IMI - INVESTMENT CLIMATE STATEMENT, 2006 ? SRI LANKA

UNCLAS SECTION 01 OF 34 COLOMBO 000321

SIPDIS

SIPDIS

STATE FOR EB/IFD/OIA AND SA/INSSTATE PASS USTR
STATE PASS OPIC, TDA, EXIM

TREASURY FOR DO/GCHRISTOPOLUS

USDOC FOR ITA/ATAYLOR

E.O 12958:N/A
TAGS: EINV, EFIN, ETRD, ELAB, KTDB, PGOV, ECON, OPIC,
USTR, CE
SUBJECT: IMI - INVESTMENT CLIMATE STATEMENT, 2006 ? SRI
LANKA
REF: (A)

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1. THE FOLLOWING IS THE INVESTMENT CLIMATE STATEMENT
FOR SRI LANKA FOR 2006.

INVESTMENT CLIMATE STATEMENT SRI LANKA

February 2006


CLAIMED OPENNESS TO FOREIGN INVESTMENT; REALITY DIFFERS
-------------- --------------

2. Over the past two years, Sri Lanka has begun to
change course economically and is heading in a more
statist direction. It has shown significantly less
interest in economic reform and the privatization of
loss-making state-owned enterprises than previous
governments and has apparently decided not to pursue a
program with the International Monetary Fund (IMF),
which, along with the World Bank, has provided budget
support in the past. On the trade front, Sri Lanka had
played an active and productive role in the WTO Doha
Round, up to the Cancun Ministerial in June 2003. More
recently, however, Sri Lanka has taken a much more
defensive posture in the WTO and has instituted a
number of import and export fees and para-tariffs that
have increased the cost of trade. While the economy
continues to grow, inflation and a depreciating
currency are deteriorating purchasing power. The
recently elected Government of President Mahinda
Rajapakse has not taken significantly different stances
economically from the previous Government headed by
President Chandrika Kumaratunga, but both have been
more statist in their approach to the economy than the
government that ruled from 2002-2004. Since the
implementation of the cease-fire in early 2002, Sri
Lanka has seen increased interest on the part of
potential foreign investors, but the on-again, off-
again nature of the peace process has tended to depress
the overall flow of funds into the country.

--Historic Progress; Conflictive History

3. Sri Lanka?s economic growth over the past decade
averages 4.6 percent annually. The country has
traditionally boasted unique human development
achievements for a developing country although it has
seen some of its neighbors surpass its earlier
achievements. Sri Lanka's per capita income of USD
1,100, a literacy rate of over 90 percent in the local
language, and life expectancy of 72 years rank well
above those of India, Bangladesh and Pakistan, yet fall
behind other neighbors such as Singapore and Thailand.
It is generally acknowledged that English ability has
declined significantly since the 1970s. While Sri
Lanka?s progress in achieving UN Millennium Development
Goals (MDGs) compared to its South Asian neighbors is
commendable, Sri Lanka needs to address several issues
in meeting the MDGs by 2015. These include disparities
in achievement at sub-national levels and reducing
poverty (23 percent according to the official poverty
line for Sri Lanka).

4. The 20-year ethnic conflict between the U.S.
designated terrorist organization Liberation Tigers of
Tamil Ealam (LTTE) and the Government of Sri Lanka
(GSL) has been widely recognized as a key impediment to
development and as an obstacle to foreign investment.
A Norwegian-brokered cease-fire between the LTTE and
the government, in effect since February 23, 2002,
continues to hold despite the LTTE withdrawal from
peace talks in April 2003 and continuous tit-for-tat
killings between LTTE members and anti-LTTE

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paramilitaries, hartals by Muslims and Tamil
communities in the east and the August 12 assassination
of Sri Lanka?s Foreign Minister, among other factors.
After a rapid escalation in violence immediately
following the election of Mahinda Rajapaksa as
President on November 17, 2005, the GSL and LTTE agreed
to meet in Switzerland on February 22 and 23 for talks
to strengthen the ceasefire. There does not seem to be
an appetite on either side for an immediate return to
full-scale hostilities, but increasing violence,
particularly on the part of the LTTE, is a worrying
trend. Despite cease-fire violations, however, the
peace process had substantially improved the political,
economic and investment climate and initially resulted
in attracting substantial funding from multilateral and
bilateral donors to rebuild the country. The lack of
recent progress on the peace front as well as
difficulty in facilitating rapid reconstruction,
however, has led to concerns that donor money for
reconstruction may be diverted to other countries.
Investment interest has also waned in the last year.

