control 
--------------------------------- 
 
7.  On the expenditure front, GSL expects a contraction 
equivalent to about 1.1% of GDP in 2003.  Significantly, all of 
this will arise from cuts in recurrent expenditure.  Public 
investment will rise from 4.6% of GDP in 2002 to 5.3% of GDP or 
Rs 95 billion ($980 million), but will remain below the 6-7% of 
GDP spent in 1998-2000 and below levels required for stronger 
economic growth.  Specific expenditure control measures in the 
budget included strict budgetary controls, controls over defense 
expenditure, public administration reforms and interest savings 
on public debt.  Otherwise the Government has little room for 
expenditure management, especially with debt servicing running 
ahead of total revenues.  Interest payments will absorb 31% of 
government expenditure (excluding repayments), public investment 
(21%), defense (14%), welfare (5%), pensions (8%) and central 
government salaries (6%).  While defense expenditure has been 
reduced by about 0.5% of GDP, it still remains one of the 
largest spending items.  Total defense spending (including 
Police) is projected at Rs 63 billion (3.5% of GDP) in 2003 
compared with 4% of GDP in 2002, 3.8% in 2001 and 5.7% in 2000. 
Significantly, the budget did not contain any of the populist 
measures typical of recent GSL budgets. 
 
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Public Debt 
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8.  Due to heavy past borrowing to fund the war and unproductive 
programs, Sri Lanka's public debt has increased to 105% of GDP, 
prompting the government to accord high priority to bringing 
debt under control.  Debt servicing at Rs 326 billion (approx 
$3.36 billion) is the largest expenditure item in the budget and 
compares to total revenues of Rs 304 billion in 2003.  The main 
feature of the new debt management policy is to reduce short- 
term debt instruments by replacing them with long-term bonds at 
lower interest rates.  A huge government overdraft from the 
banking sector is also being eliminated.  In addition, an 
independent debt management office will be established in early 
2003.  These efforts, together with lower deficits, are expected 
to gradually reduce public debt to 91.1% of GDP by end 2005. 
 
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Reforms to continue 
------------------- 
 
9.  The budget speech reiterated the government's commitment to 
economic reforms covering a litany of areas - from welfare, 
pensions and public administration to labor, land, power and 
privatization.  In addition, subsidies on a range of items from 
wheat to petroleum and electricity have been already reduced. 
The privatization program hopes to earn Rs 14 billion ($146 
million) in 2003 through the sale of remaining Sri Lanka Telecom 
shares and the opening of petroleum imports to the private 
sector.  In 2002, the government sold two sugar companies, a 
bunkering company and minority stakes in 6 bus companies.  The 
sale of Sri Lanka Insurance corporation and a 15% stake in Sri 
Lanka Telecom are underway.  Total receipts are expected at Rs 
21 billion ($219 million) in 2002. 
 
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Private sector 
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10.  The Finance Minister stressed the importance of stimulating 
growth and investment and increasing employment opportunities 
outside the armed forces.  The government hopes that the 
combination of a recovering economy and a decline in public 
sector borrowing from domestic banks will reduce inflation and 
interest rates, spurring private sector activity.  To boost 
investment, the top corporate tax band was reduced from 35% to 
30%, with half of the tax savings going into a skills 
development fund.  In addition, tax holidays were slightly 
increased from 3 years to 5 years for exporting companies 
located outside Colombo.  The maximum tax holiday for large 
infrastructure projects was also increased from 10 to 12 years. 
Furthermore, joint public-private sector apex councils will 
boost the tourism, garments, plantation, agribusiness, fishing 
and jewelry industries. 
 
11.  The budget proposed mandatory credit ratings for financial 
institutions and corporate debt instruments.  Exchange control 
liberalization will allow foreign companies to access rupee 
credit facilities.  Various other foreign exchange 
liberalization measures will facilitate trade and investment: 
import credit facilities up to 360 days, currency conversions to 
settle loans, forward facilities up to 720 days and foreign 
investment in debentures and government bonds. 
 
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North East rehabilitation not covered 
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12.  The budget did not cover the rehabilitation of the north 
and east devastated by war.  The Government hopes to receive aid 
from development partners for these activities at special donor 
meetings, the first of which took place in Oslo on November 25. 
A meeting in Tokyo in 2003 is to deal with medium term 
assistance for the countrywide programs in the budget. 
 
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Private sector welcomes the budget; opposition critical 
--------------------------------------------- ---------- 
 
13.  Private sector analysts and the business community have 
praised the budget for its commitment to fiscal discipline and 
reforms.  But they have also pressed for practical measures to 
implement new proposals and ensure accountability.  Tax experts 
and businessmen also commended tax administration proposals 
aimed at simplifying the system.  But they worry that expanded 
taxation will lead to inflation and affect export 
competitiveness.  One of the most controversial has been the 
extension of the VAT to the banking system, which analysts fear 
could lead to increased interest costs.  Another proposal to 
charge a 15% tax on inward remittances was withdrawn due to 
adverse effects on remittances of unskilled Sri Lankan workers 
in the Middle East. 
 
14.  The opposition has criticized the budget for a lack of 
relief for the working class and poor, as well as for not 
funding major development projects.  Some opposition politicians 
have accused the government of simply following the dictates of 
the World Bank and the IMF.  Key government ministers defended 
the budget moves, saying the country would incur more debt if 
the people were to be given further economic relief.  The stock 
market reacted negatively to the budget especially due to 
increased taxation on the key banking sector, which accounts for 
44% of Colombo market capitalization.  The budget was passed in 
Parliament on November 14 with 129 votes for and 93 against. 
 
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Comment 
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15.  This is the UNF's first full-year budget, its 2002 budget 
having been delayed by elections until three months into this 
year.  It is a credible first step toward reversing the slide in 
fiscal discipline that Sri Lanka has suffered in recent years. 
But with a deficit target of 7.5% of GDP, the budget is neither 
ambitious nor far-reaching in its reforms.  This is no surprise 
from a government that is pursuing a delicate peace process and 
faces elections any time at the will of the President.  Still, 
if GSL sticks to this budget - or even comes close - it will be 
well on its way to its modest medium-term goal of fiscal 
stability in 2005. 
 
Wills