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Cablegate: Sri Lanka: Inflation 17.5% in 2007; Central Bank Says

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RR RUEHLMC
DE RUEHLM #0076/01 0161158
ZNR UUUUU ZZH
R 161158Z JAN 08
FM AMEMBASSY COLOMBO
TO RUEHC/SECSTATE WASHDC 7569
INFO RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
RUEHNE/AMEMBASSY NEW DELHI 1775
RUEHKA/AMEMBASSY DHAKA 0691
RUEHIL/AMEMBASSY ISLAMABAD 7679
RUEHKT/AMEMBASSY KATHMANDU 5859
RUEHKP/AMCONSUL KARACHI 2320
RUEHCG/AMCONSUL CHENNAI 8286
RUEHLMC/MILLENNIUM CHALLENGE CORPORATION

UNCLAS SECTION 01 OF 03 COLOMBO 000076

SIPDIS

SENSITIVE

SIPDIS

STATE FOR SCA/INS AND EB/IFD/OMA
TREASURY FOR LESLIE HULL

E.O. 12958: N/A
TAGS: ECON EFIN EAID CE
SUBJECT: SRI LANKA: INFLATION 17.5% IN 2007; CENTRAL BANK SAYS
10-15% IN 2008

REF: A. 07 COLOMBO 1661 B. 07 COLOMBO 1639

1. (SBU) Summary and comment: Sri Lanka's inflation remained high
in 2007, averaging 17.5% for the year after spiking to around 20% at
times. Consumers and business both felt the impact, with food and
fuel prices rising most steeply. Correspondingly high interest
rates compounded the pain. The government blames rising oil and
other imported commodity prices, but the IMF states the government's
high deficit spending was the primary driver of the inflation. The
Central Bank aims to bring inflation down to 10-11% by the end of
2008, but concedes that continued high fiscal deficits or further
oil price increases could make this impossible. The government is
trying to control prices rises by resuming subsidies it had recently
stopped and by attempting to import and distribute "essential
commodities" more cheaply than the market can. These efforts are
likely to add to the deficits that are driving much of the
inflation. End summary and comment.

INFLATION 17.5% IN 2007
--------------------------

2. (SBU) Sri Lanka experienced a second straight year of high
inflation in 2007, with a 17.5% average 12-month increase in the
Colombo Consumer Price Index. The 2006 rise was 13.5%. Both these
figures exceed the 12% average annual inflation Sri Lanka has
experienced over the last 30 years. The government blamed high oil
and imported commodity prices as the main causes of the high
inflation. However, according to both the Central Bank's research
department and the IMF, inflation in Sri Lanka is largely a fiscal
phenomenon with government deficit spending responsible for about
half of the inflation. The Central Bank calculated that rising
prices of imported goods caused only about a quarter of the
inflation. Another major factor was Sri Lanka's removal or
reduction of subsidies on fuel, cooking gas, and wheat. A final
factor was the government's imposition of increased taxes and other
levies on most imported goods (ref A).

CONSUMERS AND BUSINESSES BOTH HURTING
-------------------------------------

3. (U) In 2007, prices of most basic foodstuffs such as bread, wheat
flour, rice, sugar, lentils and milk powder skyrocketed. Prices of
bread and wheat flour, now consumed as widely as rice, increased
most -- by over 80%. Energy and fuel prices have also increased,
due to reduced subsidies. Electricity went up by about 14%,
gasoline by over 25%, and cooking gas by over 130%. As a result of
these increases, expenses such as bus fares, shipping, and
construction costs also rose significantly in 2007.

4. (SBU) Inflation and correspondingly high interest rates have hit
businesses as well. Lending rates to prime customers currently
average 19.3%. Other customers face higher rates. To reduce their
exposure to inflation, banks have begun limiting their commercial
and personal loans to short durations, typically just a few months.
According to a business confidence index published by Lanka Monthly
Digest, 76% of companies surveyed in December 2007 reported declines
in business in the previous three months. Over 53% experienced a
sales downturn in the previous twelve months. Two major
conglomerates reported sales declines in their retail, food, and
agricultural products divisions. The high interest rates have also
hurt a previously hot real estate market, with condominiums
especially seeing a severe drop in sales.

5. (U) Inflation has also generated wage pressures throughout the
economy. Workers in several sectors including education, health
care, apparel production, and plantations pressed for wage hikes in
2007. The President mandated a wage increase to plantation workers
in October 2007. A number of unions have stated they will strike in
2008 if their members do not receive higher pay.

NEW PRICE INDEX REGISTERS SIMILARLY HIGH INFLATION
--------------------------------------------- -----

6. (U) The Government launched a new consumer price index, the
Colombo Consumer Price Index-New (CCPI-N), in November 2007. The
old CCPI had tracked the same basket of goods since 1952 and was
therefore no longer a good measure of inflation. The new index is
based on a 2002 consumer finance survey and has a lower weight for

COLOMBO 00000076 002 OF 003


food and a higher weight for electricity, fuel, and modern consumer
items like cell phones. Despite the revision, the CCPI-N, if
applied retroactively for all of 2007, would have indicated
comparably high inflation -- an average of 15.8% for the year versus
the 17.5% using the CCPI. (Note: Post will use the new index for
reporting future inflation figures.)