--December 26, 2004 Tsunami

5. The December 2004 tsunami caused extensive damage
to life and property, affecting Sri Lanka?s economic
performance. Approximately 32,000 people were killed,
another 6,300 are missing, and 443,000 people were
displaced. A joint damage and needs assessment by the
key donor agencies estimated the overall damage to Sri
Lanka at around USD 1 billion, with a large portion of
losses concentrated in the housing, tourism, fisheries
and transportation sectors. Major export sectors were
not affected. Some of the worst destruction was in
areas under LTTE control. An agreement on coordinating
tsunami aid signed between LTTE and Government

SIPDIS
representatives in June 2005 (known as Post-Tsunami
Operational Management Structure (P-TOMS)) was
challenged in court and has never been implemented.
According to post-tsunami assessments, Sri Lanka needs
approximately USD 1.5 billion to implement a
reconstruction program. After one year, Sri Lanka has
completed the construction of 53,000 transitional
shelters and is well into its permanent housing program
with approximately 20,000 units completed. The entire
rebuilding program will likely last three to five
years.

--Leadership Changes

6. Since independence, the rule of government has
alternated between the two major political parties, the
United National Party (UNP) and the Sri Lanka Freedom
Party (SLFP),or coalitions led by them. Both the UNP
and the SLFP generally support open and outward looking
economic policies. However, some coalition partners
have thwarted such policies, leading to a failure to
embrace consistent economic reform policies. This
political complexity has sent confusing and
inconsistent messages to investors and donors.

7. A Presidential election was held in Sri Lanka on
November 17, 2005. Former Prime Minister Mahinda
Rajapaksa of the SLFP, backed by the Marxist-
Nationalist Janatha Vimukthi Permuna (JVP),the
Buddhist monk-based Jathika Hela Urumaya (JHU) and some
other minor parties was elected President, narrowly
defeating Opposition Leader Ranil Wickremesinghe of the
UNP. Rajapaksa had been Prime Minister in former-
President Kumaratunga?s government, which took over
following general elections in April 2004. In those
elections, Kumaratunga aligned her party with the JVP

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to form the United People?s Freedom Alliance (UPFA).
Later, the JVP quit the Government to protest the
coordination agreement (P-TOMS) between the Government
and the LTTE.

--New Economic Policies

8. While Rajapaksa?s tenure is quite young, his broad
economic strategy was outlined in his election
manifesto ?Mahinda Chintana? (Mahinda?s Thoughts) and
used for development of the 2006 Government budget.
Mahinda Chintana loosely follows the previous
government?s Economic Policy Framework ?Creating Our
Future, Building Our Nation?
(http://www.treasury.gov.lk) which focused on
developing the small and medium enterprise sector
(SME),agriculture and infrastructure, with a heavy
reliance on government intervention in markets.
Rajapaksa?s policies also have a heavy focus on poverty
alleviation and redistribution of economic gains to
disadvantaged areas. The Government rejects the
privatization of state enterprises, including
?strategic? enterprises such as state-owned banks,
airports, and electrical utilities. Instead, it plans
to retain ownership and management of these enterprises
and make them profitable. At the same time, it is
taking steps to further expand the already enormous
civil service. The previous government created three
new agencies intended to improve state-owned
enterprises: The Strategic Enterprises Management
Agency (SEMA),the National Council for Economic
Development (NCED) and the Procurement Management
Agency. It appears the current Government will retain
these institutions.

9. The 2006 budget, presented to Parliament in
December 2005, increased corporate and personal taxes
and other indirect taxes. These taxes are in addition
to prohibitive new taxes on the acquisition of land by
foreigners (except foreign investors meeting certain
criteria) and a new import fee on a range of consumer
goods and non-essential items introduced in 2004.
These additional taxes on imports go against the
liberal trade regime once followed by Sri Lanka. An
?Economic Service Charge? (ESC) tax, ranging from 0.25
percent to 1 percent of turnover depending on the type
of business, applies to all companies with turnover
exceeding Rs 50 million (USD 500,000),including those
currently benefiting from tax holidays. Companies
already paying income tax will be able to offset the
new tax against their income taxes. Nevertheless, for
some companies, especially foreign investors which have
tax holidays, it will be an extra financial burden.
The private sector is also concerned about a government
initiative to mandate specific wage increases for
private sector workers.

