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Cablegate: Sri Lanka Fy 2007 Budget

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UNCLAS SECTION 01 OF 05 COLOMBO 002063

SIPDIS

MCC FOR D NASSIRY AND E BURKE

SENSITIVE, SIPDIS

E.O 12958: N/A
TAGS: ECON EFIN CE
SUBJECT: Sri Lanka FY 2007 Budget

1. (SBU) Summary: President Mahinda Rajapakse, who is also the
Finance Minister, presented the Government of Sri Lanka's (GSL's) FY
07 budget to Parliament on November 16. The budget envisages large
increases in both expenditure and revenue. Military expenditure
will increase by 28 percent to a record Rs 139 billion (USD 1.3
billion or 4.2 percent of GDP) in 2007. Due to past fiscal
largesse, two-thirds of government expenditure still goes to cover
recurrent expenditures. Despite a whopping USD 1 billion projected
increase in revenue estimates, there were no significant tax hikes,
although some sectors will see their tax liability increased. The
largest benefit to the private sector will come from reduced
electricity prices. The budget also granted specific assistance to
a few selected industries and agriculture. The GSL hopes to post a
small recurrent account surplus, although the government is highly
unlikely to meet that target. The budget includes substantial
infrastructure spending. It was presented within the context of a
three year framework, enabling the President to speak of plans
without actually budgeting for them. Despite criticism that the
budget failed to lower cost of living, all political parties in
Parliament except for one voted in favor of the budget in a rare
show of unity. End Summary.

2. (SBU) President Mahinda Rajapakse, who is also the Finance
Minister, presented Sri Lanka's FY 07 budget, his second, to
Parliament on November 16. Unlike his first, made shortly after
being elected, the 2007 budget did not offer significant increases
in subsidies and handouts and contained some initial efforts to
reform expenditure. Opening the budget speech, Rajapakse said he
was presenting the budget based on "Mahinda Chintana" (or "Mahinda's
Thoughts"), an election document filled with subsidies and
envisioning development of the rural poorer regions of the country.
(Comment: Mahinda Chintana is cited to justify most GSL actions,
especially those involving economic development. End Comment.)
However, the budget was remarkably short on Mahinda Chintana-like
policies that would have stretched the budget even further. Mahinda
appealed to the LTTE to enter peace talks and lay down arms, while
listing difficulties faced due to increased violence. He used the
increased violence to highlight the GSL's focus on security and his
inability to bring down the cost of living, stressing that people
need to make sacrifices.

3. (SBU) FISCAL DATA, 2006-2007: The following statistics provide
a comparison between the projected (original) budget for 2006, the
revised 2006 budget and the 2007 projected budget. The figures in
parentheses represent the percentage of GDP.


Year 2006 2006 2007
Proj. Rev. Proj.

In billions of rupees

Total Expenditure 732 (27) 722 (26) 898 (28)
-current 509 (19) 547 (20) 596 (18)
-capital 226 ( 8) 184 (7) 303 (9)
---Of which are
fully funded projs. 21( 1) 21 (1) 63 (2)

Total Revenue 484 (18) 482 (17) 600 (19)

Budget Deficit(a) 225(8.3) 218 (7.9) 235 (7.2)
Budget Deficit(b) 247(9.1) 239 (8.6) 297 (9.2)

Financing (net)
Foreign 124 84 142
Domestic 123 156 156

Notes:

Exchange rate: USD1 = approximately Rs 104 in 2006 and Rs 110 in
2007.
Figures within parenthesis represent percentage of GDP.

(a) Sri Lanka's Official Budget Deficit reported by the Finance
Ministry: There are two deficit numbers. The Finance Ministry
understates the budget deficit by excluding foreign funded tsunami
and development projects implemented through the government in
expenditure. Accounting for these foreign funded projects in
government expenditure will result in a higher deficit.
(b) Embassy-Estimated Actual Budget Deficit: We have included
foreign-funded projects in expenditure, and therefore have used the
higher deficit in our analysis.

