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Cablegate: Investment Climate Statement, 2008 - Sri Lanka

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UNCLAS SECTION 01 OF 22 COLOMBO 000061

SIPDIS

SIPDIS

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TAGS: KTDB OPIC ECON USTR EINV EFIN ETRD ELAB PGOV CE
SUBJECT: INVESTMENT CLIMATE STATEMENT, 2008 - SRI LANKA

REF: 2007 STATE 158802

1. Per reftel, below is the investment climate statement for Sri
Lanka for 2008.

[Begin text:]
INVESTMENT CLIMATE STATEMENT-SRI LANKA
JANUARY 2008

OPENNESS TO FOREIGN INVESTMENT

--Unpredictability Impedes Investment

Sri Lanka's intractable civil war, erratic policy environment, and
cumbersome bureaucracy make it an unpredictable investment
destination. However, compared to other South Asian countries, Sri
Lanka is relatively open to foreign investment. It offers a
relatively open financial system, moderately good infrastructure,
and generally capable workers. Some U.S. and other foreign
investors have realized worthwhile returns on investment in Sri
Lanka; others have tried and come away frustrated.

Sri Lanka is a lower-middle income developing nation with a gross
domestic product of about $32 billion in 2007. This translates into
a per capita income of $1,475. Despite the resumption of the civil
war, Sri Lanka's gross domestic product (GDP) grew by an estimated
6.7% in 2007. Growth was led by telecommunications, ports,
construction and manufacturing exports. Growth in 2006 and 2007
came at the cost of 15-20% inflation, which eroded domestic
purchasing power. The government predicts GDP growth of 7.0% and
10-15% inflation in 2008.

The Sri Lankan economy is remarkable for its resilience. Although
suffering a brutal civil war that began in 1983, Sri Lanka has seen
GDP growth average around 5% in the last ten years. Following a
ceasefire in 2002 and subsequent economic reforms, the economy grew
by about 5.7% in 2003-2004. Even the December 2004 Indian Ocean
tsunami -- which killed 32,000 people, displaced 443,000, and caused

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an estimated $1 billion in damage -- failed to dent GDP growth,
which was 6% in 2005 and 7.4% in 2006; this was due in part to the
damage having been offset by reconstruction.
Sri Lanka is a stable parliamentary democracy. In 1978, it shifted
away from a socialist orientation and opened to foreign investment.
However, changes in government have often been accompanied by
reversals in economic policy. Of the two major parties, the more
pro-business United National Party has been in opposition in recent
years. When it last held power, from 2002 to 2004, it pursued
privatization and regulatory reform welcomed by domestic and foreign
investors. Currently, the ruling Sri Lanka Freedom Party has a more
statist economic approach, guided by President Rajapaksa's 2005
election manifesto Mahinda Chintana ("Mahinda's Thoughts"). Mahinda
Chintana seeks to reduce poverty by steering investment to
disadvantaged areas; developing small and medium enterprises;
promoting agriculture; and expanding the already enormous civil
service. The Rajapaksa government has halted most privatization and
advocates permanent state control of what it deems "strategic"
enterprises such as state-owned banks, airports, and electrical
utilities. The government has increased direct and indirect
taxation to fund increased government expenditure.
Sri Lanka's Board of Investment (BOI) is authorized to manage a
number of export processing zones which feature business-friendly
regulations and improved infrastructure for foreign investors. BOI
incentives are attractive and real, but the BOI is not the "one stop
shop" it aspires to be. Sri Lanka's large, inefficient, and dated
bureaucracy often works at cross-purposes with BOI authorities and
commitments. Additionally, major investments in Sri Lanka, such as
infrastructure projects, require approval from the full cabinet, a
process which is not transparent and which can politicize even the
most needed investments. Registration of foreign company branch
offices in Sri Lanka can be cumbersome as well.

The 24-year ethnic conflict between the U.S.-designated terrorist
organization Liberation Tigers of Tamil Eelam (LTTE) and the
Government of Sri Lanka has been a serious impediment to foreign
investment. A Norwegian-brokered ceasefire between the LTTE and the

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government, in effect since February 23, 2002, broke down in 2006
and was formally abrogated by the government in early 2008.
Resolution of the conflict appears unlikely in the near future.

Other impediments to investment in Sri Lanka are workers' declining
English language skills, inflexible labor laws, overburdened
infrastructure, and its unreliable court system. Sri Lanka boasts a
90% literacy rate in the local Sinhala and Tamil languages, but
English, which was once widely spoken, is now far less prevalent.
Sri Lanka's labor laws include many model protections, but can make
it nearly impossible for companies to lay off workers even when
market conditions fully warrant doing so. Sri Lanka has not
invested in infrastructure to keep pace with its growth. Its roads
are narrow and congested. Its electricity supply is generally
reliable but can fail to meet peak demand in years of low rainfall.
Delays in commissioning new power plants could make installed power
inadequate to meet demand within four years. Sri Lanka's courts
cannot be relied upon to uphold the sanctity of contracts. The
courts are not practical for resolving disputes or obtaining
remediation, because their procedures make it possible for one side
in a dispute to prolong cases indefinitely. Aggrieved investors
(especially those dealing with the government of Sri Lanka on
projects) have frequently pursued out-of-court settlements, in hopes
of speedier resolution.
--Major Sectors
The service sector is the largest component of GDP at 56%. In 2007
the service sector continued its strong expansion, fueled primarily
by strong growth in telecommunications, ports, trading and financial
services. Public administration and defense expenditures increased
sharply in 2007. There also is a growing information technology
sector, especially information technology training and software
development and exports. There are about 6,000 people employed in
export-oriented software development. Sri Lanka has seen some
investment in the business process outsourcing (BPO) sector, which
currently employs 5,500 to 6,000people and has potential to grow
further. Tourism remains well below potential due to resumed ethnic
conflict.
Manufacturing accounts for about 16% of GDP. The textile, apparel,
and leather products sector is the largest, accounting for 39% of
total industrial output. The second-largest industrial sector, at
22% of total manufacturing output, is food, beverages, and tobacco.
The third-largest industrial sector is chemical, petroleum, rubber,
and plastic products. The construction sector accounts for 7% of GDP
and posted strong growth rates in 2006-7, largely due to demand for
tsunami reconstruction projects. Mining and quarrying account for

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2% of GDP.
Agriculture has lost its relative importance to the Sri Lankan
economy in recent decades. It employs 32% of the working
population, but accounts for only 17% of GDP. Rice, the staple
cereal, is cultivated extensively. The plantation sector consists of
tea, rubber, and coconut; in recent years, the tea crop has made
significant contributions to export earnings, and increasing global
demand for natural rubber augers well for that sector.
--Trade
According to preliminary data for 2007, Sri Lanka's exports (mainly
apparel, tea, rubber, gems and jewelry) were $7.5 billion and
imports (mainly oil, textiles, food, and machinery) were $11.2
billion. Apparel is a vital industry accounting for about 45% of
exports. Although garment exports face increased competition
following the 2005 expiration of the worldwide Multifiber
Arrangement, exports increased by 6% in 2006 and 10% in the first 10
months of 2007. This growth was supported by duty free access to
the EU through the EU GSP+ scheme and by U.S. and EU safeguards on
exports from China. Apparel exporters expect tougher competition
once restrictions on Chinese apparel exports are lifted in 2008.
Sri Lanka's apparel industry is undertaking various efforts to meet
increasing global competition, including the establishment of fabric
mills and accessory manufacturing factories. The industry has also
embarked on a branding campaign under the slogan of "Garments
without Guilt" to highlight the industry's adherence to relatively
high labor standards, its prohibition of child labor, and its active
corporate social responsibility culture. Tea, Sri Lanka's second
largest export, attracted premium prices in 2007. Nevertheless, the
tea industry is challenged by a shortage of plantation labor, demand
for higher wages, and growing competition.

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Exports to the United States, Sri Lanka's most important market,
were $2.1 billion in 2006, or 31% of total exports. For many years,
the United States has been Sri Lanka's biggest market for garments,
taking about 56% of total garment exports. India is Sri Lanka's
largest supplier, with exports of $2.2 billion in 2006. The United
States exported approximately $200 million to Sri Lanka in 2006
consisting primarily of industrial machinery, as well as medical
instruments, paper, specialized fabrics and textiles for use in the
garment industry, and pharmaceuticals.
--Board of Investment

The Board of Investment (BOI) (www.boi.lk), an autonomous statutory
agency, is the primary government authority responsible for
investment, with a focus on foreign investment. The BOI acts as a
facilitator for investment. It is intended to provide "one-stop"
service for foreign investors, with duties including approving
projects, granting incentives, and arranging services such as water,
power, waste treatment and telecommunications. The BOI is
relatively effective in assisting investors who want to establish
operations within its industrial processing zones; it is less
effective in facilitating and service large investments outside
these zones. It also assists people in obtaining resident visas for
expatriate personnel and facilitates import and export clearances.
The Public-Private Partnership Unit, a new division of BOI, has
responsibility for coordinating all public-private infrastructure
projects.