10. On a positive note, the government has
acknowledged the vital role that both foreign and local
private investors play in the economy. Tax holidays
have been offered to industries that set up outside the
Colombo and Gampaha Districts in the Western Province
in addition to tax holidays and other incentives
already offered to investors by the Board of Investment
of Sri Lanka. In addition, the budget also identified
a list of infrastructure projects to be developed in
the next few years.

--Economic Statistics

11. The economic situation in Sri Lanka in 2005 was
remarkably stable, considering the huge potential

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impact of the 2004 tsunami. The Tsunami?s overall
economic impact appears to have been less severe than
originally feared. Growth is expected to remain above
5.5 percent in 2005 and 6 percent in 2006. Part of the
adverse impact on growth was offset by the
reconstruction effort. Also, tourism and fishing, the
two industries most heavily affected by tsunami,
comprise a relatively small share of overall GDP.
While inflation rose significantly in the months
following the tsunami, it has begun to moderate, and
fell to around 11 percent (from a high of 16 percent)
in December 2005. Monetary policy has continued to be
looser than forecast by the Central Bank and interest
rates have been held artificially low in comparison to
inflation.

12. Foreign investment remained stagnant, below USD
150 million in 2005. External trade was quite robust:
exports rose by 10 percent and imports by 14 percent
during the first ten months of 2005. Due to higher
imports, the trade deficit has increased 25 percent to
USD 2.1 billion during this period. The Government is
trying to minimize the fiscal impact of the
reconstruction program by seeking foreign assistance.
Meanwhile, the GSL accepted a Paris Club offer by
industrialized countries, including the US, to freeze
its debt payments until the end of 2005. This released
approximately USD 300 million from the regular budget
(currently allocated for debt repayment) for
reconstruction. In addition, the IMF has provided an
emergency loan of about USD 159 million to Sri Lanka.
The World Bank and the ADB have also pledged both grant
and loan assistance. Due to the debt moratorium
granted by several donors, a USD 100 million syndicated
loan raised by the Government in December, and
increased remittances by Sri Lankan workers abroad, the
overall Balance of Payment (BOP) is projected to record
a surplus of around USD 500 million in 2005. This is a
strong contrast to Sri Lanka?s USD 200 million deficit
in 2004. Total reserves increased to USD 4.1 billion
as of October 2005 from USD 3.4 billion in December
2004 and were sufficient for 5.5 months of imports.
The rupee strengthened in early 2005 because of
speculation on aid flows for post-tsunami
reconstruction. However as aid flows began to moderate
and the underlying inflation concerns continued, the
rupee began to depreciate in late 2005. According to
the Central Bank, due to the higher nominal growth in
the GDP, the outstanding debt stock is estimated to
decline to 98 percent of GDP by end 2005 from 105.5
percent at end 2004.

--Public Finance

13. Weakness in public finance is a key worry.
Government fiscal control deteriorated in 2004-2005.
Both the new government and the previous government
focused on a larger government and increased welfare
spending. Although, the government attempted to rein
in the fiscal deficit by revising petroleum prices
upwards, and removing a costly subsidy on wheat flour,
these moves were insufficient to offset rising import
prices. Numerous subsidies continue, including those
for petroleum, electricity and fertilizer. Several
private and public sector players in these sectors have
suffered financial losses due to government?s failure
to pay the required subsidy costs or to allow price
increases in a timely manner.

14. The 2006 budget envisages a deficit of 9.1 percent
of GDP. Tsunami expenditure will account for about 1.8
percent of the deficit and will be financed largely by

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foreign grants and loans. The budget focuses on
reducing poverty through assistance to farmers and
development of the agriculture sector, increasing
welfare benefits to poorer sections and on higher
spending for public infrastructure. It also includes
significant increases in government employment and
public sector wages. The Government will hire 10,000
new graduates in 2006, in addition to about 42,000
hired in 2005, in an effort to stem unemployment,
thereby expanding public sector employment by about 5
percent. As previously explained, the Government is
trying to boost tax revenues through increased direct
and indirect taxation. The Rajapaksa Government has
expressed a desire to maintain macroeconomic stability
(albeit at a delayed pace),and put fiscal reforms in
line with the policy outlines of the Fiscal Management
?Responsibility? Act, which has a deficit and debt
reduction plan over the medium term.

