SRI LANKA ECONOMIC UPDATE, AUGUST 2005

UNCLAS SECTION 01 OF 03 COLOMBO 001492

SIPDIS

STATE FOR SA/INS

MCC FOR SGROFF, DNASSIRY AND EBURKE

E.O 12958: N/A
TAGS: ECON EAID CE ECONOMICS
SUBJECT: SRI LANKA ECONOMIC UPDATE, AUGUST 2005



1. Summary: GDP growth slowed to 4.8 percent in the first
quarter of 2005, against 6.4 percent for the same period in

2004. While the Central Bank says the growth momentum (to
achieve growth over 5 percent) is continuing as expected,
high inflation is a major worry. A recovery in agriculture
and continued growth in exports, including garments and
services, are expected to boost growth prospects in the
coming months. Tourist arrivals are up, but the industry
is unhappy as most of the tourists are budget travelers.
Both imports and exports rose sharply in the first six
months of 2005. The trade gap widened to $1.2 billion in
2005 from $1.1 billion in 2004. However, due to higher
remittances, official inflows to the government in the wake
of the December 26 tsunami and debt relief, official
reserves have increased by about $200 million to around
$2.4 billion in June 2005 from $2.2 billion in December

2004. Reflecting these developments, the rupee has
appreciated by about 3.6 percent against the dollar, as of
mid August. Political uncertainty, including constitutional
challenges to the proposed tsunami aid sharing mechanism,
the murder of the Foreign Minister, questions regarding the
date of the next presidential elections, the withdrawal of
a key Government coalition partner and the volatile security
situation could also dampen growth. End Summary

4.8 Percent Growth in the First Quarter


2. GDP growth slowed to 4.8 percent in the first quarter
of 2005, compared with 6.4 percent for the same period in

2004. The slowdown is primarily attributed to the tsunami
damage. It has seriously affected fishing and tourism
while dampening growth of banking, small industry, domestic
trade and transport sub sectors. The industrial sector
grew by 7 percent compared with 5.9 percent growth in 2004.
Domestic agriculture recovered (as Sri Lanka recorded a
bumper rice harvest),but due to heavy damages to fisheries,
the agriculture sector growth was restricted to 0.5 percent.
Services sector growth also slowed to 5.3 percent from 9.5
percent in 2004. Telecommunications sector remained robust,
expanding by 35 percent. The tourism (hotels) sector
recorded a drop of 40 percent. The banking sector recorded
a marginal decline, due to rescheduling of loans granted to
tsunami affected business as well as a narrowing of the

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interest rate spread.


3. The Central Bank is anticipating a further recovery in
the economy during the rest of the year, with all three
major sectors, agriculture, industry and services,
contributing to growth. The economy is projected to
register a growth rate of 5 to 5.5 percent in 2005. These
projections are in line with IMF observations following
Article IV consultations with Sri Lanka in early August.
The IMF observed that the near term prospects for economic
growth are positive-- with reconstruction and a strong
performance in agriculture expected to offset adverse
impact of tsunami damage. IMF, however, cautioned about
several imbalances:
-- inflationary pressures due to reconstruction
bottlenecks;
-- large fiscal deficits
-- high level of public debt
-- central Bank financing of the budget
-- high monetary expansion
-- the fiscal status of debt ridden state owned utilities.

Tourism not recovered


4. Tourist arrivals in the first seven months of 2005 were
up 13 percent when compared to 2004. However, industry
sources indicate that these numbers do not reflect the true
status of the resort tourist market. Key growth segments
in the post-tsunami period have been aid workers, visitors
(mostly Indian) on short-term, shopping-targeted, highly
discounted tour packages, and conference and business
travelers. These travelers stay mostly in city hotels,
which have consequently posted high occupancy levels (75
percent) during this period. Resort hotel occupancy, on
the other hand, has averaged below 40 percent.

Inflation remains high


5. Average inflation was running at 12.7 percent in July.
Despite high inflation, mainly due to higher oil prices,
the Central Bank in its August monetary review left key
interest rates unchanged, saying instead it would continue
to conduct aggressive open market operations to curb
inflation. The government also removed the Value Added Tax
(VAT) on diesel, milk powder and cooking gas in order to
reduce the impact of rising petroleum prices. The VAT
reductions are aimed to help the suppliers recover costs.
The Central Bank hopes these tax revisions would also help
to stabilize prices. Previously, the Central Bank raised
its benchmark interest rate twice in (in May and June) to
help dampen inflation.


