US embassy cable - 03COLOMBO806

UNCLAS SECTION 01 OF 03 COLOMBO 000806 
 
SIPDIS 
 
COMMERCE FOR ITA:ABENAISSA, 4530 MAC/AP/OSA/O:LDROKER 
TREASURY FOR OTA:GSMITH, SRI LANKA DESK:GRAO 
 
E.O 12958: N/A 
TAGS: ECON, ETRD, EFIN, CE, ECONOMICS 
SUBJECT:  SRI LANKAN GROWTH EXCEEDS EXPECTATIONS 
 
 
SUMMARY 
------- 
1. According to the latest data released by the 
Central Bank, Sri Lanka's economy expanded by 4% in 
2002, recovering from a 1.4% downturn in 2001. 
Growth exceeded Bank expectations of 3.5%, and came 
mainly from the services sector.  Despite this modest 
increase, Central Bank expressed concern over 
declining national savings, investments and 
government revenues.  Most other macroeconomic 
fundamentals, which deteriorated sharply in 2001, 
were partly restored during the year.  The current 
peaceful conditions, critical for economic recovery, 
are expected to last, leading to projections of 5.5% 
growth this year.  End Summary. 
 
GROWTH FUELED BY SERVICES 
------------------------- 
2.   The Central Bank of Sri Lanka released the final 
economic statistics for 2002 last week.  The Bank 
said the economy recovered with 4% growth after 
shrinking 1.4% in 2001.  This exceeded the Bank's 
earlier forecasts of 3.5%.  At current prices, Sri 
Lanka's GDP is now $16.6 billion and per capita 
income is $872. 
 
3.  Growth was gradual during 2002, but not broad 
based, coming mainly from the services sector.  The 
economy expanded slowly in the first half and 
accelerated to 6% in the second half.  The high 
second half growth shows recovery from the low base 
in the comparable period in 2001, when the economy 
suffered badly from terrorist attacks in Sri Lanka 
and the U.S. 
 
4. The services sector expanded by 6% and accounted 
for about 80% of overall growth in 2002.  The strong 
performance in services - mainly telecommunications, 
tourism, ports, trade and finance - is attributed to 
this sector's flexibility in a changing environment. 
Agriculture grew by 2.5%, staging a partial recovery 
from a 3.4% downturn in 2001.  The industrial sector 
grew slowest at 1% due to weak export demand. 
Domestic consumer demand contributed significantly to 
growth and aggregate demand.  The contribution to 
overall growth from investment was just 12%.  The 
Central Bank reported a notable increase in corporate 
profits (i.e., of the 30 largest companies on the 
Colombo Stock Exchange) during the year when compared 
to 2001. 
 
INVESTMENT, SAVINGS, INFLATION, UNEMPLOYMENT 
-------------------------------------------- 
5.  The Central Bank expressed concern over the 
falling national savings and investments ratios. 
National savings declined to 19.7% of GDP from 20.3% 
in 2001 while investment declined to 21.3% of GDP 
from 22% in 2001.  Both were well below the rates of 
25% and 28% of GDP, respectively, required to achieve 
sustainable growth of 7-8%. 
 
6.  Inflation declined to 9.6% in 2002 from 14.2% in 
2001 despite price increases in a number of goods and 
utility services.  This decline in inflation was the 
result of high real interest rates that checked 
demand, the relative stability of the exchange rate, 
low import prices, increased supply, and peace, as 
well as the absence of major wage increases. 
According to data for the first three quarters, 
unemployment has risen to 9.1% of 2002 from 7.9% in 
2001 with 641,000 unemployed.  Underemployment also 
remained high.  The sharp increase in unemployment 
was partly due to increased labor force 
participation. 
 