--Sri Lanka Obtains Sovereign Ratings

15. Sri Lanka received its first sovereign ratings on
December 8, 2005. Fitch Ratings assigned Sri Lanka a
?BB-minus? rating (sub-investment grade) noting that
all the long-term rating outlooks were stable.
Standard and Poor?s rating was slightly lower at ?B-
plus?. The sub-investment grade ratings were related
to continuing uncertainty surrounding Sri Lanka?s
political situation, the peace process and the
relatively high budget deficit. The rating agencies
commended Sri Lanka?s resilience to adverse shocks,
strong institutions and an unblemished debt service
record. Analysts widely expect Sri Lanka to use the
rating to seek capital on the international market at
better rates than the prevailing 11 percent domestic
rate. The GSL would possibly use the ratings to pursue
a foreign bond issue.

--IMF Programs No Longer Being Pursued

16. In 2003, the IMF approved a three year Poverty
Reduction Growth Facility (PRGF) and an Extended Fund
Facility (EFF) arrangement for SDR 413 million (USD4.31
million). The programs were put on hold after the first
disbursements in 2003 due to lack of progress with key
structural reforms. The current Government is not
pursuing an IMF program as they do not intend to
implement the kinds of economic reforms that would be
required.

--ADB/WB Investment Climate Assessment

17. According to a joint Asian Development Bank
(ADB)/World Bank (WB) investment climate assessment
released in June 2005, Sri Lankan firms have identified
sharply deteriorated infrastructure (electricity and
transport) and cost of finance as major constraints for
doing business. The study surveyed 450 urban and 1,300
rural firms during 2003/2004. Over 40 percent of urban
firms cited electricity as the biggest constraint for
investment followed by policy uncertainty, macro
instability, cost of finance and labor regulations.
Rural firms cited transport problems as the key
constraint followed by cost and access to finance and
marketing. Rural firms identified lack of electricity
as the fifth biggest constraint. The survey also
generally lists labor regulations and infrastructure
deficiencies as the most severe constraints affecting
FDI. Other perceived constraints to FDI were concerns
about the peace process, and economic and regulatory
policy uncertainty.


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--Possible Post-Tsunami Commercial Opportunities

18. There may continue to be commercial opportunities
for US companies in the post-tsunami reconstruction
program. The bulk of reconstruction expenditure will
be spent on housing, transportation infrastructure
(roads, railway and ports),fisheries infrastructure
(harbors, anchorage and related facilities),water
supply and sanitation projects, and school and hospital
buildings. There may also be opportunities in public
infrastructure programs. The government plans to
undertake several development programs in the next few
years. The 2006 budget estimates a 51 percent increase
in the public investment program.

--Risks to the Economy

19. Numerous risks and challenges to the economy
remain. Continuing cease-fire talks might not lead to
tangible progress on peace. Despite his recent
electoral victory, President Rajapaksa must depend on
an inherently unstable Parliamentary coalition. There
are concerns regarding the speed of reconstruction and
resettlement of the tsunami affected population. Other
down-side risks will stem from uncertainties over oil
prices, government fiscal largesse and the continued
impact of the end of the Multi-Fiber Agreement, which
set quotas on developing country textile exports to
developed countries, although large factories
accounting for the bulk of the exports are expected to
continue to perform well. Another major business
concern in the medium term is the cost and availability
of power. Sri Lanka has faced episodic power
shortages, with the most recent period extending from
mid 2001 to early 2002. Although new power plants have
been added, the government has yet to procure
sufficient low-cost base load power to avert a power
crisis in the medium term. There has been some recent
activity toward a 300 megawatt coal plant from China,
though the government is still to prove that it can
deal with entrenched opposition in the community around
the proposed site. Despite the dire need for power,
the JVP resists Government moves to restructure the
state owned electrical utility board, thus reducing the
possibility of solving power problems in the
foreseeable future. High oil prices are also causing
an already inefficient and money losing state-owned
electrical company to face serious cash flow
difficulties and to backtrack on power purchase
agreements and contractual obligations. Uncertainty
over the future of the energy sector has led most
businesses to install onsite generating capacity.

