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Cablegate: Sri Lanka Passes 2009 Budget

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RR RUEHBI RUEHLMC
DE RUEHLM #1123/01 3441154
ZNR UUUUU ZZH
R 091154Z DEC 08
FM AMEMBASSY COLOMBO
TO RUEHC/SECSTATE WASHDC 9040
INFO RUCPDOC/DEPT OF COMMERCE WASHDC
RUEHNE/AMEMBASSY NEW DELHI 2454
RUEHKA/AMEMBASSY DHAKA 1184
RUEHIL/AMEMBASSY ISLAMABAD 8184
RUEHKT/AMEMBASSY KATHMANDU 6400
RUEHKP/AMCONSUL KARACHI 2414
RUEHCG/AMCONSUL CHENNAI 8830
RUEHBI/AMCONSUL MUMBAI 6215
RUEHC/DEPT OF LABOR WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
RUEHLMC/MILLENNIUM CHALLENGE CORPORATION

UNCLAS SECTION 01 OF 05 COLOMBO 001123

SENSITIVE

SIPDIS

STATE FOR SCA/INS AND EEB/IFD/OMA
STATE PASS USTR FOR ADINA ADLER AND VICKY KADER
COMMERCE FOR EROL YESIN, BRIAN WILLIAMS
DOL/ILAB FOR TINA MCCARTER
TREASURY FOR ANNE ALIKONIS

E.O 12958: N/A
TAGS: ECON EFIN PGOV MARR KMCA CE
SUBJECT: SRI LANKA PASSES 2009 BUDGET

REF: COLOMBO 1107

1. Summary: (SBU) Parliament easily passed the 2009 GSL budget on
December 8, one month following President Rajapaksa's presentation
of the draft on November 6. This is Rajapaksa's fourth budget since
coming into office in 2005 on a platform of poverty reduction,
steering investment to disadvantaged areas, developing small and
medium enterprises, promoting agriculture and expanding the
government. The 2009 budget is a continuation of these policies
with a renewed stress on the need to defeat terrorism, bring
development to the north and east, and improve local production.
The overly optimistic budget, which forecasts increases in
expenditure ($11 billion) and revenue ($7.8 billion), as well as a
resulting deficit equal to 6.5% of GDP ($3.1 billion), fails to
realistically take into consideration changes in the global market
due to the economic downturn. Although the budget review process
was much smoother in 2008 than in previous years, passing with 126
votes in favor and 84 against, opposition party UNP demonstrated its
displeasure by issuing its own 2009 budget draft and circulating it
among the media. End summary.

2009 -- MORE SPENDING, LOWER DEFICIT
-------------------------------------

2. (U) FISCAL DATA, 2008-2009-Economic Format: Comparison between
the proposed 2008 budget, the revised 2008 budget, and the proposed
2009 budget. Figures in parentheses represent the percentage of
GDP. Sources: 2008 and 2009 Budget speeches.

--------------------------------------------- ----------
Year 2008 2008 2009
Proposed Revised Proposed
--------------------------------------------- ----------
Billions of rupees

Total Expenditure 1044 (24) 1016 (23) 1192 (22.8)
-current 713 743 823
-capital 335 278 371
-other -4 -5 -3

Total Revenue 751 (18) 709 (16) 855 (16.4)

Current AC
Surplus/Deficit +38 (0.9) -34 (0.8) +32 (0.2)

Budget Deficit 293 (7.0) 307 (7.0) 337 (6.5)

GDP Growth rate 7.5% 6.5% 6.8%
--------------------------------------------- ----------

3. (U) The 2009 budget forecasts large increases in both
expenditure and revenue. These increases are in line with
inflation, currently at 16.3 percent following a high of 28 percent
earlier this year. In comparison with the 2008 revised budget,
total government spending will increase 17 percent to 1.191 billion
rupees (Rs) ($11 billion) and revenue will rise 21 percent to Rs 855
billion ($7.8 billion), resulting in a deficit of Rs 337 billion
($3.1 billion). The deficit is equal to 6.5 percent of GDP, lower
in comparison to recent deficits of more than 7.0 percent of GDP.
However, these estimates should be viewed skeptically as the final
numbers are traditionally quite different from the forecasts.

