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Cablegate: Sri Lanka Is Meeting Imf Targets

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INFO RUEHIL/AMEMBASSY ISLAMABAD PRIORITY 8950
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RUEATRS/DEPT OF TREASURY WASHDC PRIORITY
RUCPDOC/DEPT OF COMMERCE WASHDC PRIORITY

UNCLAS SECTION 01 OF 02 COLOMBO 000905

SENSITIVE
SIPDIS

DEPARTMENT FOR EEB JENNIFER PETERSON AND TANYA SPENCER
DEPARTMENT OF TREASURY FOR MALACHY NUGENT AND ATTICUS WELLER
USTR FOR MICHAEL DELANEY AND VICTORIA KADER

E.O. 12958: N/A
TAGS: CE ECON EFIN IMF PGOV
SUBJECT: SRI LANKA IS MEETING IMF TARGETS

REF: COLOMBO 724

1. (SBU) Summary. An IMF team conducting its first
quarterly assessment has determined that Sri Lanka is meeting
the targets of the July IMF standby agreement, and it appears
that the IMF staff will recommend release of the second
tranche of IMF funds in October. The IMF agreement, combined
with optimism from the end of Sri Lanka,s conflict and an
improving external economic environment, has encouraged
substantial inflows of foreign capital into Sri Lanka.
Although the road forward will be challenging, the IMF
believes that Sri Lanka is on track to build international
foreign reserves, control expenditure, increase government
revenue, and reform the banking sector. The IMF will
establish an office housed in the Sri Lankan Central Bank to
monitor compliance. Overall, the IMF seems more optimistic
than several local economists. End Summary.

IMF Mission Background

2. (SBU) Sri Lanka reached an agreement in July to
disburse $2.6 billion in eight separate tranches, with the
provision that the IMF would conduct quarterly reviews of Sri
Lanka,s progress toward IMF goals. The IMF conducted the
first such review September 8-22. Brian Aitken, head of the
IMF mission, met privately with econoff to discuss their
findings on September 21, and then held a press conference
September 22 with the GSL. Aitken commented that the GSL has
been very transparent, posted the IMF letter of intent on its
Central Bank website, and was very open during the review
process. The IMF mission will prepare a report for the IMF
board in late October, and the board will decide whether to
disburse the next tranche of $322 million. The IMF will
establish an office in the Central Bank to monitor Sri
Lanka,s economic health.

Sri Lanka is meeting the IMF Targets

3. (SBU) There have been very large inflows of foreign
exchange into Sri Lanka, which swelled Sri Lanka,s foreign
exchange reserves from $1.2 billion in March (about one month
of import cover) to $4.1 billion today. The IMF agreement
provided confidence to private investors that Sri Lanka is on
the right track. For instance, a U.S. based hedge fund has
purchased $875 million in two and four year Sri Lankan rupee
denominated government bonds. The hedge fund receives a high
interest rate from these bonds, and even though they have
taken on an exchange rate risk, several economists opined
that the hedge fund,s bet is reasonable. Similarly, the Sri
Lanka Central Bank is preparing to issue $500 million in
government bonds, and the IMF,s Aitken guessed that the bond
issue would be oversubscribed. Sri Lanka,s current account
deficit declined by almost 60% in the first six months of
2009, an 18% drop in exports was overshadowed by a 36% fall
in imports, and remittances from workers abroad increased
5.4%. Finally, the Standard and Poor,s rating service has
revised Sri Lanka,s sovereign ratings outlook from negative
to stable.

4. (SBU) Sri Lanka is having some success controlling its
spending. According to a local business journal,s analysis,
total government spending increased by 8% in the first half
of 2009, a period including the end of their 30 year civil
war. After the conflict, the GSL told Aitken that military
costs would remain stable. The GSL has an ambitious plan to
spend up to $2.4 billion on reconstruction of the war ravaged
North and East, and the GSL hopes to receive substantial
donor and private sector funding to cover much of these
costs. The Central Bank estimates that yearly GSL spending
would average 0.8% of total GDP, or approximately $320
million per year. Interest rates have also fallen, which
will help reduce government payments to cover its debt. The
real test will be the 2010 budget. The GSL is scheduled to
draw up the parameters of its spending in October and will
present its budget in November.

5. (SBU) The most difficult challenge will be to increase
revenue so that Sri Lanka escapes from chronic balance of
payments crisis. Government revenue fell by an estimated 6%

COLOMBO 00000905 002 OF 002


in the first half of 2009, reflecting declining imports (GSL
derives a key segment of its revenue from import duties) and
a weak domestic economy. The GSL has targeted increasing its
revenue by 2% of GDP by 2011, starting from the 14.9%
collected in 2008. Aitken was optimist that the GSL is ready
to make fundamental reforms to increase revenue, and he noted
that Sri Lanka has already increased its "nation building
tax" from 1.5 to 3%. Sri Lanka will also benefit from
increased revenues as the economy improves and imports
increase. GSL has a Presidential Commission to examine ways
to increase revenue, focusing on widening the taxpayer base
rather than increasing tax rates. Currently there are only
650,000 taxpayers (out of a total 20 million population) but
the GSL to start collecting from 1 million taxpayers by 2010.


6. (SBU) The GSL could meet its IMF target for two key
state owned enterprises (SOE) to break even financially by
2011. The Ceylon Petroleum Company (CPC) and Ceylon
Electricity Board (CEB) chronically lose money, but the IMF
team thought that the GSL has fully committed to reforming
these SOEs to stop the drain on government finances. The CPC
has benefited from falling international oil prices, while
they have kept domestic retail oil prices high. Similarly,
the CEB is building a coal fired electricity plant, so they
could benefit from moving from high cost oil to cheaper coal.
It is not clear that the GSL has planned real reforms of
either SOE.

7. (U) The IMF assessment was that the Sri Lanka
financial industry was in good shape. Sri Lanka avoided much
of the direct contagion of the global financial crisis
because they did not delve deeply into sophisticated
financial instruments like derivatives. Although the level
of non-performing loans is rising, reflecting weakness in
certain domestic sectors, overall the financial system is
well capitalized and the IMF did not foresee a systemic
risk. The IMF also thinks that the Central Bank supervision
of the banking industry is good.

8. (U) Sri Lanka,s GDP growth expectations are picking
up. The IMF increased its growth forecast from 3% to 3.5% in
2009, within the range of the Central Bank,s forecast of
3.5% to 4.5% growth. The Central Bank forecasts growth to
improve to 6% in 2010, and it could reach the 7% range
thereafter.

Will the GSL stick to the IMF fiscal medicine?

9. (SBU) The big question is whether Sri Lanka will stick
to the IMF targets and discipline. Several private sector
economists and business leaders were pleased with the IMF,s
involvement, which they believe will encourage GSL fiscal
discipline. The GSL now has good international reserves,
although the build up in reserves is predicated on confidence
built on the IMF agreement. Therefore, at least in the short
term, it seems that the GSL has incentives to continue
meeting its IMF targets.

10. (SBU) Comment. Econoff was surprised by the IMF,s
optimistic assessment. Although clearly the GSL has built up
its reserves, and private capital is flowing into portfolio
investments, many economists and businessmen are skeptical
that the GSL will be able to continue to meet its spending
and revenue targets. The GSL plans to call Presidential and
Parliamentary elections over the next six months, which could
lead to excessive spending. End Comment.
BUTENIS

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