--Board of Investment

20. The Board of Investment (BOI) (www.boi.lk),an
autonomous statutory agency, is the primary government
authority responsible for investment, with a particular
emphasis on foreign investment. The BOI acts as a
facilitator for investment. It is intended to provide
"one-stop" service for foreign investors, with duties
including approving projects, granting incentives, and
arranging services such as water, power, waste
treatment and telecommunications. But the BOI is best
at assisting investors who want to establish operations
within its industrial processing zones. It also
assists people in obtaining resident visas for
expatriate personnel and facilitates import and export
clearances. The BOI has undertaken a major review of
its activities in order to improve its services. The
Bureau for Infrastructure Investment (BII)
(www.bii.lk),a division of BOI, has responsibility for

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coordinating all private infrastructure projects.
Projects are usually structured on the basis of build,
own, operate (BOO),build, operate, and transfer (BOT)
or build, own, operate, and transfer (BOOT).

--Laws Affecting Investment

21. The principal law governing foreign investment is
Law No. 4, created in 1978 (known as the BOI Act),as
amended in 1980, 1983 and 1992, along with
implementation regulations established under the Act.
The BOI Act provides for two types of investment
approvals. Under section 17 of the Act, the BOI is
empowered to grant concessions (see details below) to
companies satisfying certain eligibility criteria on
minimum investment, exports and in some cases
employment. Investment approval under section 16 of
the act permits entry for foreign investment to operate
under the "normal" laws of the country and applies to
investments that do not satisfy eligibility criteria
for BOI incentives. Other laws affecting foreign
investment are the Securities and Exchange Commission
Act of 1987 as amended in 1991 and 2003, and the
Takeovers and Mergers Code of 1995 revised in 2003.
Various labor laws and regulations affect investors
also. See sections below.

--Foreign Equity and Sectors

22. The government relaxed investment rules in early
2002, allowing 100 percent foreign investment in the
following services: banking, finance, insurance,
stock-brokering, construction of residential buildings
and roads, supply of water, mass transportation,
telecommunications, energy production and distribution,
professional services, and the establishment of liaison
offices or local branches of foreign companies. These
services are regulated and subject to approval by
various government agencies. The screening mechanism
is non-discriminatory and, for the most part, routine.

23. Investment in other sectors is restricted and
subject to screening and approval on a case-by-case
basis when foreign equity exceeds 49 percent. The
affected sectors are: shipping and travel agencies;
freight forwarding; fishing; timber-based industries;
growing and primary processing of tea, rubber, coconut,
rice, cocoa, sugar and spices; and the production for
export of goods subject to international quota.
Foreign investment restrictions and government
regulations also apply to international air transport;
coastal shipping; lotteries; large-scale mechanized gem
mining; and sensitive industries such as military
hardware, dangerous drugs and currency.

24. Foreign investment is not permitted in the
following businesses: non-bank money lending; pawn-
brokering; retail trade with a capital investment of
less than USD 1 million (with one notable exception:
the BOI permits retail and wholesale trading by reputed
international brand names and franchises with an
initial investment of not less than USD 150,000);
coastal fishing; and the awarding of local university
degrees. Foreign degree courses can be offered in Sri
Lanka by affiliating with foreign universities.
However, there is no scheme to monitor the quality
assurance or accreditation of the foreign courses
offered in Sri Lanka.

25. Generally, the treatment given to foreign
investors is non-discriminatory. In fact, some local
companies have complained that they are discriminated

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against, as qualifying foreign investors can benefit
from a wide range of advantages. However, entry into
sectors such as liquefied petroleum gas, flour milling
and fixed line telephony are controlled, in order to
ensure that currently existing monopolies or
oligopolies supplying products or services in Sri Lanka
are protected. Sri Lanka also does not have anti-
competition laws. Even with incentives and BOI
facilitation, foreign investors face difficulties
operating here. Problems range from the mundane but
critical matter of clearing equipment and supplies
through customs speedily, to obtaining a factory site.
Legal challenges to environmentally sensitive projects
have been particularly challenging, even when
objections are unfounded. Perhaps the most difficult
barriers to investment are the enormous set of
bureaucratic requirements and poor decision practices
of GSL entities. Several high profile and needed
infrastructural projects have dried up in the past two
years, as investors simply tired of waiting for
approval and action. In part to avoid part of these
tangles, in addition to overcoming land allocation
problems, the BOI encourages investors to locate their
factories in industrial processing zones managed by the
BOI. Investors locating in industrial zones also get
access to relatively better infrastructure facilities
such as reliable power, telecommunication and water
supplies.