Although there are appearances that the BOI has been used for
political purposes upon occasion, generally the treatment given to
foreign investors is non-discriminatory. In fact, some local
companies have complained that they are discriminated against, as
qualifying foreign investors can benefit from a range of advantages.
However, even with incentives and BOI facilitation, foreign
investors face difficulties operating in Sri Lanka. Problems range
from difficulty clearing equipment and supplies through customs
speedily to difficulty obtaining a factory site. Legal challenges
to environmentally sensitive projects have been burdensome, even
when objections are unfounded. Slow and indecisive application of
bureaucratic requirements has also obstructed investment. Several
high profile and needed infrastructure projects have dried up in the
past two years, as investors tired of waiting for approval and
action. In part to avoid these delays, and to overcome land
allocation problems, the BOI encourages investors to locate their
operations in BOI-established industrial processing zones.
Investors locating in industrial zones also get access to relatively
better infrastructure facilities such as reliable power,
telecommunication and water supplies.

--Laws Affecting Investment

The principal law governing foreign investment is Law No. 4, created
in 1978 (known as the BOI Act), as amended in 1980, 1983 and 1992,
along with implementation regulations established under the Act.
The BOI Act provides for two types of investment approvals. Under
section 17 of the Act, the BOI is empowered to grant concessions
(see details below) to companies satisfying certain eligibility
criteria on minimum investment, exports and in some cases
employment. Investment approval under Section 16 of the act permits
entry for foreign investment to operate under the "normal" laws of
the country and applies to investments that do not satisfy
eligibility criteria for BOI incentives. Other laws affecting
foreign investment are the Securities and Exchange Commission Act of
1987 as amended in 1991 and 2003, and the Takeovers and Mergers Code
of 1995 revised in 2003. A new Companies Act came into effect in
2007 replacing the Companies Act of 1982. The new law aims to
improve trade and commerce as well as corporate governance in the
business sector. It features simplified regulations concerning
company formation; provisions specifying the duties of company
directors; provisions to prevent the abuse of powers by directors;
provisions to protect creditors; and a dispute board to settle
disputes among directors. Various labor laws and regulations also
affect investors. See sections below.

--Foreign Equity Shares by Sector


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The government allows 100% foreign investment in the following
services: banking, finance, insurance, stock-brokering,
construction of residential buildings and roads, supply of water,
mass transportation, telecommunications and information technology
(software development and business process outsourcing), energy
production and distribution, professional services, and the
establishment of liaison offices or local branches of foreign
companies. These services are regulated and subject to approval by
various government agencies. The screening mechanism is
non-discriminatory and, for the most part, routine.

Investment in other sectors is restricted and subject to screening
and approval on a case-by-case basis when foreign equity exceeds
49%. The affected sectors are: shipping and travel agencies;
freight forwarding; fishing; timber-based industries; growing and
primary processing of tea, rubber, coconut, rice, cocoa, sugar and
spices; and the production for export of goods subject to
international quota. Foreign investment restrictions and government
regulations also apply to international air transport; coastal
shipping; lotteries; large-scale mechanized gem mining; and
sensitive industries such as military hardware, dangerous drugs and
currency.

Foreign investment is not permitted in the following businesses:
non-bank money lending; pawn-brokering; retail trade with a capital
investment of less than $1 million (with one notable exception: the
BOI permits retail and wholesale trading by reputed international
brand names and franchises with an initial investment of not less
than $150,000); coastal fishing; and the awarding of local
university degrees. Foreign degree courses can be offered in Sri
Lanka by affiliating with foreign universities. However, there is
no scheme to monitor the quality assurance or accreditation of the
foreign courses offered in Sri Lanka.

--Privatization Halted

The current Government has halted most privatization. Government
treatment of foreign investors in past privatization processes has
been largely non-discriminatory. In 2003, however, the government
sold part of the retail operations of state-owned Ceylon Petroleum
Corporation to Indian Oil Corporation without a formal tender
process.

Labor unions in state-owned enterprises are often opposed to
privatization and restructuring and seem particularly averse to
foreign ownership. In the past, this made the privatization of
government entities problematic for new foreign owners.

CONVERSION AND TRANSFER POLICIES

In accordance with its Article VIII obligations as a member of the
International Monetary Fund
(http://www.imf.org/external/pubs/ft/aa/aa08. htm), Sri Lanka has
liberalized exchange controls on current account transactions. In
times of balance of payments difficulties the government tends to
impose controls on foreign exchange transactions. Most recently, in
October 2006, the Central Bank required importers to keep a 50%
deposit on letters of credit on non-essential imports. The
requirement was removed in March 2007.

There are no surrender requirements on export receipts, but
exporters need to repatriate export proceeds within 120 days to
settle export credit facilities. Other export proceeds can be
retained abroad. Currently, contracts for forward bookings of
foreign exchange are permitted for a maximum period of 360 days for
the purposes of payments in trade and 720 days for the repayment of
loans.
There are no barriers, legal or otherwise, to the expeditious
remitting of corporate profits and dividends for foreign enterprises
doing business in Sri Lanka. Remittance of business fees
(management fees, royalties and licensing fees) is also freely
permitted for companies with majority foreign investment approved
under Section 17 of the BOI Act. Other companies require Central
Bank approval. Repatriation of funds for debt service and capital
gains of companies exempted by the BOI from exchange control

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regulations is permitted. Other foreign companies remitting funds
for debt service and capital gains require Central Bank approval.
The average delay period for remitting investment returns such as
dividends, return of capital, interest and principal on private
foreign debt, lease payments, royalties and management fees through
normal, legal channels is in the range of 1 to 4 weeks. All stock
market investments can be remitted without prior approval of the
Central Bank through a special bank account. Investment returns can
be remitted in any convertible currency at the legal market rate.
While controls on capital account (investment) transactions usually
prohibit foreigners from investing in Sri Lankan debt and fixed
income securities, the government allows limited access to
foreigners to invest in government rupee bonds. The Central Bank's
dollar denominated bond issues in the local market are also open to
foreign investors. Local companies require Central Bank approval to
invest abroad. The process of granting approval for such
investments was streamlined in 2002, resulting in a substantial
increase in approvals.

EXPROPRIATION AND COMPENSATION

Since economic liberalization policies began in 1978, the Sri Lankan
Government has not expropriated a foreign investment. The last
expropriation dispute was resolved in 1998.

DISPUTE SETTLEMENT

--Legal System

Sri Lanka's legal system reflects diverse cultural influences.
Criminal law is fundamentally British. Basic civil law is
Roman-Dutch. Laws pertaining to marriage, divorce, and inheritance
are communal. Sri Lankan commercial law is almost entirely
statutory. The law was codified before independence in 1948 and
reflects the letter and spirit of British law of that era. Its
amendments have, by and large, kept pace with subsequent legal
changes in the U.K. Several important legislative enactments
regulate commercial matters: the Board of Investment Law, the
Intellectual Property Act, the Companies Act, the Securities and
Exchange Commission Act, the Banking Act, the Industrial Promotion
Act and Consumer Affairs Authority Act. Most of these laws were
revised recently.

Sri Lanka's court system consists of the Supreme Court, the Court of
Appeal, Provincial High Courts and the Courts of First Instance viz.
district courts (with general civil jurisdiction) and magistrate
courts (with criminal jurisdiction). The provincial high courts
have original, appellate and reversionary criminal jurisdiction.
The Court of Appeal sits as the intermediate appellate court with a
limited right of appeal to the Supreme Court. The Supreme Court
exercises final appellate jurisdiction for all criminal and civil
cases.

All commercial matters exceeding the value of Rs 3 million
(approximately $28,000) fall within the jurisdiction of the
Commercial High Court of Colombo. There are also a number of
tribunals which exercise judicial functions, such as the Labor
Tribunals to hear cases brought by workers against their employers.
Until recently, the court system was largely free from government
interference. There are allegations that the judiciary is sometimes
subject to political influence, but this has not been evident in
commercial litigation so far. Litigation can be slow and
unproductive, though. Monetary judgments are usually made in local
currency. Procedures exist for enforcing foreign judgments.

--Bankruptcy Laws

The Companies Act and the Insolvency Ordinance provide for
dissolution of insolvent companies, but there is no mechanism to
facilitate the re-organization of financially-troubled companies.
Other laws make it difficult to keep a struggling company solvent.
The Termination of Employment of Workmen Act, for example, prohibits
employers from dismissing workers even on the grounds of
inefficiency. The Termination Act was recently revised to
facilitate downsizing. Under the revised act, a compensation

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formula for laid-off workers has been published. But employers have
protested that it is excessive compared to similar formulae in the
Asian region, with terms in Sri Lanka about twice as generous as the
East Asian average. (Please see section on "Labor" for details.)