4. (SBU) The budget lacks any expenditure rationalization efforts.
Recurrent expenditure on interest payments, salaries, pensions,
subsidies, and welfare payments will make up nearly 70 percent of
government expenditure in 2009. The remaining 30 percent is meant
for capital investment. However, since most of capital expenditure
is financed from foreign borrowing, it is likely that 2009 capital
spending will be significantly reduced due to current global
financial constraints. Also, it is customary in Sri Lanka for
recurrent expenditure to rise and the capital expenditure to fall
late in the year. The Central Bank's head of research, P N
Weerasinghe, stated publicly that while he does not see a risk in
funds expected from donors such as the World Bank, Asian Development

COLOMBO 00001123 002 OF 005


Bank, Japan, Iran and China, about $500 million in commercial
financing to provide counterpart funds for development projects may
not fully materialize. Others at the Central Bank remain very
concerned about the difficulty to raise financing in 2009.

5. (U) It is unlikely, as in the previous years, the government will
meet revenue targets. Therefore, the government forecast of a 20
percent increase in revenue in 2009 is overly optimistic. Revenue
shortfalls are very likely given the global slowdown and its effects
on Sri Lankan economy.

6. (U) In late 2008 the government reduced capital expenditure
drastically in order to keep the deficit intact at 7 percent of GDP.
Soon after the initial November 6 budget presentation, the Treasury
imposed a spending freeze for the remainder of the year. Revenue
was also much lower than targeted in 2008. Similar and additional
cutbacks will be required early in 2009 if the government hopes to
achieve its proposed deficit of 6.5 percent of GDP.

7. Note: The economic format of the budget does not include debt
service (principle payments) of Rs 383 billion ($3.5 billion) in
2008 and 476 billion ($4.37 billion) in 2009. Total funding
requirement including debt roll over will be Rs 813 billion ($7.4
billion) in 2009.

DEFENSE SPENDING
REACHES USD 1.6 billion
-------------------------

8. (U) Sri Lanka - Defense budget 2006-09
--------------------------------------------- --------
2006 2007 2008 2009
Rev. est.
--------------------------------------------- --------
Defense (Rs billion) 104.8 155.7 194 177
($ billion) 1.0 1.4 1.8 1.6

As percent
of GDP 3.6% 4.4% 4.4% 3.4%
of govt expenditure 14.7% 18.2% 19.1% 14.8%
--------------------------------------------- --------
Source: Budget estimates 2008 and 2009, Fiscal Management Report
2009

9. (U) A significant expenditure item in 2009, and a key focus for
the government, is financing for the war. Military spending in 2009
is budgeted at Rs 177 billion ($1.6 billion), or 3.4 percent of GDP
and 14.8 percent of the total budget. This actually represents a 9
percent decrease from 2008 defense expenditures when compared with
the revised 2008 budget forecast of Rs 194 billion ($1.8 billion).
With the 2009 figures, the Rajapaksa administration's defense
spending since coming to power in late 2005 is nearly USD 6 billion.


10. (U) Rajapaksa's November 6 budget speech focused heavily on
government efforts to fight terrorism and liberate the north and
east, and the President once again called on the LTTE to lay down
arms and join the democratic process. In justifying large defense
expenditures throughout the last three years and in particular in
this budget, Rajapaksa said "we view such expenditure as a priority
need towards establishing a stable economic environment to restore
democracy, consolidate human rights, and achieve economic
development... A country that is free of terrorism is also the prime
need of private sector investors." Rajapaksa also highlighted and
reminded the country of the sacrifices made by soldiers fighting in
dangerous conditions. Salaries of soldiers were increased by Rs
2,000 ($18.37) per month. A further Rs 3.5 billion ($31.8 million)
was allocated to build houses for them.

FOR THE LITTLE PEOPLE, AND KEY INDUSTRIES
------------------------------------------

11. (U) The budget offers some relief to various constituencies, but
not by enough to meet expectations or challenges posed by inflation

COLOMBO 00001123 003 OF 005


and global economic turmoil. It provides a Rs 1,000 ($9) per month
salary increase to government servants and a Rs 560 ($5) per month
pension increase. This, combined with the salary increase for
soldiers, will cost Rs 22.5 billion ($200 million) or about 2
percent of total expenditure in 2009. The tax burden of the private
sector workers was reduced slightly by widening the tax brackets.
In addition, the maximum tax rate for resident Sri Lankans providing
international professional services was reduced from the current 35
percent to 20 percent. The budget increased taxes on a range of
imports, a measure expected to aid local farmers and producers and
save foreign exchange. In addition, fuel prices were reduced
slightly, but not enough to be in line with current world market
prices. Low income families will be given a monthly allowance of Rs
200 ($2) for children under 5 years to buy milk powder. Discounts
on electricity and water bills will be given to low income earners.