--Privatization Frozen

26. Previous governments, including ones headed by the
SLFP, actively pursued privatization. When the UPFA
Government came to power in 2004, however, it pledged
to halt the privatization process of strategic
enterprises and to institute more effective government
oversight while privatizing smaller entities. The
current Government has said that it will not privatize
any government entity.

27. Government treatment of foreign investors in past
privatization processes had been largely non-
discriminatory. In 2003, however, the then UNP
government sold part of the retail operations of state-
owned Ceylon Petroleum Corporation (CPC) to Indian Oil
Corporation (IOC) without a formal tender process. One
US firm, which had earlier acquired a government-owned
lubricant plant and obtained exclusivity in the sale of
lubricants in CPC outlets until mid-2004, has also
complained that the government had reneged on the terms
of the exclusivity agreement.

--Labor Unions Block Privatization

28. Labor unions in state-owned enterprises are often
opposed to privatization and restructuring and seem
particularly averse to foreign ownership. In the past,
this made the purchase of certain strategic entities
problematic for new foreign owners.

--Investment Trends

29. From 1998-2001, foreign direct investment (FDI)
flows to Sri Lanka averaged only about USD 150 million
per year (excluding privatization receipts). Following
the commencement of the peace process and improved
investor confidence, annual FDI flows have averaged
about USD 200 million. Although initially FDI was
expected to rise faster following the cease-fire, it
has stagnated due to the stalemate in the peace
process. In 2004, FDI was about USD 178 million. The
Sri Lankan government reported with its budget an

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anticipated USD 250 million of FDI for 2005, but this
amount appears to be overstated since FDI had been
about USD 110 million by October 2005. FDI could
eventually be reported at less than USD 150 million for
2005. No single big investment occurred in 2005. Most
2005 FDI occurred in housing projects, existing
business expansion, and spillover effects of
investments that came in 2004 when FDI mainly funded
telecommunications and manufacturing industries (cement
and textiles).

--The Colombo Stock Exchange

30. The Colombo Stock Exchange (CSE) has been growing
markedly since 2002, due to local investor activity.
The CSE is taking steps to broaden the investor base
both in Sri Lanka and abroad. The CSE has been one of
the best performing stock markets globally since 2001
and has recorded a consistent annual growth of over 30
percent in market indices for the last 4 years.
However, the November 2005 election of President
Mahinda Rajapaksa backed by Marxist JVP and a string of
serious cease-fire violations dampened the market in
December 2005. Foreign investors have largely stayed
out of the market, and were net sellers in 2003-2004.
Uncertainty about the peace process, weak macro
economic fundamentals, and reversals in economic
reforms, are major concerns to foreign investors.


CONVERSION AND TRANSFER POLICIES
--------------

31. Sri Lanka has accepted Article VIII status of the
IMF and has liberalized exchange controls on current
account transactions. There are no surrender
requirements on export receipts, but exporters need to
repatriate export proceeds within 120 days to settle
export credit facilities. Other export proceeds can be
retained abroad. Currently, contracts for forward
bookings of foreign exchange are permitted for a
maximum period of 360 days for the purposes of payments
in trade and 720 days for the repayment of loans.

32. There are also no barriers, legal or otherwise, to
the expeditious remitting of corporate profits and
dividends for foreign enterprises doing business in Sri
Lanka. Remittance of business fees (management fees,
royalties and licensing fees) is also freely permitted
for companies with majority foreign investment approved
under Section 17 of the BOI Act. Other companies
require Central Bank approval. Funds for debt service
and capital gains of BOI-approved companies exempted
from exchange control regulations are freely permitted.
Other foreign companies remitting funds for debt
service and capital gains require Central Bank
approval. All stock market investments can be remitted
without prior approval of the Central Bank through a
special bank account. Investment returns can be
remitted in any convertible currency at the legal
market rate. Controls on capital account (investment)
transactions usually prohibit foreigners from investing
in debt and fixed income securities. One exception has
been the Central Bank?s dollar denominated bond issues
in the local market that were opened to foreign
investors. It has been proposed to allow foreigners to
invest in corporate debentures and government bonds.