In the absence of proper bankruptcy laws, extra-judicial powers
granted by law to financial institutions protect the rights of
creditors. When a company cannot meet the demands of a creditor for
a sum exceeding Rs 50,000, (approximately $500) the creditor may
petition for company to be dissolved by the court. Lenders are also
able to enforce financial contracts through powers that allow them
to foreclose on loan collateral without the intervention of courts.
However, loans below Rs 5 million ($460,000) are exempt from the
application of the law. Additionally, a recent judgment ruled that
these powers would not apply with respect to collateral provided by
guarantors to a loan. These two moves have weakened creditors'
rights. Financial institutions also face other legal challenges as
defaulters obtain restraining orders on frivolous grounds due to
technical defects in the recovery laws. Also, for default cases
filed in courts, the judicial process is extremely slow.

The new Companies Act of 2007 introduced a "solvency test" to
determine the financial health of a company. There are provisions
relating to duty of a company's directors on serious loss of
capital. The solvency test is intended to prevent companies without
sufficient assets from obtaining loans and to protect rights of
creditors.

The Companies Act does not provide for the revival of struggling
companies. However, as in the past, it is expected that the courts
would take a liberal attitude towards any restructuring plans that
may be of benefit to a company.

--Investment Protection

In principle, foreign investments are guaranteed protection by the
Constitution of Sri Lanka. The government has entered into 24
investment protection agreements with foreign governments (including
the United States) and is a founding member of the Multilateral
Investment Guarantee Agency (MIGA) of the World Bank. Under Article
157 of the Constitution of Sri Lanka, investment protection
agreements enjoy the force of law and no legislative, executive or
administrative action can be taken to contravene them. The
government has ratified the Convention on Settlement of Investment
Disputes, which provides the mechanism and facilities for
international arbitration through the World Bank's International
Center for the Settlement of Investment Disputes (ICSID).

The U.S.-Sri Lanka Bilateral Investment Treaty (BIT) was ratified by
both governments in 1993
(www.state.gov/documents/organization/43588.p df).

--Arbitration

The Arbitration Act of 1995 gives recognition to the New York
Convention on recognition and enforcement of foreign arbitral
awards. Arbitral awards made abroad are now enforceable in Sri
Lanka. Similarly, awards made in Sri Lanka are enforceable abroad.
A center for arbitration known as the Institute for the Development
of Commercial Law and Practice (ICLP)
(www.iclparbitrationcentre.com) has been established in Colombo for
the expeditious, economical, and private settlement of commercial
disputes. However, the ICLP appears unlikely to become involved in
disputes involving the Sri Lankan Government, which is often a party
to disputes involving foreign investors.

Sri Lanka's first commercial mediation center was established in
2000 and became operational in mid 2001. Commercial mediation is
conducted under the Commercial Mediation Act. Interest in mediation
is still low.

The Labor Department has a process involving labor tribunals for
settling industrial disputes with laborers or unions, and
arbitration is required when attempts to reconcile industrial
disputes fail. The Labor Commissioner typically becomes involved in

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labor-management mediation. Other senior officials, including the
Labor Minister, and the President, have intervened in particularly
difficult cases.

The government record in handling investment disputes is
problematic. Disputes often become politicized, causing the
government to put political interests ahead of its respect for the
sanctity of contracts. For example, in 2006, Indian Oil
Corporation's petroleum retailing subsidiary in Sri Lanka
temporarily closed its operations when the government failed to
honor its commitment to reimburse the company for fuel sold at the
government-controlled price.

--Investment Disputes Involving U.S. Companies

U.S. companies have experienced problems with payment of valid
contracts; implementation of agreements with the government; and
inexplicable failure to secure contracts, despite demonstrated
superior performance, high value, and competitive bids.

A U.S. power company producing electricity in Colombo has been
unable to obtain payment since 2004 for power that it produced under
a temporary, more costly, operating mode following a fire in its
plant. The company had intended to suspend operations to conduct
repairs following the fire, but agreed to the government's request
that it keep producing power even at a higher cost. However, the
government has withheld payment on the basis of a questionable
Attorney General finding that the higher than usual electricity
price was imposed on the government "under duress."

In 2000, the Sri Lankan Supreme Court effectively blocked an
investment agreement between the Government of Sri Lanka and a U.S.
mining company. Although the agreement was already initialed and
approved by the Sri Lankan cabinet, work on the project had not yet
begun. A group of citizens filed a fundamental rights case under a
Sri Lankan law that allows any person to seek Supreme Court
protection if a government or administrative act impedes their
rights. In this case, the plaintiffs alleged that their rights
would be violated if the project was implemented, and the court
upheld their complaint. Without any technical argument, a partial
bench of three judges ruled that the project could not proceed
before completion of a new series of comprehensive and expensive
studies, some of which appeared to be technically impractical. The
Supreme Court decision has never been reversed.

PERFORMANCE REQUIREMENTS AND INCENTIVES

--Performance Requirements

The Board of Investment specifies certain minimum investment amounts
for both local and foreign investors to qualify for incentives.
Firms enjoying preferential incentives in the manufacturing sector
in most cases are required to export 80% of production, while those
in the service sector must export at least 70% of production. Sri
Lanka complies with WTO Trade Related Investment Measures (TRIMS)
obligations.

Sri Lanka encourages foreign investment in information technology,
electronics assembly, light engineering, automobile parts and
accessories manufacturing, industrial and information technology
parks, rubber based industries, information and communication
services, tourism and leisure related activities, agriculture and
agro processing, port-related services, regional operating
headquarters, and infrastructure projects. Foreign investors are
generally not expected to reduce their equity over time, nor are
they expected to transfer technology within a specified period of
time, except for build-own-transfer or other such projects in which
the terms are specified within pertinent contracts.

In some BOI-approved enterprises, businesses are required to
maintain certain levels of employment to enjoy incentives. In
addition, privatization agreements generally prohibit new owners
from dismissing workers, although the owners are free to offer
voluntary retirement packages to reduce their workforce. Some
foreign investors have received political pressure to hire workers

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from a particular constituency or a given list, but have
successfully resisted such pressure with no apparent adverse
effects.

Foreign investors who remit at least $250,000 can qualify for a
one-year resident visa, which can be renewed. Employment of foreign
personnel is permitted when there is a demonstrated shortage of
qualified local labor. Technical and managerial personnel are in
short supply, and this shortage is likely to continue in the near
future. Foreign employees attached to BOI-approved companies
usually receive preferential tax treatment for an initial period and
do not experience significant problems in obtaining work or
residence permits.

--Investment Incentives

The Board of Investment (www.boi.lk) has various incentives, with
such investments typically requiring prior approval by various
ministries. Please see the note at the end of this section on
proposed changes to the incentive programs listed:


Incentive Program I:

Qualifying industries:
-Non-traditional manufacturing exports and companies supplying to
exporting companies. Minimum investment of $500,000(a);
-Export oriented services. Minimum investment of $500,000;
-Manufacture of industrial tools and/or machinery. Minimum
investment of $500,000;
-Small-scale infrastructure. Minimum investment of $500,000;
-Research and development. Minimum investment of $100,000;
-Agriculture and agro processing industries. Minimum investment of
$150,000;
-Export trading houses of rural sector. Minimum investment of
$150,000

Incentives: Currently, the above industries qualify for a five-year
tax holiday. A preferential tax of 10% in the 6th and 7th years
follows the tax holiday for some industries. Some of these
industries qualify for duty-free imports (generally, during the life
of the project for export-oriented projects, and during the project
implementation period for others). Exporting companies and
export-oriented services will be exempted from exchange control
regulations. They will also qualify for free repatriation of
profits and dividends and free transferability of shares. A
two-year tax holiday is available for investments with an investment
less than $500,000. A recently introduced Economic Service Charge
(ESC) at 0.25% of income applies to BOI-approved companies with tax
holidays. The tax applies even to existing companies -- there is no
grandfather clause. ESC will apply to BOI approved manufacturing
companies from the fourth year of operation.

Incentive Program II:

Qualifying Industries:
-Information technology (IT) or information technology enabled
services. Minimum investment of $150,000. Minimum employment
levels apply;
-Information technology training institutes. Minimum number of
students applies;
-Business Process Outsourcing (BPO). Minimum investment of
$150,000. Minimum employment levels apply;
-Regional operating headquarters providing the following services to
related businesses outside Sri Lanka: administration, business
planning, sourcing raw materials, research and Development,
technical support, financial and treasury management, marketing and
sales promotion. Minimum investment of $250,000.

Incentives: Currently, IT services, IT training institutes, and BPO
firms qualify for tax holidays of 5-12 years provided they meet
minimum employment and student levels. Otherwise, a preferential
tax of 10% applies for 2 years. Regional operating headquarters
qualify for a tax holiday of 3 years. A preferential tax of 10%
will apply in the 4th and 5th years. From the 6th year onwards, a

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preferential tax of 15% will apply. Capital goods for these
projects will be exempted from import duty for above investments. A
recently introduced Economic Service Charge at 0.25% of income
applies to BOI-approved companies enjoying tax holidays, from the
fourth year of operation. The new tax applies even to those
companies already operating in Sri Lanka.

