SRI LANKA: ECONOMIC GULF BETWEEN NORTH AND SOUTH

C O N F I D E N T I A L SECTION 01 OF 03 COLOMBO 000495

SIPDIS

STATE PASS USTR

E.O. 12958: DECL: 03/25/2013
TAGS: ECON PTER EINV CE LTTE ECONOMICS
SUBJECT: SRI LANKA: ECONOMIC GULF BETWEEN NORTH AND SOUTH
POISED TO WIDEN

REF: A. COLOMBO 172 (NOTAL)


B. 02 COLOMBO 893 (NOTAL)

Classified By: Deputy Chief of Mission W. Lewis Amselem. Reasons:
1.5 (b, d)


1. (C) Summary: The economic gulf between northern and
southern Sri Lanka, formed over two decades of conflict, is
poised to widen in the coming years. Sri Lanka, though
nominally a united nation, is in fact divided on multiple
fronts - political, military, social and economic. Since the
formal cease-fire came into effect just over one year ago,
the economic differences between north and south have
persisted. In the south, the economy has benefited from the
cease-fire, and the government of Sri Lanka (GSL) has
initiated ambitious economic reform plans that aim to improve
the nation's productivity and per capita income. In the
north, meanwhile, the Liberation Tigers of Tamil Eelam (LTTE)
has kept the areas it controls isolated, endangering
prospects for a peace dividend. Continued divergence of
these two economies will increase the substantial north/south
wealth gap and lengthen the odds for peace in a united Sri
Lanka. End Summary.

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One country, two systems
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2. (U) When the formal cease-fire began in February 2002, Sri
Lanka's economic landscape was characterized by two distinct
economic systems - one run by the LTTE in the north, and one
run by GSL in the rest of the country. The two systems were
underpinned by radically different economic philosophies and
world-views. As would be expected, the two systems produced
radically different results.


3. (U) During two decades of civil war, GSL succeeded in
strengthening its trading links with the global economy by
developing a range of export-oriented industries. Thriving
tea and apparel exports centered in the south helped propel
the overall Sri Lankan economy to an average annual growth
rate of 5% in the 1990s. Repeated LTTE terrorist attacks,
including in the heart of Colombo, did not halt the south's
steady rise in average living standards. In the north, by
contrast, frequent and heavy fighting ravaged the local
economy: LTTE held areas saw very little formal economic
activity over a period of twenty years. In 1995, GSL imposed
an economic embargo on the LTTE that further isolated and
weakened the region's economy. The end result was a dramatic
difference in wealth between north and south. A local think
tank estimated in 2001 that GDP per capita in the Western
Province (which includes greater Colombo as well as poorer
outlying areas) stood at $1400, while per capita income in
the North and North Eastern Provinces stood below $400.


4. (U) One of GSL's early objectives after the cease-fire
began was to re-integrate the economies of north and south.
It lifted the economic embargo on LTTE areas and re-opened
the A9 road linking Jaffna with the south. GSL encouraged
traders to do business island-wide, in the hopes of
stimulating domestic commerce. One year later, however, we
find that economic integration of north and south has not
materialized and the two economic systems are set to move
further apart.

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The South: GSL prioritizes growth
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5. (U) The February 2002 cease-fire had immediate and
positive benefits for the economy of the south. In 2002
overall economic growth will come in at around 3%, a big
improvement over the 1.3% contraction the economy experienced
in 2001. (Note: Overall Sri Lanka growth rates are a
reasonable proxy for growth in GSL-held areas. The Central
Bank includes estimates of economic activity in LTTE held
areas in its overall GDP figures, but the numbers from the
north are not large enough to sway significantly the
magnitude of growth measured in the rest of the island. End
Note.) Much of the improved economic performance was due to
better crop yields, particularly in tea and paddy production.
But a cease-fire conducive to tourism and foreign investment
also played a role. Tourist arrivals in 2002 increased by
8%, and foreign direct investment was up 35% to $230 million.


