FTA IMPLICATIONS OF SRI LANKAN INVESTMENT CLIMATE

C O N F I D E N T I A L SECTION 01 OF 03 COLOMBO 001686

SIPDIS

DEPT PLEASE PASS TO E, EB, SA/INS, SA/RA, DRL
DEPT ALSO PASS TO USAID FOR BERNADETTE BUNDY - ANE/SA
DEPT ALSO PASS TO USTR FOR AUSTR WILLS
TREASURY FOR JERRY ADKINS
DOL FOR SUDHA HALEY
NSC FOR ELIZABETH MILLARD
COMMERCE FOR ARIADNE BENAISSA
TOPEC

E.O. 12958: DECL: ONE YEAR AFTER CONCLUSION OF US-SL FTA
TAGS: ETRD EAID ECON EFIN KIPR ELAB PREL CE ECONOMICS
SUBJECT: FTA IMPLICATIONS OF SRI LANKAN INVESTMENT CLIMATE

Ref: a) Colombo 1673, b) Colombo 1386, c) Colombo 772


1. (U) Classified by Ambassador Jeffrey J. Lunstead for
reasons 1.5 B and D.


2. (C) Summary: The investment climate in Sri Lanka is
improving and the GSL is committed to economic reforms and
attracting more capital as the island continues its efforts
to restore peace and prosperity. The Indo-Lanka FTA,
increasing interest of major U.S. companies, and efforts by
the GSL and the private sector to diversify exports and
improve competitiveness are indicators of a government we
can work with in forging a closer bilateral trade
relationship. Challenges remain, however, and one avenue
for our influence is through FTA negotiations. USAID is
already involved in several areas of capacity building and
economic reform and has indicated it could do more in the
lead up to FTA negotiations. End Summary

Investment Climate
--------------


3. (U) The investment climate in Sri Lanka is improving
and well poised to take advantage of a potential US-SL FTA
(Ref A). GSL emphasis on free trade and bilateral FTAs has
spurred interest in foreign investment. U.S. and other
foreign investment is steadily climbing upward (admittedly
from a very low base). Private sector interest is
increasing in the power, IT, telecom, infrastructure and
financial services sectors and the GSL is actively
soliciting additional investment in these areas. The Indo-
Lanka Free Trade Agreement has led to some increased
investment in SL as a production point for the Indian
market (Ref C). There is great potential for US firms to
reach the huge Indian market through Sri Lanka at greatly
reduced, even zero, tariff rates. FTAs with Bangladesh and
Pakistan are reportedly also in the offing.


4. (U) Increasing interest in Sri Lanka on the part of
global investors and the GSL's sound fiscal policies, are
having an overall positive effect on the economy.
Inflation has shown a sharp decrease this year (latest
estimates are approximately 6.5 percent, down from 9
percent a year ago). The central bank has further reduced
interest rates and the currency has strengthened, with a
three percent appreciation in the last two months.
Projected GDP growth is estimated to be somewhere between
5.5 and 6.5 percent for the year. Finally, the budget
deficit appears to be on track for hitting its target of
7.5 percent of GDP.


5. (SBU) However, major problems have not yet been
eliminated. Regulatory barriers, corruption and a lack of
transparency, as well as general bureaucratic hassles (due
in part the proliferation of ministries - over 75 and
counting),continue to plague the investment process.
Further, the GSL currently keeps tremendous responsibility
and decision-making authority in a tiny inner circle
surrounding the PM. This causes significant decision-
making bottlenecks and creates a serious transparency
issue. Devolution of decision-making authority and
responsibility, along with regulations and reforms to help
insulate decision makers from political influence - while
still protecting the integrity of the process - are
imperative. The government procurement process is slow and
opaque, lacks technical capacity and is subject to
political and personal influences.


6. (C) As mentioned in previous reporting (Ref A),U.S.
companies such as Microsoft, Dell, Honeywell, Program
Development International, Bechtel, Lockheed Martin, GE and
Caterpillar are seriously looking at Sri Lanka or are
already present in the market. The potential for
investment in infrastructure and market development
programs over the next five to ten years is over USD 5
billion.


7. (C) On the other hand, the January 2005 expiration of
the Multi-Fiber Agreement (MFA) looms large, and Sri Lanka
believes that only a FTA with the US will help offset the
negative effects on the garment industry. The rationale is
clear; 68 percent of Sri Lanka's garment exports are to the
US. Best estimates are that Sri Lanka's garment industry
will consolidate significantly. Those companies that have
focused on the high-end specialty garment markets will
survive and, potentially, thrive while smaller, general
merchandise factories will close or merge. The GSL is also
attempting to diversify its exports to end its reliance on
the garment sector.


8. (C) Many of Sri Lanka's garment manufacturers have
begun the transition to insulate themselves against the end
of the MFA. The Joint Apparel Association specifically is
promoting a move to high-end, specialized garments,
improved efficiency, introduction of new manufacturing
techniques and is offering assistance to factories seeking
ways to become more competitive in the post-MFA world. We
recognize that an FTA would not allow 100 percent duty-free
entry of all garments, but the GSL will be sure to push
hard on garments in any FTA negotiations.

Economic Reforms
--------------


9. (C) The GSL is committed to the economic reform
process and continues to make headway - particularly in the
areas of debt management, monetary policy and macroeconomic
stabilization. In the past two years, the GSL has
implemented promising changes in many areas. It has made
upward adjustments of utility, transport, wheat flour and
fuel prices and eliminated subsidies. One hundred percent
foreign ownership is now allowed in formerly restricted
sectors, including banking, insurance, finance, supply of
water, mass transport, telecom and professional services.
Long-term debt instruments have been added and incentives
offered to investors under the Board of Investment were
restructured and reduced. Civil service recruitment was
frozen. Some licensing controls on agricultural products
were removed. The tax system was reformed with the
introduction of a VAT in August 2001, a tax on bank debits
and interest and a reduction in the import duty surcharge.


10. (C) While progress has been made on privatization, it
proceeds at a slow and uneven pace. Contract enforcement
mechanisms are a weak spot and revenue collection needs
more improvement. Several areas of reform are under
review, including land, labor laws, banking and regulatory
issues.


11. (C) The GSL also will benefit from considerable
outside expertise in the reform arena. This is true
particularly with regard to:

-- the budget process and debt management (through U.S.
Treasury Advisors),

-- investment (via an UNCTAD consultant on investment),
-- the financial services sector (through new laws and
policies aimed at deepening the financial sector and the
creation of a stronger secondary debt market) and

-- competitiveness policy (via the USAID sponsored
competitiveness initiative).


12. (C) The GSL is committed to making many of the tough
decisions necessary to move forward with economic reform,
setting the right tone as capital comes looking for a place
to invest. While there are still areas that need to be
improved, our influence can have a powerful effect, and our
interests would be well served by engaging on many of these
topics through the mechanism of FTA negotiations as
outlined in Ref A.

LUNSTEAD