33. Local companies require Central Bank approval to
invest abroad. The process of granting approval for
such investments was streamlined in 2002, resulting in
a substantial increase in approvals.

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EXPROPRIATION AND COMPENSATION
--------------

34. Since economic liberalization policies began in
1978, the Sri Lankan Government has not expropriated a
foreign investment. Under the terms of the US/Sri
Lanka Bilateral Investment Treaty (BIT),investors have
the right to arbitration under the International Center
for the Settlement of Investment Disputes (ICSID) of
the World Bank. The last expropriation dispute was
resolved in 1998.


DISPUTE SETTLEMENT
--------------

--Legal System

35. Sri Lanka's legal system reflects diverse cultural
influences. Criminal law is fundamentally British.
Basic civil law is Roman-Dutch. Laws pertaining to
marriage, divorce, and inheritance are communal. Sri
Lankan commercial law is almost entirely statutory.
The law was codified before independence in 1948 and
reflects the letter and spirit of British law of that
era. Its amendments have, by and large, kept pace with
subsequent legal changes in the U.K. Until recently,
the court system was largely free from government
interference. There are allegations that the judiciary
is sometimes subject to political influence, but this
has not been evident in commercial litigation so far.
Procedures exist for enforcing foreign judgments.
Litigation can be very time consuming. Several
important legislative enactments regulate commercial
matters: the Board of Investment Law, the Intellectual
Property Act, the Companies Act, the Securities and
Exchange Commission Act, the Banking Act, the
Industrial Promotion Act and Consumer Affairs Authority
Act. Most of these laws were revised recently.

--Bankruptcy Laws

36. The Companies Act and the Insolvency Ordinance
provide for dissolution of insolvent companies. But
currently, there is no mechanism to facilitate the re-
organization of financially-troubled companies. Other
laws make it very difficult to keep a troubled company
afloat. The Termination of Employment of Workmen Act
(TEA),for example, prohibits employers from dismissing
workers even on the grounds of inefficiency. The
Termination Act was recently revised to facilitate
retrenchment. Under the revised act, a compensation
formula for retrenched workers has been published. But
employers have protested that it is excessive compared
to similar formulae in the Asian region, with terms in
Sri Lanka about twice as generous as the East Asian
average. [Please see section on ?LABOR? for details].
Obviously, this compensation plan could adversely
affect companies? restructuring plans and discourage
future employment growth.

37. In the absence of proper bankruptcy laws, extra-
judicial powers granted by law to financial
institutions protect the rights of creditors and have
helped strengthen credit discipline. Lenders are able
to enforce financial contracts through powers that
allow them to foreclose on loan collateral without the
intervention of courts. A recent judgment, however,
ruled that these powers would not apply with respect to
collateral provided by guarantors to a loan. Financial

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institutions also face other legal challenges as
defaulters obtain restraining orders on frivolous
grounds due to technical defects in the recovery laws.
Also, for default cases filed in courts, the judicial
process is time consuming. The private sector has
urged the government to introduce US Chapter 11-style
bankruptcy laws, although the enactment of a similar
procedure is unlikely as government officials currently
take a dim view of this approach. Additionally, the
financial community has requested the strengthening of
debt recovery laws.

--Investment Protection

38. In principle, foreign investments are guaranteed
protection by the Constitution of Sri Lanka. The
government has entered into 24 investment protection
agreements with foreign governments (including the
United States) and is a founding member of the
Multilateral Investment Guarantee Agency (MIGA) of the
World Bank. Sri Lanka is also a founding member of the
World Trade Organization. The government has ratified
the Convention on Settlement of Investment Disputes,
which provides the mechanism and facilities for
international arbitration through the World Bank?s
ICSID.

39. The U.S.-Sri Lanka Bilateral Investment Treaty
(BIT) was ratified by both governments in early 1993.
A bilateral treaty to prevent double taxation went into
effect on June 12, 2004.

40. Settlement of disputes through the Sri Lankan
court system is subject to protracted and inexplicable
delay. Aggrieved investors (especially those dealing
with the government of Sri Lanka on projects) have
frequently pursued out-of-court settlements, which
offer a possibility of speedier dispute resolution.

