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Cablegate: Sri Lanka: Government Revives Sovereign Bond Issue Plans;

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RHEHAAA/NATIONAL SECURITY COUNCIL WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHDC
RUEHLMC/MILLENNIUM CHALLENGE CORPORATION

UNCLAS SECTION 01 OF 03 COLOMBO 001218

SIPDIS

SENSITIVE

SIPDIS

STATE FOR SCA/INS AND EEB/IFD/ODF
MCC FOR S. GROFF, D. TETER, D. NASSIRY AND E. BURKE
TREASURY FOR LESLIE HULL

E.O 12958: N/A
TAGS: ECON EINV EFIN KMCA CE

SUBJECT: SRI LANKA: GOVERNMENT REVIVES SOVEREIGN BOND ISSUE PLANS;
OPPOSITION SEEKS TO BLOCK

REF: A. 06 Colombo 550 B. Colombo 170

1. (SBU) Summary: The Government of Sri Lanka plans to issue the
country's first international sovereign bond, in hopes of raising
$500 million to fund infrastructure projects. However, the main
opposition United National Party has announced that a future UNP
government would not honor the bonds, which it claims the country
cannot afford. UNP reps told us that their effort to sink the bond
issue is primarily political though -- an effort to keep the
government from being able to buy the continued loyalty of former
UNP MPs who joined the government as ministers last January. While
markets will likely correctly view the UNP threat as a political
move that would never materialize, the timing of the pending bond
issue appears to be as bad or worse as sixteen months ago, when the
government shelved an earlier plan for a $1 billion sovereign bond
issue. Sri Lanka has had little good news to reassure currently
skittish international debt markets. Nevertheless, market watchers
say that the relatively small bond issue will probably appeal to a
sufficient number of international investors who remain interested
in diversifying their holdings of high-yielding emerging market
debt. End Summary.

$500 MILLION BOND TO FUND
INFRASTRUCTURE, "SET A BENCHMARK"
---------------------------------

2. (U) The Government of Sri Lanka has revived plans for the
country's first international sovereign bond issue. The government
seeks to raise $500 million, or more if demand is strong. The
government says it intends to invest the cash it raises in
infrastructure projects. It also expects the bonds to provide an
interest rate benchmark for private Sri Lankan companies seeking to
borrow in international capital markets. This is the second time
the government has prepared to tap international markets for a large
bond issue (ref A). In mid-2006 the government abandoned plans to
raise $1 billion when advisor Citibank judged that the resumption of
civil war made the timing inopportune.

3. (SBU) The Central Bank of Sri Lanka, which will float the bond on
behalf of the Government, has selected JP Morgan, Barclays Capital
and HSBC as joint lead managers of the issue, from among twelve
local and international banks that bid on the role. According to a
senior Central Banker, the bank plans an October road show to
financial centers like New York, London, Frankfurt, Singapore, and
Hong Kong to publicize the planned bond issue.

OPPOSITION SEEKS TO BLOCK THE BOND ISSUE
----------------------------------------

4. (U) The opposition United National Party has challenged the
government's plan to issue the bonds. UNP leader Ranil
Wickremesinghe wrote to JP Morgan, Barclays, and HSBC August 24,
stating that "the bond issue is in violation of the law" and that
the "a future Government formed by the United National Party will
not be able to honour the repayment obligations under this bond
issue." In the letters, Wickremesinghe charges that the government
has not informed Parliament of its plans to issue the bonds; that
interest payments on the bonds "will hamper the sustainability of
Sri Lanka's long-term programme for servicing its existing public
debt repayments"; and that the bonds may contribute to corruption,
since planned "major infrastructure projects... have all been funded
by bilateral and multilateral" lenders. Wickremesinghe sent similar
letters to U.S. Securities and Exchange Commission Chairman
Christopher Cox and to Cox's UK equivalent, urging them to "consult
with the banks concerned and bring to a halt the issuance of this
sovereign bond."