COLOMBO 00002063 002 OF 005

BUDGET PROJECTIONS

4. (SBU) The budget has been structured with the expectation that
both government spending and revenue are estimated to grow
significantly, by 24 percent, resulting in a deficit of about 9.2
percent of GDP in 2007. The government is set to borrow about Rs
230 billion (USD 2.1 billion) in 2007, over and above the Rs 63
billion (USD 570 million) project lending that has already been
secured in order to bridge the budget deficit. In 2006, despite
substantial overruns in recurrent expenditure, the fiscal deficit
was held at 8.6 percent of GDP through cuts in capital spending.
The government has not been able to meet targets set by the Fiscal
Management Responsibility Act (FMRA) which sets a deficit target of
5 percent for 2006 and beyond.

5. (SBU) The 2007 budget foresees a large increase in capital
expenditure compared to 2006. However, almost two-thirds of
government expenditure (equivalent to about 18 percent of GDP) has
been allocated for recurrent expenditure. Although committed
expenditure on wages, interest and subsidies leaves little room for
allocating funds to vital sectors, the budget makes some effort to
rationalize expenditure. As an example, the government plans to
spend less on subsidies and more on education and health in 2007.
However, defense expenditure is set to increase substantially in
2007 (see para 9).

6. (SBU) Revenue estimates seem precariously optimistic. Total
revenue is estimated to increase by 24 percent (Rs 112 billion or
USD 1 billion) to over 18 percent of GDP. The increase is not in
line with inflation and growth. In 2006, revenue increased by 29
percent following substantial increases in taxation. Therefore, in
the absence of a similar tax hike, it is unlikely the government
will meet this target in 2007. The fiscal direction of the budget,
however, was laudable as the government has budgeted for a marginal
surplus in the current account (revenue-current expenditure), which
indicates that revenue would be sufficient to cover current
expenditure.

MACROECONOMIC MANAGEMENT

7. (SBU) According to the President, the government is designing a
10 year strategy which aims at an annual GDP growth of over 8
percent and raises the per capita income from the current USD 1,200
to USD 3,000. In 2007, economic growth is expected at 7.5 percent,
up from 7 percent in 2006. Inflation and monetary expansion were
high in 2006 due to high oil prices and increased borrowing by both
government and private sector. Dr P B Jayasundera, Treasury
Secretary, speaking at a post-budget seminar said he expects

SIPDIS
inflation to moderate to around 9 percent in 2007 with measures
taken to tighten monetary policy. However, revealing the government
stance on inflation, he said the government would not sacrifice
economic growth for lower inflation.

INFRASTRUCTURE FOCUS, IN PART

8. (SBU) The government expects capital spending to increase
dramatically from Rs 184 billion (USD 1.7 billion) in 2006 to Rs 303
billion (USD 2.8 billion) in 2007. While this increase is touted as
investment in further economic development, it should be noted that
all of this will not be for key economic infrastructure. Some of the
funding will be for defense, office buildings and vehicles. Key
infrastructure projects which are already funded and included in the
budget are the Norochcholai coal power plant (funded by China), the
Southern expressway (ADB/Japan), the Colombo south harbor breakwater
(ADB), the outer Colombo circular road (Japan), and the Kotmale
hydro power project (Japan). There are other key projects, which
still need to be funded. This latter investment, however, will
depend on foreign inflows and domestic investors. There are
concerns that with the increased violence and the breakdown of the
peace process it will be difficult to attract foreign investors in
the scale envisaged by the government. The IMF has also warned the
country against borrowing on commercial terms. The budget proposed
a new tax of 2.5 percent on motor vehicle imports to fund
infrastructure.

INCREASE IN DEFENSE SPENDING

9. (SBU) Defense spending will increase by 28 percent to a record
Rs 139 billion (USD 1.3 billion) in 2007 (4.2 percent of GDP), and
could increase further if the conflict escalates. Defense spending
was Rs 108 billion (3.9 percent of GDP) in 2006 and Rs 83 billion

COLOMBO 00002063 003 OF 005


(3.5 percent of GDP) in 2005. Various groups have criticized higher
defense spending, leading to the impression that the government is
preparing for a war. But a large portion of the increase is due to
inflation, currently at 18 percent. Further, in these more tense
times, the government will increase the GDP percentage for defense
by 0.7 percent compared to 2005. In support of the increased
defense spending, Jayasundera said that national security "cannot be
compromised." Further, not only the war, but the need to maintain
law and order and reduce crime compelled the government to increase
defense spending. In addition, salary increases (due to increases
granted to public service including military) also contributed to
the rise in expenditure.