12. (U) The budget also offers some relief to key industries -- in
particular tea, tourism and garments -- by providing a reduction in
electricity tariffs applicable to tourist hotels, reductions in the
price of furnace oil, a six month moratorium on loan repayments to
export industries, export marketing assistance, a treasury guarantee
for tea exported on credit terms, and a new fertilizer subsidy for
small tea growers. It is unclear how some of these programs, such
as the debt moratorium and the tea export credit, will be
implemented.

13. (U) Rajapaksa's budget introduces new tax increases meant to
protect local industries. For example, import taxes increased on
numerous products, including: wheat grain; wheat flour; imported
grains; sugar; milk; fruits and vegetables (excluding apples);
animal feed; paper; furniture; confectionary; salt; footwear and
other leather products; clothing; and electrical items. Taxes on
some imports, already at more than 100 percent, increase further
with these taxes. Unfortunately, as highlighted by Ernst and Young
Colombo senior partner Lakmali Nanayakkara, the new taxes make
import tax calculation even more complicated, as nearly 10 different
taxes and duties are levied on various bases.

TAX BURDEN INCREASING
---------------------

14. (U) While Sri Lanka's tax system is already exceptionally
cumbersome, Rajapaksa introduced yet another new tax, the Nation
Building Tax (NBL), further complicating the tax system. Rajapaksa
said the new tax should be considered as a "social contribution" to
rebuild communities and damaged infrastructure in the north and east
and to provide welfare for security forces. This one percent tax
will apply on imports, domestic production and services; it will be
in effect for two years. The finance sector, which is already taxed
at over 70 percent, is excluded. Parliament must still pass
legislation to enact this tax. In addition, the maximum liability
of the Economic Service Charge increased, the telephone tax was
extended from mobile services to fixed line, and the port and
airport tax on imports has increased from 3-5 percent.

15. (SBU) In a half-hearted bid to address business concerns, the
budget proposes to appoint a (unfunded) Presidential Task Force to
prepare a people friendly tax policy by 2010. The government did
reduce the standard Value Added Tax (VAT) rate from 15 percent to 12
percent, with the aim of reducing the cost of living. The 18
percent VAT on luxury items remains unchanged. However, tax experts
have said that the reduction in VAT will not provide much relief as
the new National Building Tax and higher import duties will make up
for the reduction. According to GSL estimates, the VAT reduction is
estimated to cost the government Rs 45 billion ($409 million).
Increases in other taxes are expected to bring Rs 75 billion ($681
million), providing a net gain of over Rs 30 billion ($272 million)
to the treasury.

FISCAL IMPRUDENCE
------------------

16. (SBU) The GSL's policy of not privatizing public enterprises

COLOMBO 00001123 004 OF 005


remains unchanged in the 2009 budget. As a result, the government
will continue to lose revenue as it bails out failing institutions,
including significant losses by the Ceylon Electricity Board (CEB).
Of particular interest is the government's decision to spend Rs 6
billion ($54 million) to revive Mihin Lanka, a failed airline named
for the President that was forced to cease operations in 2008 after
only thirteen months due to significant losses. The GSL has assured
citizens that Mihin Lanka will be a profit making venture within
three months of recommencing operations in December 2008; however,
most believe it will fail again. In the face of severe criticism by
the opposition for funding a lost cause, the Minister of Foreign
Affairs claimed that there was "no going back when one commences
such large scale commercial ventures." He added that the government
can afford to pump six billion rupees into the project. The budget
also provides the government USD 5 million to build an unnecessary
airport in President's constituency in the deep south.

DEBT BURDEN
(DOMESTIC AND FOREIGN DEBT SERVICE)
------------------------------------
17. (U)
2007 2008 2009
Rs billions

Interest payment 183 216 250
-- Domestic 158 189 220
-- Foreign 22 27 30
Amortization 307 383 476
-- Domestic 235 301 391
-- Foreign 71 73 84
Total 490 599 726
--(USD Billions 4.5 5.5 6.6)

Additional items:
Oil hedging losses - NA
Iranian credit line - NA

Sources: Budget 2009, Budget estimates 2009, embassy estimates

18. (U) According to the Fiscal Management Report 2009 issued with
the budget, the debt/GDP ratio continues to fall. Debt/GDP ratio is
estimated at 78.2 percent of GDP in 2008, well below its peak of 106
percent of GDP in 2004. It will likely decline further to 75.6
percent of GDP in 2009. The decline is attributed to moderate
growth in debt financing, high inflation, GDP growth in excess of 6
percent, and the stability of the exchange rate. Although debt
ratios have been falling, this is offset by the emergence of other
risks. Government borrowing in foreign currency has increased.
Foreign commercial loans have also increased. Total debt service
(excluding payments due for oil purchases) is estimated around 85
percent of projected revenue in 2009; interest payments will be
around 29 percent. The Supreme Court, examining public interest
litigation (see para 23), said that staggering debt service cost
reflects the reckless and irresponsible handling of public finance
by the Treasury.