5. (SBU) A UNP economic advisor told Econoff, however, that if given
the opportunity to do so in a future government, the party does not

COLOMBO 00001218 002 OF 003


in fact intend to default on the bonds. The move, he said, is
rather a political tactic in the UNP's strategy to bring down the
Rajapaksa government. The UNP believes that, if it can block the
bond issue, it will be able to lure back former UNP members of
parliament who joined the Rajapaksa government as ministers in
January (ref B). Conversely, the UNP believes that if the bond goes
through, the government will be able to buy the continued support of
those MPs by allocating much of the cash to the ministries they
control. The advisor stuck with the UNP's charge that the bond
issue would violate the law, saying that it would cause the
government's total outstanding debt to exceed a maximum established
by Parliament. One of the UNP ministers who joined the SLFP in
January likewise told Ambassador that the UNP had made, but not
followed through on, a similar threat to block the partial
privatization of the national airline in the 1990s.

6. (SBU) The CEO of HSBC in Sri Lanka discounted the UNP threat as
"silly... political tub-thumping." He said there was no way a
future UNP government would voluntarily default, and was confident
that international markets would be unconcerned by the UNP position.
Other international bank and credit rating agency reps gave Econoff
the same assessment. (The Colombo-based JP Morgan representative
told Econoff he could not comment on the impact of the UNP's letter
to JP Morgan while his firm conducted due diligence preparations for
the bond issue.)

7. (SBU) As for the government's legal right to proceed with the
bonds, the senior Central Banker told Econoff that in fact the
government had notified Parliament, in its November 2006 budget
proposal for 2007, that it planned "foreign borrowings up to one
billion dollars." Finance Ministry and Central Bank officials told
EconFSN that Foreign Loans are covered under Sri Lanka's Foreign
Loans Act and therefore do not need special parliamentary approval
and that debt levels under the Fiscal Management Responsibility Act
are only targets to improve transparency and accountability, not
binding limits.

S&P SAYS SRI LANKA CREDIT OUTLOOK "STABLE"
------------------------------------------

8. (U) On August 9, Standard & Poor's Ratings Services upgraded its
outlook on Sri Lanka's credit ratings from "negative" to "stable."
(According to S&P, a negative outlook is used to signal that the
rating may be lowered in the near future, whereas stable signals the
rating is unlikely to change.) S&P kept Sri Lanka's long-term
foreign currency rating unchanged at B+, or four tiers below
investment grade. S&P attributed the improved outlook to "higher
tax collections, strengthening of fiscal and macroeconomic
coordination, elimination of fuel subsidies and revision of
electricity prices" and "the limited impact on the economy from the
renewed fighting."

9. (SBU) The senior Central Banker told Econoff that JP Morgan had
been influential in the S&P outlook decision, both by helping the
Bank prepare for the S&P assessment and by convincing S&P during its
deliberations that the Sri Lankan economy was in fact holding
stable. According to the Central Banker, Citibank had not been as
helpful in preparing the bank for the April 2007 Fitch Ratings
assessment, which ended with Fitch keeping its outlook at
"negative." The new local Citibank head acknowledged to Econoff
that JP Morgan had beaten Citibank on "customer service," but
maintained that Citi would have been a better choice than JP Morgan,
Barclay's or HSBC to lead the bond issue.

COMMENT: POLITICS ASIDE, TIMING FAR FROM OPTIMAL
--------------------------------------------- ---

10. (SBU) Aside from its political agenda, the opposition seeks to
block this bond issue because it doubts the government will

COLOMBO 00001218 003 OF 003


productively invest the proceeds in infrastructure projects. This
is a valid concern on three levels. First, as the opposition fears,
the government may well use the funds to retain the loyalty of
ex-UNP ministers by permitting them to pursue pork-barrel projects.
Second, the government has said it intends to build infrastructure
even where there is not currently a market demand (like the
Weerawila airport), or which could be built more efficiently by the
private sector (like an expanded oil refinery at Sapagaskunda).
Third, the government is showing signs of being short on cash to
bridge an apparently growing fiscal deficit, so it will likely use
some of the bond funds for current, rather than capital,
expenditures.

11. (SBU) While markets will likely correctly view the UNP threat as
a political move that would never materialize, the timing of the
pending bond issue appears to be as bad or worse as sixteen months
ago, when the government shelved its earlier sovereign bond issue
plan. Aside from the S&P outlook returning to stable, Sri Lanka has
had little good news to reassure currently skittish international
debt markets. Nevertheless, market watchers say that the relatively
small bond issue will probably appeal to a sufficient number of
international investors who remain interested in diversifying their
holdings of high-yielding emerging market debt.
BLAKE

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