CONTROVERSIAL PROPOSALS LEADING TO A MORE BLOATED GOVERNMENT

10. (SBU) In keeping with Mahinda Chintana, big government was seen
prominently in the budget. For instance, the government proposed to
control dividend distribution of private companies. Accordingly,
companies that pay less than 25 percent of their distributable
profits as dividends are required to pay a penalty tax of 15
percent, on top of normal tax on profits. This proposal has been
widely discussed. Companies say they need to save to fund future
investment. Capital market analysts argue that boards of directors
should be allowed to decide how much they would distribute and how
much they would keep for future needs. In addition, the government
made it mandatory for insurance companies to cede 50 percent of the
re-insurance business with the new state-owned National Insurance
Trust Fund, which has raised concerns regarding quality of insurance
products in the future. The government also proposed to create a
National Wealth Corporation to own and manage government lands and
other assets. A new bank named Lanka Putra Bank, will take over
functions of regional development banks (RDB) and the newly created
SME Bank. There are concerns that the new bank will centralize
functions of the regional development banks, leading to inefficiency
and corruption. Already, Fitch Ratings has put the regional
development banks on its rating watch. In another move, the budget
declared that Sri Lankans working overseas should get a minimum wage
of USD 250 per month from 2007. The government argues this move
will ensure that Sri Lanka will provide a pool of skilled labor for
overseas market. Currently, the majority of Sri Lankans working
overseas are female housemaids. Foreign remittances of over USD 2
billion are the second largest source of foreign exchange to Sri
Lanka after garment exports. Although not mentioned in the budget,
the disruption of families due to migration of women has become a
social issue.

A PASSING MENTION OF MUCH NEEDED REFORMS

11. (SBU) The budget speech briefly mentioned the need for crucial
reforms. Among them was a government commitment to monthly
adjustments to petroleum prices in line with world prices. On labor
and education, the President said that educated youth are not
capable of securing gainful employment and stressed the need to
re-orient education and improve the studies programs in universities
and vocational institutes. There was no mention of new programs to
address this issue to expand English education, nor the status of
the current efforts. The budget speech also mentioned the need for
judicial reforms, and the need for management and unions to work
together to strengthen performance in key public services such as
electricity, ports and petroleum.

12. (SBU) The budget was silent on much needed welfare reforms,
public sector reforms and public enterprise reforms. However, on
the positive front, total expenditure on subsidies and welfare
programs have been reduced from 4.9 percent of GDP in 2006 to 3.9
percent of GDP. The allocation for Samurdhi, the main income
transfer (welfare) program has declined from 0.7 percent of GDP in
2006 to 0.5 percent of GDP in 2007. According to a recent report by
the Colombo-based Institute of Policy Studies (IPS), efforts to
improve targeting are underway. As a first step, over 40,000
recipients have voluntarily exited the program by mid 2006.
Currently, there are over 1.9 million Samurdhi recipients.

ENORMOUS CIVIL SERVICE A DRAIN ON THE BUDGET

13. (SBU) The public sector wage and pension spending of Rs 265
billion in 2007 has become a drag on the budget. These expenses
will use 45 percent of government revenue. The public sector is to
be given a part of a salary increase announced in the 2006 budget.
In addition, the government has proposed to add another 8,000
graduates to the approximately 1 million-strong public sector
workforce in keeping with a 2006 budget proposal. The government

COLOMBO 00002063 004 OF 005


has absorbed 45,000 graduates in 2005-2006, fulfilling the prior
administration's promises, and partially fulfilling the President's
election promise. On the positive side, the budget proposes to
rationalize the salary structure and improve the recruitment policy.