6. (U) GSL is wisely not content with 3% growth. It has
launched an ambitious plan - summarized in a policy document
called "The Future: Regaining Sri Lanka" - for achieving long
term growth rates of 8-10%. The document begins by
acknowledging that some sectors of Sri Lanka's economy have
remained inefficient and uncompetitive, subsidized by more
productive sectors. It then lays out a strategy for achieving
growth targets by "removing the barriers to productivity and
putting in place review mechanisms to ensure that new
barriers do not arise."


7. (U) Thus far, after 16 months in office, the United
National Front government of Prime Minister Ranil
Wickremesinghe has made solid progress toward productivity
improvements. A new wave of privatization of state-run
enterprises has begun, with GSL having sold off full or
partial stakes in oil, telecom, mass transit and insurance.
To improve the efficiency of labor markets, GSL has enacted
legislation that gives employers more flexibility to entrench
staff when necessary. GSL has also begun to contain the
budget deficit by limiting government spending and putting in
place measures to improve revenue collection. While
implementation of "Regaining Sri Lanka" is only in the early
stages, GSL's performance to date indicates it has a credible
chance of achieving the dramatic growth rates it desires.

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The North: LTTE prioritizes control
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8. (C) The sophisticated policy prescriptions of "Regaining
Sri Lanka" are a world away from the on-the-ground situation
in Sri Lanka's war-torn north. The LTTE's plan for economic
growth - to the extent there is one - appears to be focused
on aid, not trade. The LTTE rightly reasons that it is
easier to control aid flows than it is to control capital
flows. It will gladly accept donor funds targeted at
reconstructing the north, because it can control how and
where the money is spent. Opening up the north to commerce,
by contrast, would require the LTTE to sacrifice some degree
of control over the lives of the local people - one sacrifice
the LTTE is not willing to make.


9. (C) In a press conference last April, LTTE leader
Velupillai Prabhakaran voiced the LTTE's commitment to
pursuing an open economy. But the actions of the group
indicate just the opposite: it is building a
centrally-planned economy based on a quasi-socialist model.
The LTTE is developing a sophisticated financial system (ref
A),but that system rests entirely in its hands, without any
apparent role for the private sector. The LTTE does permit
trade, but its prohibitive taxation system - especially its
"import duties" into the areas it controls - serve to dampen
economic activity. The LTTE has done nothing to attract
investment from Colombo's blue chip corporates, much less
from foreign firms. The Tigers have made a few patriotic
appeals to the Tamil diapsora to invest in the "Tamil
homeland," but it has shown no interest in working with GSL's
Board of Investment to lure capital to the north.


10. (C) To be fair, the LTTE does not have many economic
resources to work with in the north. Even before the ethnic
conflict broke out, infrastructure in the north was much less
developed than in the south. And mother nature has not been
as kind to the north as to the south: the land is less
fertile and incapable of producing high value crops like the
tea grown in south-central Sri Lanka. The Wanni region where
the LTTE is based, for instance, is exactly the kind of harsh
jungle terrain you would expect to be home to an insurgency
movement. Still, the economic policies of the LTTE since the
cease-fire have made a bad economic situation worse. If the
LTTE continues to prioritize maintaining its own control
higher than fostering trade, it will share the poor
performance of the world's other centrally-planned economies.
Aid flows may provide a temporary boost to the region, but
long-term growth in living standards will not materialize.
And the gap between north and south will widen instead of
shrinking.

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Comment: Implications for peace
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11. (C) The economic divisions that formed between north and
south over two decades of war have crystallized during the
past year. Both the LTTE and GSL have settled into their
preferred economic models: in the south, a free market
economy based on trade; in the north, a centrally planned
economy based on future aid. Unfortunately, these divergent
systems cast doubt on the future of the peace process. If
current trends continue, the south will continue to outgrow
the north, widening the prosperity gap between the regions.
The underlying economic tensions, therefore, that helped
spawn the war will not disappear, nor will the risk of
further conflict.


12. (C) Furthermore, the LTTE's unwillingness to open the
economy of the north to trade belies its commitment to a
federal system. If the LTTE were truly committed to
remaining part of a united Sri Lanka, it would welcome rather
than eschew trade links with the south and the rest of the
world. Instead, the LTTE's economic strategy is more
indicative of an organization intent on walling itself off in
a de facto separate state.

WILLS