Incentives for Regional Development:

The BOI has a separate incentive program to promote regional
development, with the aim of establishing new factories or service
companies (such as hotels, hospitals, or training institutes) in the
regions outside the capital Colombo. The incentives include 10-20
year tax holidays for investments in northern and eastern provinces
and 2-10 year tax holidays for investments located in other
provinces. In addition, imports of machinery and equipment are
exempted from both customs duty and the value-added tax. Minimum
investment levels apply.

Incentives for Infrastructure Development:

Companies acquiring existing companies in petroleum, power
generation, transmission, development of highways, seaports,
airports, railways, water services, public transport, agriculture
and agro processing and other infrastructure projects approved by
the BOI will qualify for tax holidays ranging from 5 to 8 years
depending on the magnitude of investment. A preferential tax of 15%
will follow after the tax holiday period. These companies will also
qualify for duty free imports of capital goods. A minimum
investment of $12.5 million is required.

Large-scale new infrastructure projects in power generation,
transmission and distribution; development of highways, seaports,
airports, public transport and water services; establishment of
industrial parks, and other infrastructure projects approved by the
BOI will qualify for tax holidays ranging from 3 to 15 years
depending on the size of the investment. A preferential tax of 15%
will follow the tax holiday. They will also qualify for duty free
imports of capital goods. A minimum investment of $12.5 million is
required.

Incentives for Other Investments:

-Industrial estates. Minimum investment of $500,000 to $10 million;
tax holidays ranging from 3 to 15 years;
-Textile fabric manufacturing, processing. Minimum investment of
$500,000 to $10 million; tax holidays ranging from 5 to 15 years.

Note: The Government has proposed to reduce all tax holidays listed
above to 3 years other than the tax holidays offered under regional
development program (to be revised to 5 years) and large
infrastructure projects of national importance. It is not known
when this revised incentive scheme will be implemented.

For further information on investment incentives and other
investment-related issues, potential investors are encouraged to
contact the Board of Investment directly. The BOI can be found at
www.boi.lk, or reached via e-mail at info@boi.lk. The BOI has
introduced an investor matchmaking service via the BOI website.
Information regarding this service can be found at
www.boi.lk/partnership.

--Trade Agreements Enhance Market Access to South Asia and Europe

A preferential trade agreement, the Indo-Lanka Free Trade Agreement
(ILFTA) (www.doc.gov.lk) between Sri Lanka and India, is now in
effect. Under this agreement, most products manufactured in Sri
Lanka with at least 35% domestic value addition (if raw materials
are imported from India, domestic value addition required is only
25%), qualify for duty free entry to the Indian market. Tariff
concessions for Sri Lankan products include zero tariffs on 4,235
items; 50 to 100% reduction for tea and garments under quota; 25%
reduction for 553 textile items; and no reduction for 431 items on
India's "negative list." Discussions are underway to reduce the
negative lists of both countries. The two countries are also

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discussing services sector liberalization, under a proposed
Comprehensive Economic Partnership Agreement (CEPA). Other areas
potentially covered by the CEPA are investment and economic
cooperation. Because production constitutes a portion of value
addition, ILFTA and the proposed CEPA enables foreign firms
operating in Sri Lanka to gain preferential entry into the Indian
market.

Some U.S. companies currently avail themselves of the ILFTA by
adding at least 35% value in Sri Lanka and getting import duties
into India reduced from as much as 15% to as little as zero. The
American Chamber of Commerce in Sri Lanka, in a study on the ILFTA,
identified agro processing, food preparation, tea, rubber products,
coconut products, spices, furniture, ceramic and confectionary as
having growth potential in India. The study also found vehicles and
vehicle parts, aircraft parts and motorcycles to be possible
attractive sectors for U.S. manufacturers under the Indo-Lanka
Agreement.

Sri Lanka's Board of Investment promotes the following product
sectors under ILFTA: confectionary and cocoa products, rubber
products, plastics, footwear, ceramics, jewelry, machinery and
mechanical appliances, electronics and electrical products,
automobiles and spare parts, medical instruments, furniture, and
doors.

The 2005 Sri Lanka-Pakistan Free Trade Agreement (SLPKFTA)
(www.doc.gov.lk) provides Sri Lanka with duty-free entry into
Pakistan for 206 items. Pakistan's negative list contains 541 items
with no duty concessions. Pakistan will phase out tariffs on the
balance of approximately 4,000 items over a 3 year period, meaning
Pakistan will offer duty free entry to almost all Sri Lankan exports
by June 2008. Sri Lanka's Board of Investment promotes the
following product sectors under SLPKFTA: rubber products, ceramics,
machinery and mechanical appliances, electronics and electrical
appliances, medical instruments, and automobiles and spare parts.

Sri Lanka and six other South Asian nations belonging to the South
Asian Association for Regional Cooperation (SAARC) agreed in 2004 to
establish a South Asian Free Trade Area (SAFTA)
(http://www.saarc-sec.org/main.php), which began operation on July
1, 2006. SAFTA offers regionalized tariff reductions for imports
from member countries. Stated goals of SAARC members under SAFTA
are to reduce duties for imports from member countries to between
zero and 5% over a period of 7-10 years.

These agreements help make Sri Lanka a gateway to South Asia for
foreign investors.

Sri Lankan exports to the European Union (EU) are also duty free
under the "GSP-Plus" incentive agreement, which came into force on
July 1, 2005. Under this program, 7,200 Sri Lankan products meeting
rules-of-origin criteria can enter the EU duty free.

RIGHT TO PRIVATE OWNERSHIP AND ESTABLISHMENT

Private entities are free to establish, acquire, and dispose of
interests in business enterprises. Private enterprises enjoy
benefits similar to those granted to public enterprises, and there
are no known limitations to access to markets, credit, or licenses.
Foreign ownership is allowed in most sectors. Private land
ownership is limited to fifty acres per person. The government owns
about 80% of the land in Sri Lanka, including the land housing most
tea, rubber, and coconut plantations. The government has leased
most of these plantations to the private sector on 50-year terms.
Although state land for industrial use is usually allotted on a
50-year lease, 99-year leases may also be approved on a case-by-case
basis, depending on the nature of the project.

While foreign investors can purchase land from private sellers, the
government has imposed a 100% tax on land transfers to foreigners.
For this purpose, Sri Lanka has defined foreign investment to
involve as little as 25% foreign ownership - a definition that can
be particularly difficult for companies listed on the Colombo Stock
Exchange since on any particular day, their ownership

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characteristics may vary. Apartments above the third floor of
condominium buildings, land for the development of large housing
schemes, hospitals and hotels with a minimum investment of $10
million, exporting companies with a minimum investment of $1
million, and large infrastructure projects with a minimum investment
of $50 million are exempted from the tax. Regulations regarding
these exceptions have been published in Gazette No 1386/18 dated
March 30, 2005.

PROTECTION OF PROPERTY RIGHTS

--Property Rights

Secured interests in property are recognized and enforced. The
legal system is nondiscriminatory and protects and facilitates
acquisition and disposition of property rights by foreigners,
although it has recently become subject to political influence. A
fairly reliable registration system exists for recording private
property including land, buildings and mortgages. However, there
are problems due to fraud and forged documents. The Government has
begun to address these issues under a World Bank-sponsored judicial
reforms project.

--Intellectual Property Rights Protection

Sri Lanka is a party to major intellectual property agreements
including the Berne Convention for the Protection of Literary and
Artistic Works, the Paris Convention for the Protection of
Industrial Property, the Madrid Agreement for the Repression of
False or Deceptive Indication of Source on Goods, the Nairobi
Treaty, the Patent Co-operation Treaty, the Universal Copyright
Convention, and the Convention establishing the World Intellectual
Property Organization (WIPO). Sri Lanka and the United States in
1991 signed a Bilateral Agreement for the Protection of Intellectual
Property Rights. Sri Lanka is also a party to the Trade Related
Intellectual Property Rights (TRIPS) agreement in the World Trade
Organization. Sri Lanka has not acceded to the WIPO Performances
and Phonograms Treaty (WPPT); the WIPO Copyright Treaty (WCT); or
the WTO Information Technology Agreement.

In November 2003, a new intellectual property law came into force
that was intended to meet both U.S.-Sri Lanka bilateral IPR
agreement and TRIPS obligations to a great extent. The law governs
copyrights and related rights, industrial designs, patents,
trademarks and service marks, trade names, layout designs of
integrated circuits, geographical indications, unfair competition,
databases, computer programs, and undisclosed information. All
trademarks, designs, industrial designs and patents must be
registered with the Director General of Intellectual Property. Sri
Lanka recently introduced regulations to regulate the commercial use
of local creations.