6. Nevertheless, money supply growth remains around 20
percent due to increased credit to both public sector and
private sector (the GSL had earlier announced it would
target 15 percent money supply growth for the year). Money
supply growth is expected to moderate following an expected
lag in the transmission of the effects of the rate hikes to
the financial system.

External Sector


7. Sri Lanka?s exports in the first half of 2005 rose 11.5
percent to $2.9 billion. Imports were up 10.3 percent to
$4.1 billion. Consequently, the trade deficit widened to
$1.2 billion from $1.1 billion in 2004. Despite fears of
market losses following abolition of the MFA, Sri Lanka?s
apparel exports rose by about 9 percent to $1.08 billion in
the first five months of 2005. Tea exports also rose by
7.7 percent to $307 million during this period. While tea
production has risen this year, average tea prices at the
Colombo tea auction have dropped quite sharply in June and
July. The drop has been attributed to reduced demand from
Europe, lower quality tea, and the appreciation of the Sri
Lankan rupee. Detailed trade data for the first half of
2005 is not yet available. Due to higher remittances,
official post-tsunami inflows to the government and debt
relief, official reserves have increased by about $200
million to around $2.4 billion in June 2005 from $2.2
billion in December 2004. Reflecting these developments,
the rupee has appreciated by about 3.6 percent against the
dollar through mid-August.

Fiscal Operations


8. Recent tax (VAT) cuts on diesel, milk powder and
liquefied petroleum gas are expected to cost over Rs 10
billion (USD 100 million) or about 0.5 percent of GDP. In
addition, Government expenditure will also increase due to
subsidies, particularly on petrol and diesel. As a result,
the budget deficit is likely to exceed the pre-tsunami
deficit target of 7.6 percent. Due to increases in VAT and
import duty in 2004, government revenue rose by over 20
percent in the first five months of 2005.

Political Uncertainty


9. The withdrawal of the Janatha Vimukthi Peramuna (JVP)
(a nationalist/Marxist party) from the Government, reducing
it to minority status, legal problems confronting the Post
Tsunami Operational Management Structure (P-TOMS - also

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known as the ?joint mechanism? - was to facilitate
unspecified donor funding to the North and East, including
the LTTE controlled areas, through a transparent mechanism
involving GSL, LTTE and the foreign donors rather than
channeling aid directly to the LTTE),the controversy over
the date of the next presidential election, the August 12
assassination of the foreign minister, and the volatile
security situation will affect the economic climate in the
next few months. Yet, despite several of these
uncertainties, Sri Lanka?s equity market boomed in early
July when a major mobile operator raised Rs 8.5 billion
($85 million) through a public share issue. The share
issue attracted heavy foreign interest, reflecting the
investment potential for well run companies in rapidly
growing sectors.


10. The assassination of the Foreign Minister also did not
have a major negative impact on the stock market. On the
first day of trading following the assassination, the All
Share Price Index lost 17 points (0.88 percent) and
capitalization was down by Rs 5.3 billion ($53 billion).
There was no further erosion of indices since then and the
market has stabilized at this level.


11. The JVP?s withdrawal from the Government may have
strengthened the Government?s policy making abilities.
For example, since the JVP withdrawal, the Cabinet has
been able to approve a new restructuring plan for the
Ceylon Electricity Board (CEB). The new plan replaces a
controversial proposal, which would have dismantled the CEB
and formed several independent companies. The plan was
opposed by the JVP and was later withdrawn due to threatened
blackouts by JVP-led unions. The new plan does not have the
approval of the JVP-led union either, but the Cabinet was
able to approve it without dissent. The new plan proposes
to form several subsidiary companies, still under the CEB,
and also requires tariff revisions and the adoption of a
least cost generation plan with heavy reliance on new coal
plants as a total solution to the current CEB problems.
CEB's major professional trade union, the CEB Engineers'
Union, has given its approval to the new plan.

Entwistle