TRANSFERS
---------

19. (U) Major programs present in 2008 will continue in 2009. The
government will spend Rs 196 billion (up 1.1 percent from 2008) in
welfare payments, subsidies, pensions and transfers to state-owned
enterprises operating at a loss. The high-cost fertilizer subsidy
will continue. (Note: In 2008, the government spent Rs 27 billion
on the subsidy; in 2009, the government will likely spend Rs 25
billion, which will now include an extension of the subsidy to small
tea plantations owners.) The Samurdhi program, which provides a
monthly cash grant to poor families, is another significant transfer
program; however, its cost remains unchanged at approximately Rs
11.6 billion in 2009.

INFRASTRUCTURE SPENDING
-----------------------


COLOMBO 00001123 005 OF 005


20. (U) Although many analysts have commended the government for its
commitment to infrastructure development, in 2008 the government
spent only approximately USD 2.5 billion in capital spending, a sum
much smaller than budgeted. In 2009, it has approval to expend USD
3.3 billion. Main projects include roads, power, and ports.
However, taking into account a lack of liquidity in the global
market and the fact that many of these projects are only partly
financed by international organizations, the government will have to
cut back if unable to raise the necessary capital to finance its
portion of these projects.

2009 Budget News and Controversy
---------------------------------
21. (U) For the first time ever, the budgets of 21 "less significant
ministries" were referred to a sub-committee for debate, while the
ministries considered "important" were debated in the full house of
the Parliament. The sub-committee budgets were approved in
Parliament on December 5.
22. (U) The main opposition party, UNP, submitted an alternative
budget to the press and Parliament. The UNP, which has historically
promoted fiscal prudence, promised large subsidies for low income
families, massive salary hikes to state workers, additional
fertilizer subsidies and other social welfare programs. The party
proposed to finance the budget through a flat consumption tax,
foreign aid, and interest rate savings. This alternative budget was
not reviewed by Parliament.
23. (U) The Supreme Court, examining a public interest litigation
case, announced on November 4 that it detected flaws in the
preparation of the budget accounts. Specifically, expenditures
stated in the appropriations bill did not include a debt service of
Rs 722 billion; this amounted to an inconsistency with the
Constitution. The government, in its defense, said that certain
payments allowed by specific laws are not included in the budget
bill. Nevertheless, it subsequently submitted a new schedule to
Parliament containing debt service costs as directed by the Supreme
Court.
24. (U) The opposition used the high price of fuel to attack the
government. Retail fuel prices were reduced slightly with the new
budget, but -- as of December -- Sri Lanka's gasoline and diesel
were around 400 percent and 160 percent higher than the Mean of
Platts Singapore (MOPS) price. This puts Sri Lanka at a
disadvantage compared with other competitors in the region. The UNP
charged that the government is making a monthly profit of 50 billion
from petroleum. Responding to these charges the Government said the
revenue is being used to fund infrastructure projects. Analysts say
there are signs that taxes on petroleum will be used as a major
source of revenue to plug holes in the budget next year.

COMMENT:
--------

25. (SBU) The 2009 budget contains no real surprises. The
government continues to be too optimistic, with unrealistic
forecasts of revenue (up 21 percent) and expenditure (up 17 percent)
and deficit (6.5 percent of GDP), especially in light of global
recessionary conditions. The fact that it passed easily was
expected due to the current state of the conflict. Budget
discussions, always highly political, included members of the
government trying to paint those who would vote against the budget
as unpatriotic and unsupportive of military action. Even the UNP,
which did vote against the overall budget, begrudgingly abstained
rather than vote against the defense budget. The wide margin in the
final vote (126 for, 84 against) demonstrates support for the
President's plan to continue the war at all costs while moving
forward with increasingly protectionist import substitution plans
the GSL is selling a beneficial to the "little guy." Sri Lanka may
face extreme difficulty in obtaining commercial loans in 2009 to
assist in the financing of its deficit. With a continued refusal to
even consider IMF assistance in the future, it will need to either
significantly revise its forecasts for 2009, or find other sources
of funds from bilateral friends, such as China and Iran.

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