Infringement of intellectual property rights (IPR) is a punishable
offense under the law. Intellectual property rights come under both
criminal and civil jurisdiction. Recourse available to owners
includes injunctive relief, seizure and destruction of infringing
goods and plates or implements used for the making of infringing
copies, and prohibition of imports and exports. Penalties for the
first offence include a prison sentence of 6 months or a fine of up
to Rs 500,000 ($4,600), but smaller penalties are the norm.
Penalties can be doubled for a second offense. Aggrieved parties
can seek redress for any IPR violations through the courts, though
this can be a frustrating and time-consuming process.

Since the passage of the 2003 IPR law Sri Lanka has slowly begun
enforcing its provisions. The Police occasionally raid counterfeit
CD/VCD stores as well as counterfeit garment sellers. However, it
is rare for the police to act without a formal complaint and
assistance from an aggrieved party. Several offenders have been
charged or convicted by courts. But the minimal damages and
suspended sentences imposed suggest that the court system still fail
to recognize the significance of intellectual property rights.

Counterfeit goods continue to be widely available in Sri Lanka.
Local agents of well-known U.S. and other international companies

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representing recording, software, movie, clothing and consumer
product industries continue to complain that lack of IPR protection
is damaging their businesses. Piracy of sound recordings and
software is widespread, making it difficult for the legitimate
industries to protect their market and realize their potential in
Sri Lanka. Software companies complain of the lack of IPR
enforcement within government institutions and even some larger
corporations, including several banks. An IPR working group of
adversely affected industries, led by the American Chamber of
Commerce of Sri Lanka, is working to pursue more aggressive
enforcement and enhance public awareness.

--Patents, Copyrights and Trademarks

Patents are valid for 20 years from the date of application but must
be renewed annually. Patents are granted for inventions, with the
following exceptions: discoveries, scientific theories and
mathematical methods, plant or animal varieties (other than micro
biological processes) and essential biological processes for the
production of plants and animals (other than non-biological and
microbiological processes), business rules and methods, methods of
treatment by surgery or therapy, and diagnostic methods practiced on
a human or animal body. The law also permits compulsory licensing
and parallel imports of pharmaceutical products. Compulsory
licensing will allow the government to grant licenses to manufacture
certain patented drugs, overruling patent licenses in a national
emergency. The parallel imports will allow the import of a branded
drug from an alternative source.

Copyrights are not registered. A work is protected automatically by
operation of law. Original literary, artistic, and scientific works
including computer programs and databases are protected under the
new law. There are enforcement limitations applying to copyrights,
including software.

Sri Lanka recognizes both trademarks and service marks. The
exclusive right to a mark is acquired by registration. A mark may
consist of words, slogans, designs, etc. Protection also is
available to well known marks not registered in Sri Lanka.
Registered trademarks are valid for ten years and renewable. The
law also recognizes both certification marks and collective marks.

TRANSPARENCY OF REGULATORY SYSTEM

The Board of Investment strives to inform potential investors about
laws and regulations that may affect operations in Sri Lanka. Laws
are in place pertaining to tax, labor and labor standards, exchange
controls, customs, environmental norms, and building and
construction standards. However, some of the laws and regulations
are difficult to access.

Foreign and domestic investors often complain that the regulatory
system is unpredictable due to outdated regulations, rigid
administrative procedures, and excessive leeway for bureaucratic
discretion. Effective enforcement mechanisms are sometimes lacking,
and coordination problems between the BOI and relevant line agencies
frequently emerge. Lethargy and indifference on the part of mid-
and lower-level public servants compound transparency problems.
Lack of sufficient technical capacity within the government to
review financial proposals for private infrastructure projects also
creates problems during tendering. An example of weakness in
regulations occurred in mid-2006, when police and government
agencies closed two satellite television broadcasting stations for
not possessing required licenses. The two stations remained closed
for over five months, before various government agencies
reauthorized their operations.

In 2005-2007, the Government awarded several key infrastructure
projects to Chinese companies outside the tender process. They
included a 300 megawatt coal power project, a fuel bunkering
project, and a large port construction project in the Southern
district of Hambantota. In addition, the Government has promised
oil exploration rights to India and China outside the tender
process.


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Although many foreign investors, including U.S. firms, have had
positive experiences in Sri Lanka, some have encountered significant
problems with government practices and regulations. Some
multinational firms have experienced extensive unexplained delays in
trying to reach agreement on investment projects. Others have had
contracts arbitrarily canceled without compensation, even though the
Sri Lankan Cabinet had approved those contracts.

Proposed laws and regulations are generally made available for
public comment. However, occasionally they are published without
public discussion.

EFFICIENT CAPITAL MARKETS AND PORTFOLIO INVESTMENT

--Availability of Financial Resources

Retained profits finance about 70% of private investment, with short
term borrowing financing a further 20% of investment. The stock
market and corporate securities market have not been significantly
used to raise capital. Foreign direct investment (FDI) finances
about 4% of overall investment. Foreign investors are allowed to
access credit on the local market. They are also free to raise
foreign currency loans.

The state consumes over 50% of the country's domestic financial
resources and has a virtual monopoly on the management and use of
long-term savings in the country. This inhibits the free flow of
financial resources to product and factor markets. For 2008, the
government's net borrowing from the local market is forecast to be
Rs 155 billion ($1.3 billion). Due to high inflation and increased
government borrowing, interest rates rose sharply towards the end of
2007.

--Credit Instruments

Commercial banks and two development finance institutions, the
National Development Bank (NDB) and the Development Finance
Corporation of Ceylon Bank (DFCC), are the principal source of bank
finance. Bank loans are the most widely used credit instrument for
the private sector. Financial institutions also raise syndicated
bank loans to fund large-scale investment projects undertaken by the
private sector.

The domestic debt market in Sri Lanka is still at a nascent stage.
The first credit rating agency in Sri Lanka was Fitch Rating Lanka
(www.fitchratings.lk), which opened an office in Colombo in 1999.
Fitch Ratings Lanka is joint venture between Fitch Ratings Inc,
International Finance Corporation, (IFC), Central Bank of Sri Lanka,
and several leading local financial institutions. Credit ratings
are now mandatory for all deposit-taking institutions and for all
varieties of debt instruments and have helped numerous Sri Lankan
companies raise funds through debt markets.

Sri Lanka received its first sovereign credit ratings in December
2005, with a "BB-minus" from Fitch Ratings and a "B-Plus" from
Standard and Poor's (S&P). These sub- investment grade ratings
reflect the high level of government indebtedness and weak revenue
mobilization, together with political and security concerns. The
two agencies changed their rating outlook, but not the ratings, from
stable to negative in April 2006 following escalating violence. The
S&P rating outlook was revised to stable in September 2007. The
Government borrowed $500 million at an interest rate of 8.25% for
five years in October 2007. This was Sri Lanka's first sovereign
bond sale to international markets.

--Accounting Standards

There is an active and fairly competent accounting profession, based
on the British model. The source of accounting standards is the
Institute of Chartered Accountants of Sri Lanka (ICASL), and
standards are constantly updated to reflect current international
accounting and audit standards adopted by the International
Accounting Standards Board (IASB). Due to the lack of an adequate
enforcement mechanism, however, problems with the quality and
reliability of financial statements still exist.

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Sri Lankan accounting standards are applicable for all banks, stock
exchange listed companies and all other large and medium-sized
companies in Sri Lanka. Accounts of such business enterprises are
required to be audited by professionally qualified auditors holding
ICASL membership. ICASL has published accounting standards for
small companies as well. The Accounting Standards and Monitoring
Board (ASMB) is responsible for monitoring compliance with Sri
Lankan accounting and auditing standards. British professional
accounting bodies are quite active in Sri Lanka. The Chartered
Institute of Management Accountants (CIMA), a leading professional
accounting body based in the UK and spread over the Commonwealth,
has its largest overseas presence in Sri Lanka.

--Securities and Exchange Commission

The Securities and Exchange Commission (SEC) regulates the
securities market in Sri Lanka. The SEC law was revised in 2003,
enhancing the SEC's coverage and investigative powers. The SEC now
covers stock exchanges, unit trusts, stock brokers, listed public
companies, margin traders, underwriters, investment managers, credit
rating agencies and securities depositories.

Foreign investors can purchase up to 100% of equity in Sri Lankan
companies in numerous permitted sectors. In order to facilitate
portfolio investments, country funds and regional funds may obtain
Ministry of Finance approval to invest in Sri Lanka's stock market.
These funds make transactions through share investment external
Rupee accounts maintained in commercial banks.

--Colombo Stock Exchange

The Colombo Stock Exchange (CSE), while small by "big emerging
market" standards, is one of the most technologically sophisticated
in the region. The CSE has fully automated trading, clearing and
settlement systems. The CSE has a rolling settlement period of 3
days. Fifteen local and foreign joint venture brokers currently
operate at the CSE. Foreign stockbrokers are permitted to hold up
to 100% equity in stock brokerage firms operating at the CSE. The
SEC has a settlement guarantee fund with an initial capital of Rs
100 million ($93,000), which aims to guarantee the settlement of
trades between clearing members of the exchange.