FISCAL CONTROL 
-------------- 
7.  The government was able to exert fiscal control 
after experiencing major slippages in 2001.  The 
budget deficit was restricted to 8.9% of GDP, a 
significant improvement from 10.8% deficit recorded 
in 2001, although it was still higher than the 
budgeted estimate of 8.5% of GDP for 2002.  Revenue 
was below expectations at 16.5% of GDP.  With revenue 
shortfalls of Rs 17 billion (approx. $178 million), 
budgetary control was achieved through expenditure 
cuts, which restricted government spending to 25.4% 
of GDP.   The Central Bank expressed concern over 
falling revenues.  Revenue slipped from 21% of GDP in 
the early 1990s due to tax exemptions and a decline 
in revenue mobilization.  Public debt reached 105.3% 
of GDP. 
 
TRADE DEFICIT WIDENS - CAPITAL FLOWS HELP 
----------------------------------------- 
8.  On the external front, export sector performance 
was disappointing, declining by 2%.  Imports 
increased by 2%.  Consequently, the trade deficit 
increased to $1.41 billion in 2002 from $1.15 billion 
in 2001.  The Services account improved 
significantly, recording a surplus of $271 million. 
Private remittances also grew strongly by 11% to $1.3 
billion.  The current account recorded a deficit of 
1.6% of GDP, but was offset by a surplus in the 
capital account.  The BOP recorded a surplus of $338 
million compared to a surplus of $220 million in 
2001.  Gross official reserves rose to $1.7 billion 
at end of 2002, sufficient to finance 4.9 months of 
imports. 
 
OUTLOOK FOR 2003: GROWTH AND THE PEACE DIVIDEND 
--------------------------------------------- -- 
9.  According to the Central Bank, the Sri Lankan 
economy is expected to grow by 5.5% in 2003.  All 
major sectors of the economy are expected to expand. 
This growth will, however, depend on the continuation 
of the peace process, policy adjustments 
(particularly budgetary control) and structural 
reforms.  Recovery in the global economy is also 
needed - especially demand for Sri Lanka's apparel 
exports and effective utilization of concessionary 
assistance announced by IMF and other donors. 
 
10.  Inflationary pressures are expected to further 
decline and annual inflation is expected at 7.5%. 
The trade deficit is forecast to rise as imports grow 
faster than exports, due to increasing investor and 
consumer confidence.  Foreign financial flows are 
expected to rise and contribute to a BOP surplus once 
again.  Investment is projected to increase from 
21.5% of GDP in 2002 to 24% in 2003.  The budget 
deficit is forecast around 7.5% of GDP, almost 1.5% 
lower than in 2002. 
 
11.  At a seminar to explain the outcome of 2002 
economic performance, Central Bank's director for 
economic research said that the economy has been 
helped by the current cease-fire and ongoing peace 
process.  Peace has led to an increase in economic 
activity (especially in agriculture, tourism, trade 
and internal transport) and the containment of non- 
productive expenditure.  Significantly, defense 
expenditure has declined to 4.0% of GDP in 2002 from 
4.9% in 2001.  In nominal terms, the actual defense 
bill was Rs 60 billion ($627 million) in 2002, 
compared with an estimated requirement of Rs 100 
billion ($1 billion) in the absence of peace. 
 
12.  These savings have contributed to a reduction of 
2% of GDP in the budget deficit, helped to contain 
the rapid increase of public debt witnessed in the 
previous years and, at least partially, reigned in 
other macroeconomic imbalances in the economy.  The 
relative decline in government demand for domestic 
resources (due to lower defense spending) helped to 
ease the pressure on interest rates.  The 
availability of goods and services increased, due to 
removal of road barriers.  Business confidence also 
rose as indicated by sharp increases in the Colombo 
Stock Exchange (CSE) indices.  CSE indices rose 45% 
during 2002.  Defense related imports also declined, 
easing pressure on external assets. 
 
13.  More importantly, the peaceful environment has 
created a conducive environment for the government to 
launch the key - and difficult - structural reforms 
needed for economic management.  These include labor 
market reforms, increases in administered prices, 
privatization, and social safety net reforms.  It 
also enabled the government to announce explicit 
short and medium term fiscal discipline targets 
contained in the Fiscal Management (Responsibility) 
Act.  Critically, the environment enabled donors to 
approve long-term concessionary funds required to 
rebuild Sri Lanka under PRGF facilities. 
 
Wills