SRI LANKAN GROWTH EXCEEDS EXPECTATIONS

UNCLAS SECTION 01 OF 03 COLOMBO 000806

SIPDIS

COMMERCE FOR ITA:ABENAISSA, 4530 MAC/AP/OSA/O:LDROKER
TREASURY FOR OTA:GSMITH, SRI LANKA DESK:GRAO

E.O 12958: N/A
TAGS: ECON ETRD EFIN CE ECONOMICS
SUBJECT: SRI LANKAN GROWTH EXCEEDS EXPECTATIONS


SUMMARY
--------------

1. According to the latest data released by the
Central Bank, Sri Lanka's economy expanded by 4% in
2002, recovering from a 1.4% downturn in 2001.
Growth exceeded Bank expectations of 3.5%, and came
mainly from the services sector. Despite this modest
increase, Central Bank expressed concern over
declining national savings, investments and
government revenues. Most other macroeconomic
fundamentals, which deteriorated sharply in 2001,
were partly restored during the year. The current
peaceful conditions, critical for economic recovery,
are expected to last, leading to projections of 5.5%
growth this year. End Summary.

GROWTH FUELED BY SERVICES
--------------

2. The Central Bank of Sri Lanka released the final
economic statistics for 2002 last week. The Bank
said the economy recovered with 4% growth after
shrinking 1.4% in 2001. This exceeded the Bank's
earlier forecasts of 3.5%. At current prices, Sri
Lanka's GDP is now $16.6 billion and per capita
income is $872.


3. Growth was gradual during 2002, but not broad
based, coming mainly from the services sector. The
economy expanded slowly in the first half and
accelerated to 6% in the second half. The high
second half growth shows recovery from the low base
in the comparable period in 2001, when the economy
suffered badly from terrorist attacks in Sri Lanka
and the U.S.


4. The services sector expanded by 6% and accounted
for about 80% of overall growth in 2002. The strong
performance in services - mainly telecommunications,
tourism, ports, trade and finance - is attributed to
this sector's flexibility in a changing environment.
Agriculture grew by 2.5%, staging a partial recovery
from a 3.4% downturn in 2001. The industrial sector
grew slowest at 1% due to weak export demand.
Domestic consumer demand contributed significantly to
growth and aggregate demand. The contribution to
overall growth from investment was just 12%. The
Central Bank reported a notable increase in corporate
profits (i.e., of the 30 largest companies on the
Colombo Stock Exchange) during the year when compared
to 2001.

INVESTMENT, SAVINGS, INFLATION, UNEMPLOYMENT
--------------

5. The Central Bank expressed concern over the
falling national savings and investments ratios.
National savings declined to 19.7% of GDP from 20.3%
in 2001 while investment declined to 21.3% of GDP
from 22% in 2001. Both were well below the rates of
25% and 28% of GDP, respectively, required to achieve
sustainable growth of 7-8%.


6. Inflation declined to 9.6% in 2002 from 14.2% in
2001 despite price increases in a number of goods and
utility services. This decline in inflation was the
result of high real interest rates that checked
demand, the relative stability of the exchange rate,
low import prices, increased supply, and peace, as
well as the absence of major wage increases.
According to data for the first three quarters,
unemployment has risen to 9.1% of 2002 from 7.9% in
2001 with 641,000 unemployed. Underemployment also
remained high. The sharp increase in unemployment
was partly due to increased labor force
participation.

FISCAL CONTROL
--------------

7. The government was able to exert fiscal control
after experiencing major slippages in 2001. The
budget deficit was restricted to 8.9% of GDP, a
significant improvement from 10.8% deficit recorded
in 2001, although it was still higher than the
budgeted estimate of 8.5% of GDP for 2002. Revenue
was below expectations at 16.5% of GDP. With revenue
shortfalls of Rs 17 billion (approx. $178 million),
budgetary control was achieved through expenditure
cuts, which restricted government spending to 25.4%
of GDP. The Central Bank expressed concern over
falling revenues. Revenue slipped from 21% of GDP in
the early 1990s due to tax exemptions and a decline
in revenue mobilization. Public debt reached 105.3%
of GDP.

TRADE DEFICIT WIDENS - CAPITAL FLOWS HELP
--------------

8. On the external front, export sector performance
was disappointing, declining by 2%. Imports
increased by 2%. Consequently, the trade deficit
increased to $1.41 billion in 2002 from $1.15 billion
in 2001. The Services account improved
significantly, recording a surplus of $271 million.
Private remittances also grew strongly by 11% to $1.3
billion. The current account recorded a deficit of
1.6% of GDP, but was offset by a surplus in the
capital account. The BOP recorded a surplus of $338
million compared to a surplus of $220 million in

2001. Gross official reserves rose to $1.7 billion
at end of 2002, sufficient to finance 4.9 months of
imports.

OUTLOOK FOR 2003: GROWTH AND THE PEACE DIVIDEND
-------------- --

9. According to the Central Bank, the Sri Lankan
economy is expected to grow by 5.5% in 2003. All
major sectors of the economy are expected to expand.
This growth will, however, depend on the continuation
of the peace process, policy adjustments
(particularly budgetary control) and structural
reforms. Recovery in the global economy is also
needed - especially demand for Sri Lanka's apparel
exports and effective utilization of concessionary
assistance announced by IMF and other donors.


10. Inflationary pressures are expected to further
decline and annual inflation is expected at 7.5%.
The trade deficit is forecast to rise as imports grow
faster than exports, due to increasing investor and
consumer confidence. Foreign financial flows are
expected to rise and contribute to a BOP surplus once
again. Investment is projected to increase from
21.5% of GDP in 2002 to 24% in 2003. The budget
deficit is forecast around 7.5% of GDP, almost 1.5%
lower than in 2002.


11. At a seminar to explain the outcome of 2002
economic performance, Central Bank's director for
economic research said that the economy has been
helped by the current cease-fire and ongoing peace
process. Peace has led to an increase in economic
activity (especially in agriculture, tourism, trade
and internal transport) and the containment of non-
productive expenditure. Significantly, defense
expenditure has declined to 4.0% of GDP in 2002 from
4.9% in 2001. In nominal terms, the actual defense
bill was Rs 60 billion ($627 million) in 2002,
compared with an estimated requirement of Rs 100
billion ($1 billion) in the absence of peace.


12. These savings have contributed to a reduction of
2% of GDP in the budget deficit, helped to contain
the rapid increase of public debt witnessed in the
previous years and, at least partially, reigned in
other macroeconomic imbalances in the economy. The
relative decline in government demand for domestic
resources (due to lower defense spending) helped to
ease the pressure on interest rates. The
availability of goods and services increased, due to
removal of road barriers. Business confidence also
rose as indicated by sharp increases in the Colombo
Stock Exchange (CSE) indices. CSE indices rose 45%
during 2002. Defense related imports also declined,
easing pressure on external assets.


13. More importantly, the peaceful environment has
created a conducive environment for the government to
launch the key - and difficult - structural reforms
needed for economic management. These include labor
market reforms, increases in administered prices,
privatization, and social safety net reforms. It
also enabled the government to announce explicit
short and medium term fiscal discipline targets
contained in the Fiscal Management (Responsibility)
Act. Critically, the environment enabled donors to
approve long-term concessionary funds required to
rebuild Sri Lanka under PRGF facilities.

Wills