There are 235 companies listed on the stock exchange with the top
ten positions by market capitalization held by telecommunication
companies, banks, conglomerates and food and beverage companies.
The CSE, after being one of the best performing markets in the
region in 2005-6, suffered due to increased conflict-related
violence in 2007, declining by about 7%. While the market is
sensitive to the security situation, strong corporate performance
and sometimes negative real interest rates have encouraged stock
purchases in an environment with few other attractive opportunities.


Stock market development, though progressing, has been slowed by the
long term impact of the civil war on investor confidence. Other
issues include lack of liquidity and limited market size.
Improvements are also needed in corporate governance,
accountability, and public disclosure. The Accounting and Auditing
Standards Monitoring Board, the Ceylon Chamber of Commerce, the
Colombo Stock Exchange, and professional accounting bodies are
taking initiatives in these areas.

Acquisition of companies through mergers and acquisitions is
governed by the Takeovers and Mergers Code of 1995 made under the
Securities and Exchange Commission of Sri Lanka Act. This law
applies only to companies listed on the Colombo Stock Exchange. It
is modeled on the lines of the London City Code on Takeovers and
Mergers. Acquisition of more than a 30% stake of a listed company
requires the buyer to make an offer to all other shareholders. The
articles of association of a few listed companies restrict foreign
equity to certain levels.

--Banking System


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Sri Lanka has a fairly well diversified banking system. There are
23 commercial banks - eleven local and twelve foreign. In addition,
there are thirteen local specialized banks. Citibank NA is the only
U.S. bank operating in Sri Lanka. ICICI Bank of India is the newest
foreign bank in Sri Lanka; it commenced operations in January 2006.
In 2001-2003, Mashreq Bank, American Express Bank, Nova Scotia Bank
and ABN Amro Bank all sold their banking operations in Colombo to
existing banks. Sri Lanka experienced its first bank failure in
December 2002 when the Central Bank took action to revoke the
license of a small licensed specialized bank as it approached
insolvency. There was no fallout for other banks from this
incident. Two other small troubled banks were restructured under
Central Bank guidance.

The Central Bank is responsible for supervision of all banking
institutions. It has driven improvements in banking regulations,
provisioning, and public disclosure of banking sector performance.
Since 2004, credit ratings have been mandatory for all banks
operating in Sri Lanka. In 2006, the Central Bank introduced higher
capital requirements for commercial banks to further stabilize the
banking system, promote consolidation, and facilitate entry of
larger banks. In January 2008, the Central Bank issued corporate
governance rules for banks. The new rules are aimed at promoting
the safety and soundness of the banking system. Nevertheless, the
Central Bank still suffers from lack of autonomous authority,
especially with regard to the large state owned banks.

Sri Lanka has enacted laws to deal with money laundering and
terrorist financing. The Bank Supervision Department of the Central
Bank supervises and examines financial institutions for compliance
with anti-money laundering and terrorist financing regulations. A
Financial Intelligence Unit (FIU) was created in 2006 and has
authority to establish requirements and issue instructions to banks
regarding these anti-money laundering and terrorist financing
regulations.

State-Owned Banks

Total assets of commercial banks stood at Rs 1,771 billion ($17
billion) as of December 31, 2006. The two state-owned commercial
banks, Bank of Ceylon and People's Bank, with assets of Rs 378
billion ($3.6 billion) and Rs 339 billion ($3.2 billion)
respectively, still dominate banking, accounting for about 40% of
all assets.

The two state banks are inefficient and have accumulated extensive
bad debt. However, as these banks are implicitly guaranteed by the
state, their problems have not harmed the credibility of the rest of
the banking system. Progress has been made in restructuring the two
banks - their nonperforming loan ratios have declined from 18% in
2003 to 5-7% in 2006, while provisioning and profitability have
improved. Capital adequacy ratios have also improved. However,
fast credit growth (especially to the government and state-owned
Ceylon Electricity Board and Ceylon Petroleum Corporation) and
directed lending to some sectors have once again raised concerns
about credit quality.

Private Commercial Banks and Foreign Banks

Private commercial banks and foreign banks operating in Sri Lanka
generally follow more prudent credit policies and, as a group, are
in better financial shape. The average rate of non performing loans
to total loans in domestic private banks was 8.5% and in foreign
banks was 2.0% in 2005. According to the World Bank, the banks
continue to make high provisions for the nonperforming loans and
risk management of the banks has significantly improved. Foreign
banks tend to make provisions in line with international best
practices, as most foreign bank branches are subject to host country
supervision in addition to that of the Central Bank of Sri Lanka.
There are concerns regarding credit acceleration in the housing and
consumer sectors. The banking system could also become vulnerable
to credit and liquidity risk due to a sharp rise in the ratio of
credit to deposits.

Capital Adequacy

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Sri Lanka adopted capital adequacy standards set by the Basel
Committee on banking regulations and supervisory practices in 1993.
The minimum capital adequacy ratio required by the Central Bank is
5% for core capital (Tier I) and 10% for risk weighted assets (Tier
I and Tier II). The Central Bank has decided to adopt Basel II
standards for all banks in 2008.

Risk-based capital adequacy in the banking sector was 11.9% in 2006.
The Bank of Ceylon's capital adequacy ratio has increased to 12
percent. People's Bank currently does not meet capital adequacy
requirements, but it has a Ministry of Finance guarantee for funds
required to meet its obligations. The government has commenced a
recapitalization program at the People's Bank to enable the bank to
meet its minimum capital requirements.

POLITICAL VIOLENCE

In 2006, fighting between the ethnic separatist Liberation Tigers of
Tamil Eelam (LTTE) and the Sri Lankan military intensified in
northern and eastern Sri Lanka; other parts of the country,
including Colombo, suffered sporadic terrorist attacks. In 2007,
fighting escalated further, including the first-ever LTTE air
attacks -- one against a military base that adjoins the
international airport north of Colombo, another on oil storage
facilities outside Colombo. In July 2007, following heavy fighting,
the government regained control of the East from the LTTE. Targeted
attacks by LTTE against politicians -- and on one occasion against
civilians in a crowded shopping area -- continued in Colombo.

Prior to 2006, LTTE terrorist activities had declined after the LTTE
and the government signed a formal open-ended Cease-Fire Agreement
in February 2002. Between 2002 and 2005, there was a marked
improvement in the business climate due to the relatively peaceful
atmosphere prevailing in the country.

In 1997, the United States designated the LTTE as a Foreign
Terrorist Organization (FTO). In 2007, the United States froze the
assets of and blocked transactions with the Tamils Rehabilitation
Organisation (TRO), a U.S.-registered non-profit group, on the
grounds that it provided support for the LTTE. During two decades
of war, tourists and foreign business representatives have not been
terrorist targets, but they have been injured in attacks on other
targets. In 2001, the LTTE attacked Colombo's international airport
and destroyed commercial and military aircraft. Several military
personnel were killed in the attack, airport employees were injured,
and Sri Lankan civilians were caught in the crossfire. Sri Lankan
Airlines, jointly owned by the Government of Sri Lanka and Emirates
Airlines of Dubai, lost several commercial aircraft in the attack.
The LTTE prior to 2001 attacked several foreign-flagged commercial
ships in the waters off the north and east of the country. In
response to these attacks, insurers imposed war risk insurance
surcharges on aircraft and ships using Sri Lankan seaports and
airports. These surcharges have been lifted since the cease-fire
went into effect. The LTTE has also in the past bombed Colombo's
financial and business districts, causing numerous casualties and
extensive damage to property.

CORRUPTION

Sri Lanka has generally adequate laws and regulations to combat
corruption, but they are unevenly enforced. U.S. firms identify
corruption as a constraint on foreign investment, but, by and large,
it is not a major threat to operating in Sri Lanka - at least once a
contract has been won. Corruption appears to have the greatest
effect on investors in large projects and on those pursuing
government procurement contracts.

There is a consensus that corruption is increasing in Sri Lanka.
Both the Transparency International Corruption Perception and the
World Bank's Control of Corruption indices for Sri Lanka show a
decline in recent years. The World Bank Control of Corruption Index
has shown a decline from -0.17 in 2004 to -0.30 in 2005, with a
minimal improvement to -0.29 in 2006. Transparency International's
Corruption Perception Index shows a decline from 67th place in 2004

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to 84th in the 2006 ranking. During the 2006 USAID Democracy and
Governance assessment, anecdotal evidence from the private sector
indicated that the percentage of a public sector contract paid in
bribes nearly tripled. According to Transparency International,
corruption is perceived as most pervasive in political appointments
to government institutions and in government procurement awards, as
well as in high frequency/low value transactions. The police force
and the judiciary are perceived to be the most corrupt public
institutions. Corruption is also a persistent problem in customs
clearance and enables wide smuggling of certain consumer items, to
the detriment of legitimate manufacturers and importers.