TAXATION

14. (SBU) Both direct and indirect taxation have risen sharply in
recent years. Private companies in various sectors have complained
of the high tax obligations and reporting complexities in Sri Lanka.
According to the World Bank's Doing Business 2007 report, Sri Lanka
ranked 157 out of 175 countries in terms of tax liability/ease of
paying taxes. However, in the absence of significant government
efforts to control recurrent spending, taxation is expected to
continue expanding.

15. (SBU) The FY 2007 budget heaps additional taxes on businesses
while curtailing leakages from the system.

Some of the increases are:

--a 0.5 percent increase in the ports and airports levy to 3
percent
--limiting input tax credit under the VAT and extending its
coverage
--lowering income threshold for economic service charge
--changes to tax treatment of loan loss provisioning in banks
--insurance companies will not be able to offset losses from life
policies against profits in general business
--increase in imputed profit margins for the calculation of VAT and
Export Development Board levy.
--Export Development Board levy on selected items was increased.

INDUSTRY ASSISTANCE

16. (SBU) Noting that industries were fast losing their
competitiveness due to the high prices of electricity and industrial
fuel (used to generate electricity in some plants), the budget
proposed to lower the electricity tariff. This will be done by
exempting electricity from VAT. In addition, agriculture,
livestock, prawn farming and construction will benefit from
industry-specific assistance which ranged from VAT exemptions and
concessionary duty for imported machinery to a Rs 3 billion credit
line for farmers. The following industries benefited from
protection through increases in import tariffs and other import
charges, as well as VAT exemption on local manufacture: handloom
textiles, bus transport, panels, footwear, jewelry, and personal
care products. The local film industry was also given various
generous concessions.

MIXED REACTIONS

17. (SBU) The budget received mixed reactions. Sectors projected
to obtain government assistance have been quick to praise the
budget. For example, the Gem and Jewelry Association termed the
budget "a glittering budget" as a result of concessions granted to
the industry. Overall, the private sector chambers have praised the
infrastructure program of the budget while asserting the need for
the implementation of the proposals. They have also praised the VAT
exemption on electricity as it will enhance the competitiveness of
industries. The dividend tax, however, received heavy criticism.
Trade unions representing the private sector have condemned the
budget as it did not grant them any concessions.

18. (SBU) Following the joint government-United National Party
(UNP) Memorandum of Understanding to work together on the security
situation in the country, the UNP has agreed to support the budget
in principle. Nevertheless, during parliamentary discussions of the
budget, the UNP blamed the government for not addressing the rising
cost of living and for pushing the country into war. The UNP urged
the government to pursue the peace process. The Janatha Vimukthi
Peramuna (JVP) and the Jathika Hela Urumaya (JHU) have complained
that the budget did not contain their proposals and that it is not a
people friendly budget. Tamil National Alliance (TNA) members
allege that defense expenditure is increasing to buy warplanes and
ships in preparation for war.

19. (SBU) The budget was passed by an overwhelming majority of 130
votes, with 142 voting for and 12 against. The UNP, JVP, JHU, CWC
and SLMC voted with the government, with only the TNA opposing.
This was the first time in recent history that a budget received

COLOMBO 00002063 005 OF 005


such broad support amongst the political parties.

20. (SBU) Comment: The government's FY 07 fiscal targets, for both
revenue and expenditure, seem overly ambitious and unrealistic. In
particular, revenue is expected to increase by 24 percent (Rs 112
billion or USD 1 billion). As such, as seen in recent years, a fall
in revenue and recurrent expenditure overruns are likely to be met
by cuts in capital spending. Government borrowing in 2007 is likely
to rise further than anticipated and contribute to further
depreciation of the rupee and fuel inflation which could stifle
growth. However, the budget was able to underline some economic
realities. The government should be commended for not granting new
subsidies, and for attempting to end the oil subsidy despite the
rising cost of living. Further, while the budget did not contain a
clear path for economic development, it signaled the government's
stand on infrastructure. Stronger fiscal adjustments and reforms
will be needed to attain macro economic stability which will create
room for private sector development and economic growth in the 8
percent range in the medium term.
BLAKE

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