MONETARY POLICY TO REMAIN TIGHT, BUT CANNOT DO IT ALL
----------------------- -----------------------------

7. (SBU) In a January 2 presentation to bankers, business leaders,
and diplomats entitled "Road Map: Monetary and Financial Sector
Policies for 2008," Central Bank Governor Cabraal spelled out the
Bank's goals for 2008. In this second annual road map presentation,
the governor said this "new tradition," would assist the financial
sector to "synchronize [its] economic decisions with...national
goals." He explained that the Central Bank uses monetary targeting
-- attempting to control the growth of the money supply -- to
achieve price and economic stability because it lacks the policy
levers to conduct inflation targeting.

8. (SBU) According to Cabraal, in 2007 the Central Bank raised its
"repurchase" rate for overnight bank borrowing by 50 basis points to
12%, one of the highest policy rates in the region. Because this
rate was below the rate of inflation, the Bank also attempted to
contain market liquidity by limiting the number of times commercial
banks could turn to the Central Bank for overnight or other
short-term credit. Despite these efforts, the money supply
increased by 18% compared to a planned 14.8%. This was primarily a
result of heavy borrowing -- to cover deficits -- by government and
government corporations from the Central Bank and from commercial
banks. The government borrowing both added to the money supply and
drove market interest rates up to around 20%.

2008 GOAL OF 10-11% INFLATION MAY BE HARD TO REACH
-------------------------- -----------------------
9. (SBU) Cabraal stated that the Central Bank's 2008 monetary
program was designed to accommodate real GDP growth of 7.0%. (Note:
The government's 2008 budget figures were based on projected 2008
GDP growth of 7.5% (ref A). Cabraal's was the first admission that
the GDP projection was unrealistic.) Reserve money is to increase
by 15% and broad money by 17% in 2008. The Bank expects a net
repayment of loans by state entities and a decline in new credit to
state corporations for the year -- in part, he stated, due to Iran's
"highly welcome" extension of credit to Sri Lanka for seven months
worth of oil purchases (ref B). Credit to the private sector is
expected to increase, but more slowly than it did in 2007. These
targets, according to Cabraal, would bring inflation down to 10-11%
by the end of 2008. He acknowledged that inflation could easily
come in at 12-14% if oil prices remain over $90 per barrel, if Sri
Lanka experiences an escalation of terrorism, or if the government's
deficit is larger than planned.

GOVERNMENT FISCAL RESPONSE - REINSTITUTE SUBSIDIES
------------------------- ------------------------

10. (SBU) The government has responded to rising prices mainly by
trying to control them administratively or with subsidies. It has
come to an agreement with the main association of commodity
importers and traders to control wholesale prices of ten "essential"
food items: the government will remove import taxes on these
products in exchange for the dealers agreeing to hold down prices
correspondingly. The government also administers prices for a
number of products like fuel, cooking gas, milk powder, and wheat
flour; with inflation high, it routinely delays approval of sellers'
requests for permission to increase prices in line with market
prices. The government has also resumed subsidizing fuel prices,
abandoning its mid-2007 decision to permit prices to adjust with
global market prices. Finally, the government says it will revive a
previously failed program for the state to import food and sell it
at cost through state-run retail and wholesale outlets.

POLITICAL REACTIONS -- BLAME THE GOVERNMENT
-------------------------------------------

11. (SBU) The opposition United National Party has sought to
capitalize on public dissatisfaction with the high inflation. In
2007, the UNP organized several anti-government rallies around the

COLOMBO 00000076 003 OF 003


country, at which the cost of living increases were a central
criticism. The UNP has also started visiting village fairs
distributing pamphlets about the rising cost of living. The
populist JVP has also held rallies against the rising cost of
living.

COMMENT: GOVERNMENT WON'T ADMIT IT IS THE PROBLEM
--------------------------------------------- ----

12. (SBU) Sri Lanka's 2007 inflation far exceeded that of other
South Asian countries, some of which are also heavy importers of
essential commodities. Also, prices of many locally produced
commodities rose steeply. For example, coconut rose 27% and rice
over 20%. These facts further reinforce the IMF's conclusion that
the government's deficit spending, not just the worldwide rises in
commodity prices, drove the high inflation. The government's
efforts to address the inflation problem -- subsidies, small tax
reductions, and promises of government distribution channels -- have
been designed for political value: to enable politicians to tell
voters "we are doing something." Worse, each of these will add to
the persistent deficit, which is the main cause of the inflation, so
will obviously not solve the problem. Moreover, continued high
government borrowing and increasingly entrenched expectations of
inflation will keep interest rates high, crowding out private sector
investment, which is more productive than government spending. The
result eventually will be lower real growth rates than the
relatively healthy 6-7% growth Sri Lanka has been achieving lately.

BLAKE

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