In January 2007, a parliamentary commission found evidence of
serious and widespread waste, fraud, and abuse in the management of
Sri Lanka's numerous government enterprises. Privatization of a
handful of government enterprises between 2001 and 2004 also appears
to have been done in a corrupt manner. The mismanagement and
corruption reviewed by the Commission have cost Sri Lanka an
estimated USD 1.3 billion. However, the government has taken little
concrete action to date to address the commission's findings.
Following the commission's report, several other large scale
corruption incidents and frauds materialized, including at the
government's tax office.

Sri Lanka ratified the UN Anti-corruption Convention in 2004. Sri
Lanka has signed but not ratified the UN Convention against
Transnational Organized Crime. Sri Lanka became a signatory to the
OECD-ADB Anti-Corruption Regional Plan in May 2006.

--Bribery Commission is not effective.

The Bribery Commission is the main body responsible for
investigating allegations of bribery and corruption. The function
of the Commission, under Act No 19 of 1994, is to investigate
allegations brought to its attention and to institute proceedings
against responsible individuals in the appropriate court. The law
states that a public official's offer or acceptance of a bribe
constitutes a criminal offense and carries a maximum sentence of
seven years imprisonment and a fine at the discretion of the courts.
A bribe by a local company to a foreign official is not covered by
the Bribery Act.

Several other government entities try to address corruption, the
most important being the Auditor General's Department and the
National Procurement Agency. However, there is a confusion of
mandates and these institutions frequently interpret their mandates
narrowly, inhibiting their effectiveness.
Few Sri Lankans have been found guilty of corruption in recent
years. Although highly publicized, efforts to investigate bribery
and corruption have failed, damaging public confidence in such
processes. While corruption charges have been leveled against
politicians and top officials in charge of key government
corporations, none of the accused has been convicted.
BILATERAL INVESTMENT AGREEMENTS

The Government of Sri Lanka has signed investment protection
agreements with the United States (which came into force in May
1993) and with the following countries:

1. Belgium
2. People's Republic of China
3. Denmark
4. Egypt
5. Finland
6. France
7. Germany
8. Indonesia
9. India
10. Iran
11. Italy
12. Japan
13. Korea
14. Luxembourg
15. Malaysia
16. Netherlands

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17. Norway
18. Romania
19. Singapore
20. Sweden
21. Switzerland
22. Thailand
23. United Kingdom

--Taxation

A bilateral treaty between Sri Lanka and the United States to avoid
double taxation was ratified and entered into force on June 12,
2004.

Foreign investors not qualifying for Board of Investment incentives
such as tax and exchange control exemptions or concessions are
liable to pay taxes on corporate profits, dividends, and remittances
of profits. They are also liable to pay a Value Added Tax on goods
and services. The government has also imposed a tax of 0.1% on
debits to any current or savings account maintained at any bank in
Sri Lanka. Debits made to accounts of government and international
organizations are excluded. Accounts maintained at Foreign Currency
Banking Units, accounts maintained for stock exchange transactions
(SIERA), and resident and non-resident foreign currency accounts are
exempted from the tax. The Embassy encourages prospective U.S.
investors to contact an international auditing firm operating in Sri
Lanka to assess their tax liability.

OPIC AND OTHER INVESTMENT INSURANCE PROGRAMS

The United States and Sri Lanka concluded in 1966 (and renewed in
1993) an agreement that allows the Overseas Private Investment
Corporation (OPIC) to provide investment insurance guarantees for
U.S. investors. OPIC currently provides coverage to banking and
power sector investments in Sri Lanka. Sri Lanka's membership in
the Multilateral Investment Guarantee Agency (MIGA) offers the
opportunity for insurance against non-commercial risks.

The U.S. Embassy and other U.S. Government institutions spend over
$15 million annually in Sri Lanka. This amount can potentially be
utilized by OPIC to honor an inconvertibility claim; however, no
such claims have been made to date in Sri Lanka. The Embassy
purchases local currency at the financial rate.

LABOR

--Labor Force
Sri Lanka's labor force is literate (particularly in local
languages) and trainable, although weak in certain technical skills
and the English language. The average worker has eight years of
schooling. Two thirds of the labor force is male.
The unemployment rate has declined in recent years to around 6.5%.
The rate of unemployment among women and high school and college
graduates, however, has been proportionally higher than the rate for
less-educated workers. Youth and entry-level unemployment and
underemployment remain a problem. A significant proportion of
unemployed people seek "white collar" jobs. However, most sectors
seeking employees offer manual or semi-skilled jobs or require
technical or professional skills such as management, marketing,
information technology, accountancy and finance, and English
language proficiency. The construction, plantation and apparel
industries report a shortage of workers. Some investors have faced
problems in finding sufficient employees with the requisite skills.


The government has initiated educational reforms it hopes will lead
to better preparation of students and better matches between
graduates and jobs. More computer, accounting and business skills
training programs and English language programs are becoming
available. But the demand for these skills still outpaces supply.


--Migrant Workers Abroad

There are an estimated 1.5 million Sri Lankan workers abroad.

COLOMBO 00000061 019 OF 022


Remittances from migrant workers, at around $2.7 billion, are one of
Sri Lanka's largest sources of foreign exchange. The majority of
this labor force is unskilled (housemaids and factory laborers) and
located primarily in the Middle East, but Sri Lanka is also losing
many of its technically and professionally qualified workers to more
lucrative jobs abroad.

--Wages and Holidays

Labor is available at relatively low cost, though it is priced
higher than in some other South Asian countries. Productivity lags
behind other countries in Asia. Child labor is prohibited and is
virtually nonexistent in the organized sector, although child labor
occurs in informal sectors. The minimum legal age for employment is
set at 14. Most permanent full-time workers are covered by laws
pertaining to maximum hours of work, minimum wage, leave, the right
of association, and safety and health standards.

There is widespread belief that Sri Lanka's labor laws and its
numerous official holidays dampen productivity. The full moon day
of each month (sacred in the Buddhist faith), if it falls on a
weekday, is a paid holiday. There are also eight other public
holidays. The public sector and banks enjoy additional holidays.
These statutory holidays are in addition to 21 days of annual/casual
leave and approximately 21 days of sick leave (the number of days
for sick leave is at the discretion of the management). Further,
female employees are entitled to 84 days fully paid maternity leave
for the first two pregnancies. Female workers are permitted 60
hours of overtime work per month.

The Government continues to interfere with private sector wage
setting. In October 2005 the Government, through an act of
Parliament, took steps to mandate a wage increase (of approximately
Rs 1,000 per month) to private sector workers. The private sector
is concerned about such interference in wage setting, which could
damage competitiveness in certain sectors.

--Termination Laws

The Termination of Employment of Workmen Act (TEA) makes it
difficult to fire or lay off workers who have been employed more
than six months for any reason other than serious, well-documented
disciplinary problems. Disputes over dismissals can be brought to a
labor tribunal administered by the Ministry of Justice. The labor
tribunals have large backlogs of unresolved cases. Certain labor
disputes founded upon fundamental rights (allegations of
termination/transfers based upon discrimination, etc.) can be
brought directly to the Supreme Court.

The government has introduced a standard compensation formula under
the TEA to facilitate termination. Recent amendments to the
Industrial Disputes Act (IDA) include labor dispute resolution rules
to expedite the dispute process.

The compensation formula takes into account the number of years of
service and offers 2.5 months salary as compensation for 1 year of
service, 12.5 months salary for 5 years of service; 38 months for 20
years and up to a maximum of 48 months salary for 34 years service.
This assumes that the government will approve such a termination,
which frequently is not the case. The proposed unemployment benefit
insurance scheme to provide an additional payment has not yet come
into effect. According to a recent IMF report, Sri Lanka's firing
cost for 20 years of service, at 38 months, is among the highest in
Asia compared with Pakistan and Nepal's 22.5 months, India's 19.6
months, Malaysia's 18.5 months, China's 13.2 months and Bangladesh's
11.7 months. The Labor Commissioner's approval or the affected
employee's consent is required to fire workers. Employers complain
that the package is excessive, especially compared to international
norms. They have also pointed out that higher compensation could
adversely affect companies requiring restructuring, and discourage
investment.

--Trade Unions

About 20% of the 6.8 million-strong work force is unionized, but

COLOMBO 00000061 020 OF 022


union membership is declining. There are more than 1,650 registered
trade unions (many of which have 50 or fewer members), and 19
federations. About 15% of labor in the industry and service sector
is unionized. Most of the major trade unions are affiliated with
political parties, creating a highly politicized labor environment.
Several trade unions with affiliations to major political parties
have formed themselves into an organized group, the National
Association for Trade Union Research and Education (NATURE), to
promote education and training among trade unionists.

All workers, other than police, armed forces, prison service, and
those in essential services, have the right to strike. By law,
workers may lodge complaints to protect their rights with the
commissioner of labor, a labor tribunal, or the Supreme Court. The
president retains the power to designate any industry as an
essential service.

