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Cablegate: Sri Lankan Economy Continues to Grow Despite

This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 03 COLOMBO 001702

SIPDIS

E.O 12958: N/A
TAGS: ECON CE ECONOMICS
SUBJECT: Sri Lankan Economy Continues to Grow Despite
Confusion Over Policies

1. (U) SUMMARY: The Sri Lankan economy grew by 5.2% in
the second quarter, following 6.2% growth in the first
quarter. Consequently, first half GDP growth is estimated
around 5.7% and the Central Bank is optimistic of 5 to 5.5%
overall growth in 2004. The Bank attributes the growth
this year to the continuation of economic momentum
following the signing of the ceasefire agreement. The
economy, however, faces several challenges: high oil
bills, drought in agricultural districts, deficit in the
Balance of Payments, inflationary pressures, subsidy costs,
stalemate in the peace front and economic uncertainty. The
GSL seems to be coming around to the realization that
fiscal restraint is needed, and is making some efforts to
curb subsidies, but its prospects for long-term success on
this front are poor. End Summary.

GDP Growth Continues
--------------------

2. (U) The Sri Lankan economy grew by 5.2 percent in the
second quarter, down from 6.2 percent in the first quarter.
Second quarter growth was fueled by a strong services
sector, which grew by 7.1 percent. Within services,
telecommunications, port services, import trading and
banking did well. The agriculture sector declined
slightly. Tea, rubber and coconuts increased, but rice
recorded a 12 percent decline due to drought. Growth in
factory output slowed to 3 percent from 9 percent in 2003.

External sector
---------------

3. (U) As the oil bill soared and aid flows slowed, the
BOP recorded a USD 223 million deficit in the first half of
2004 from a USD 187 million surplus for the same period in
2003. On the bright side, exports gained from continuing
global economic recovery and rose by 10 percent. Tourism,
foreign inward remittances and shipping also recorded
healthy growth and partly offset the huge trade deficit,
caused by a 21 percent rise in imports. The trade deficit
increased to USD 1.1 billion in the first half of 2004
(2004H1) from 0.7 billion in 2003H1. The oil bill was $539
million in 2004H1 compared with $375 million in 2003H1.
The treasury expects it to rise further to about $1.2
billion by year-end. Import of machinery and other
investment goods also increased. The current account
deficit was $428 million compared with a deficit of $1.5
million in 2003.

4. (U) Capital inflows have slowed. Government borrowing
declined to $284 million in 2004H1 compared to $315 million
in 2003H1, as IMF and WB have withheld program loans to Sri
Lanka while the new Government pursues its development
plan. To cover the shortfall, the government hopes to
borrow up to US$400 million through dollar bond issues in
2004. The Central Bank said that FDI inflows remained at
last year's levels -- around $100 million. Outflows have
increased due to a large investment abroad by a local bank.
Portfolio investment saw a drastic drop to just US $6
million as investors sought greater clarity in government
policy on the economic and peace fronts. The worsening BOP
situation resulted in official reserves declining to $2.1
billion by June from $2.3 billion in December 2003. Total
reserves declined to $3.1 billion from $3.2 billion,
providing 5.2 months of import cover.

5. (U) The Central Bank recently said that a small BOP
surplus for the second half of 2004 could be expected if
privatization proceeds from the sale of a petroleum retail
unit and program loans flow in and oil returns to below $40
a barrel - neither of which appears likely at this point.
Without such changes, the BOP deficit for the full year
could exceed $200 million.

Exchange rate, interest rate and inflation
------------------------------------------

6. (U) Exchange rates, interest rates and prices are under
severe pressure due to BOP deficit, government subsidies
and price hikes. The government has, however, been able to
temporarily keep a tight rein through state intervention in
both money and exchange markets. Despite Central Bank
intervention, in which the bank sold USD 235-300 million,
the rupee depreciated by 6.2 percent by the end of August.
The news of an increased BOP deficit has further weakened
the rupee. It is currently trading at around 104 rupees to
the dollar.