Unions represented workers in many large private firms, but workers
in small-scale agriculture and small businesses usually did not
belong to unions. Public sector employees were unionized at very
high rates. Labor in export processing zone enterprises tends to be
represented by non-union worker councils.

Unions have complained that the Board of Investment and some
employers, especially in the BOI-run export processing zones,
prohibit union access and do not register unions on a timely basis.
Employers allege that the JVP, a Marxist political party opposed to
private enterprise, could provoke labor to strike under the pretense
of trade union activity. Due to the JVP's violent past, employers
are generally not in favor of it or its trade union arm, the
Inter-Company Trade Union.

In BOI enterprises, including those in the export processing zones,
worker councils composed of employees generally engage in labor and
management negotiations. These worker councils have functioned well
in some companies in providing for worker welfare. The BOI has
requested that companies recognize trade unions and accept the right
to collective bargaining. According to the BOI, where both a
recognized trade union with bargaining power and a non-union worker
council exist in an enterprise, the trade union will represent the
employees in collective bargaining.

The International Labor Organization's (ILO) Freedom of Association
Committee has observed that Sri Lankan trade unions and employee
councils can co-exist, but advises that there should not be any
discrimination against those employees choosing to join a union.
The right of employee councils to engage in collective bargaining
has been held as valid by the ILO. The ILO has, however, noted
weaknesses in rules governing operation of employee councils and low
prevalence of collective bargaining agreements and requested that
the Government address these issues.

In response to these observations, the BOI revised its labor manual
in March 2004, requesting that companies located in export
processing zones allow union access to zones and provide official
time off to union members to attend meetings. Along with this
revision, the BOI also issued new guidelines for the formation and
operation of employee councils, giving powers to employee councils
to negotiate binding collective agreements.

In 2002, the American Federation of Labor and Congress of Industrial
Organizations (AFL-CIO) submitted a petition to the United States
Trade Representative seeking suspension of Generalized System of
Preferences (GSP) benefits for Sri Lanka due to labor rights
violations in some factories in the export processing zones. USTR
did not act on this petition. A Sri Lanka trade union made a
similar case with the European Union (EU) when Sri Lanka applied for
benefits under the special incentive arrangements of the GSP. After
an audit, the EU, in January 2004, granted significant benefits to
Sri Lanka under EU GSP in recognition of the country's efforts to
implement core labor standards. The EU, however, urged improvements
in freedom of association.

Key public sector entities such as the Ceylon Electricity Board and
the Sri Lanka Ports Authority also have large unions which have

COLOMBO 00000061 021 OF 022


protested anticipated moves towards privatization or restructuring.
In July 2006, the Supreme Court broke a port slowdown which had
disrupted shipping through the Colombo Port for over a week.
However, in response to a challenge lodged by several unions, the
ILO Freedom of Association Committee noted that the port "go-slow"
action did not disrupt an essential service, i.e. one whose
disruption would endanger life, personal safety or health of the
whole or part of the population.

--Collective Bargaining

Collective bargaining is not yet popular. While about half of the
500 members of the Employers' Federation of Ceylon is unionized,
currently only about 44 of these companies (including a number of
foreign-owned firms) have collective agreements and use them to
conduct negotiations on their behalf.

--Labor-Management Relations

Formerly confrontational labor-management relations have improved in
the last few years as employers have worked harder to motivate and
care for workers. Work stoppages and strikes in the private sector
are on the decline. While labor-management relations vary from
organization to organization, managers who emphasize communication
with workers and offer training opportunities generally experience
fewer difficulties. U.S. investors in Sri Lanka (including U.S.
garment buyers) generally promote good labor management relations
and labor conditions that exceed local standards.

--ILO conventions

Sri Lanka is a member of the International Labor Organization (ILO)
and has ratified 31 international labor conventions. The labor laws
of Sri Lanka are laid out in almost 50 different statutes. The
Ministry of Labor has published a Labor Code, consolidating
important labor legislation. Sri Lanka has ratified all eight of
the core labor conventions included in the 1998 ILO Declaration on
Fundamental Principles and Rights at Work. ILO Convention 138 on
minimum age for admission to employment and Convention 182 on worst
forms of child labor were ratified during 2000-2001. Sri Lanka
ratified ILO convention 105 on Forced Labor in 2003. The ILO and
the Employers' Federation of Ceylon are working to improve awareness
of core labor standards. The ILO also promotes its Decent Work
Agenda program in Sri Lanka.

FOREIGN TRADE ZONES/FREE PORTS

Sri Lanka has 12 free trade zones, also called export-processing
zones, administered by the BOI. The oldest, the Katunayake and
Biyagama Zones, located north of Colombo near the Bandaranaike
International Airport, are fully occupied. The third zone is
located at Koggala on the southern coast. Several new mini
export-processing zones were opened in the provinces during the last
few years. There are nearly 200 foreign export processing
enterprises operating in these zones. There are also two industrial
parks that have both export-oriented and non-export oriented
factories. They are located in Pallekelle, near Kandy in central
Sri Lanka, and in Seethawaka in Avissawela about 60 kilometers from
Colombo. In addition, a large private apparel company recently
opened Sri Lanka's first privately run fabric park. The company
invites local and foreign companies to set up fabric and apparel
factories in this eco-friendly park.

In the past, firms preferred to locate their factories near Colombo
harbor or airport to reduce transport time and cost. However,
excessive concentration of industries around Colombo has caused
heavy traffic, higher real estate prices, environmental pollution,
and scarcity of labor. The BOI and the government now encourage
export-oriented factories to set up in industrial zones farther from
Colombo. However, Sri Lanka's poor roads make these outlying zones
less appealing.

FOREIGN DIRECT INVESTMENT STATISTICS

--Investment Trends

COLOMBO 00000061 022 OF 022

From 1998-2001, foreign direct investment (FDI) flows to Sri Lanka
averaged only about $150 million per year (excluding privatization
receipts). Since the 2002 ceasefire improved investor confidence,
annual Foreign Direct Investment (FDI) has averaged about $200
million. In 2006, FDI increased to about $450 million. FDI is
expected to total $550 million in 2007, centered on
telecommunications, business process outsourcing, and hotel and
restaurant services.

--U.S. Investments

Total cumulative U.S. investment in Sri Lanka is estimated to be in
the range of $200 million. Major U.S. investors include: Energizer
Battery, Mast Industries, Smart Shirts (a subsidiary of Kellwood
Industries), Chevron, Citibank, Caterpillar, 3M, Coca Cola, Tandon
Corporation, Paxar Corporation, Pepsi Co, Sportif, Worldquest, Fitch
IBCR, AES Corporation, American International Group (AIG), American
Premium Water, Virtusa, Avery Denison, North Sails, Amsafe Bridport,
and RR Donnelly (through Office Tiger). Several Sri
Lankan-Americans have started IT and BPO companies in Sri Lanka
serving the US market. In addition, IBM, Lanier, NCR, GTE,
Motorola, Procter & Gamble, Liz Claiborne, Tommy Hilfiger, J.C.
Penney, Sun Microsystems, Microsoft, Bates Strategic Alliance,
McCann-Erickson, Pricewaterhouse Coopers, Ernst and Young, and KPMG
all have branches, affiliated offices or local
distributors/representatives. Kentucky Fried Chicken, Pizza Hut,
Federal Express, UPS, and McDonald's are represented in Sri Lanka
through franchises. Numerous other American brands and products are
represented by local agents.

--Non-U.S. Investments

Leading sources of foreign direct investment in Sri Lanka are
Malaysia, the United Kingdom, the United States, Singapore, India,
China, the UAE, and Korea. Major non-U.S. investors include:
Unilever, Nestle, British American Tobacco Company, Mitsui, Pacific
Dunlop/Ansell, Prima, FDK, Telekom Malaysia Bhd, S.P. Tao, HSBC and
the Indian Oil Corporation. Leading U.S. and foreign investors that
have acquired significant stakes in privatized companies include
Chevron, Norsk Hydro of Norway, Hanjung Steel of Korea, Nippon
Telephone and Telegraph, Mitsubishi Corporation and C. Itoh (A.K.A.
Itochu) of Japan, Emirates Airlines of United Arab Emirates, Shell
Oil of the UK, P&O Netherlands, and the Indian Oil Corporation.

Web Resources:

Board of Investment of Sri Lanka: www.boi.lk

International Monetary Fund (IMF) Sri Lanka country information:
www.imf.org/external/country/LKA/index.htm

Article VIII obligations of the International Monetary Fund:
www.imf.org/external/pubs/ft/aa/aa08.htm

U.S.-Sri Lanka Bilateral Investment Treaty:
www.state.gov/documents/organization/43588.pd f

Institute for the Development of Commercial Law and Practice:
www.iclparbitrationcentre.com

Indo-Lanka Free Trade Agreement: www.doc.gov.lk

South Asian Free Trade Area: www.saarc-sec.org/main.php

Fitch Ratings Lanka: www.fitchratings.lk

Development Assistance Database: www.dad.tafren.gov.lk

[End text]

BLAKE

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