7. (U) As of the end of September, the Central Bank
maintained its interest rates, despite rising inflation and
exchange rate pressures. T-bill rates, which increased by
about 200 basis points through July 2004, have started to
decline in the last few auctions as state institutions
increased buying, reportedly on instructions from the
Finance Ministry. The current 3 month T-bill rate is about
7 percent compared with 7.26 percent a year ago. The
average prime-lending rate is around 9.68 percent compared
with 9.32 percent a year ago.

8. (U) The money supply expanded by about 18 percent in
July as both private and public sector credit grew. The
Central Bank has expressed concern about the high growth in
public sector credit due to subsidies on petroleum, wheat
and several other services. The Bank said that the impact
could be mitigated by revising prices, which would also
support interest and exchange rate stability.

9. (U) Inflation has once again become a major concern to
the Government and policy makers. Average inflation as
measured by the Colombo Consumer Price Index (CCPI) was 5.4
percent in September. A much faster rate of inflation was
indicated in the point-to-point change (September
2004/September 2003) in the index, which rose by 11.6
percent as the full effect of recent price hikes began to
be captured by the index. Prices have been rising as a
result of oil price hikes, depreciation of the rupee, and
lower agricultural supplies due to a drought. Inflationary
pressures will rise further in the coming months due to
price hikes on petroleum, transport, and electricity
announced in late September.

Government fiscal operations
----------------------------

10. (U) On the fiscal front, the GSL Treasury maintains
that the budget deficit for 2004 will be 8%, despite
subsidy costs and increased government recruitment. The
treasury has said that subsidies up to Rs 8 billion could
be accommodated within a deficit of 8 percent of GDP.
According to reports, subsidies on petroleum alone have
amounted to about Rs 7.5 billion (USD 75 million) so far
this year. The government has begun to gradually raise the
price of petroleum products (gasoline and diesel),
electricity, and public bus transport. Even with prices
recently allowed to rise on diesel, kerosene, and wheat
flour, these products are still subsidized. Sri Lanka has
sought, with only marginal success, OPEC assistance
(concessionary financing through the OPEC fund) to ease the
pressure on government finances. Some of the price
increases requested by the private sector (such as bus
fares, wheat flour, cooking gas) are under intense debate.

11. (U) The Central Bank expects investment will continue
to achieve a higher growth in the medium term. Future
investment will depend on several factors affecting
consumer and investor confidence: political stability, a
resumption of, and progress in, the peace talks,
improvements in macroeconomic management, greater fiscal
control, improved clarity in economic policy, reduced price
distortions, improved infrastructure, structural reforms,
and effective utilization of donor assistance.

Comment
-------

12. (SBU) While the picture is not dire on the economic
front, it could be far better, particularly with exports
surging as they are. It appears that monetary policy is
looser than might be expected despite increasing interest
rates and a weakening rupee. While the depreciating rupee
should be good for Sri Lankan exports, much of its effect
is offset by the increasing cost of imported inputs for the
export sector. The losses of IMF and World Bank budgetary
support magnify the balance of payments problem even more.

13. (SBU) Continued floundering and a failure of the
Government to speak with one voice on matters of economic
policy will continue to send the wrong signals to markets
and potential investors. During upcoming TIFA talks in
Washington, USG interlocutors will hear from the GSL that
they intend to "stay the course" on economic reform. This
is only partially true. The current Government has taken
privatization off the table and cuts to subsidies are just
now beginning to be considered, as continuing price
increases bring home the reality of the nation's fiscal
situation. The GSL has begun to change its tone, with the
President recently commenting that subsidies are no longer
sustainable and should not be expected to continue.
Whether this rhetoric will translate into concrete action
on the fiscal front is questionable. The President's
coalition remains tethered to a socialist firebrand party
(JVP) with keen interests in seeing continued payouts for
its constituent base in the rural, poor southern regions.
LUNSTEAD

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