--Arbitration

41. The Arbitration Act of 1995 gives recognition to
the New York Convention on recognition and enforcement
of foreign arbitral awards. Arbitral awards made
abroad are now enforceable in Sri Lanka. Similarly,
awards made in Sri Lanka are enforceable abroad. A
center for arbitration known as the Institute for the
Development of Commercial Law and Practice (ICLP) has
been established in Colombo for the expeditious,
economical, and private settlement of commercial
disputes. The ICLP appears unlikely to become involved
in disputes involving the Sri Lankan Government, the
source of most disputes with U.S. companies in recent
years.

42. Sri Lanka's first commercial mediation center was
established in 2000 and became operational in mid 2001.
Commercial mediation is conducted under the Commercial
Mediation Act. Interest in mediation is still low.

43. The Labor Department has a process involving labor
tribunals for settling industrial disputes with
laborers or unions, and arbitration is required when
attempts to reconcile industrial disputes fail. The
Labor Commissioner typically becomes involved in labor-
management mediation. Other senior officials,
including the Labor Minister, and the President, have
intervened in particularly difficult cases.

--Investment Disputes Involving U.S. Companies

44. There continue to be trade and investment

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disputes, particularly surrounding government
procurement. The government procurement process in Sri
Lanka is slow and opaque. US companies continue to
face problems with payment of valid contracts,
finalization of agreement language, implementation of
agreements with the Government, and inexplicable
failure to secure contracts, despite demonstrated
superior performance, high value, and low bids. Some
US companies have found it difficult to secure payment
for power generation due to CEB?s tight cash flow
situation, with at least one major payment currently
disputed by the Government under the ironic theory that
the Government was forced to enter into a contract
?under duress? because a fire forced an energy plant to
produce energy in a more costly manner than prior to
the fire. The Government had asked the plant?s
management to continue operations, and the company
despite management?s strong preference to shut down for
repairs.

45. In May 2000, the Sri Lankan Supreme Court
effectively blocked an existing investment agreement
between the Government of Sri Lanka and a US mining
company. Although the investment agreement was already
initialed and approved by the Sri Lankan cabinet, work
on the project had not yet begun. A group of citizens
filed a fundamental rights case under a Sri Lankan law
that allows any person to seek protection from the
Supreme Court if a government or administrative act
impedes his/her rights. In this case, the plaintiffs
alleged that their rights would be violated if the
project was implemented, and the court upheld their
complaint. Without any technical argument, a partial
bench of three judges ruled that the project could not
proceed before completion of a new series of detailed
and highly comprehensive and expensive studies, some of
which appeared to be technically impractical. Because
this is a Supreme Court decision, options for reversing
the decision appear limited.

46. In another case, a US investor with a substantial
investment in an export manufacturing company has faced
lengthy delays in a court case over a large insurance
claim. The company instituted legal action in June
1999 and court proceedings are still ongoing. The
Company withdrew its operations from Sri Lanka in 2004.
In many disputes, defendants resort to obtaining
injunctions, stay orders, or postponements to drag
cases on for years.


PERFORMANCE REQUIREMENTS/INCENTIVES
--------------

--Performance Requirements

47. The Board of Investment specifies certain minimum
investment amounts for both local and foreign investors
to qualify for incentives. Firms enjoying preferential
incentives in the manufacturing sector in most cases
are required to export 80 percent of production, while
those in the service sector must export at least 70
percent of production. Sri Lanka complies with WTO
Trade Related Investment Measures (TRIMS) Obligations.

48. Foreign investment is encouraged in information
technology, electronic assembly, light engineering,
automobile parts and accessories manufacturing,
industrial and IT parks, rubber based industries,
information and communication services, tourism and
leisure related activities, agriculture and agro
processing, port-related services, regional operating

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headquarters, and infrastructure projects. Foreign
investors are generally not expected to reduce their
equity over time, nor are they expected to transfer
technology within a specified period of time, except
for build-own-transfer or other such projects in which
the terms are specified within pertinent contracts.

49. In some BOI-approved enterprises, businesses are
required to maintain certain levels of employment. In
addition, privatization agreements prohibit new owners
from dismissing workers as a rule, although the owners
are free to offer voluntary retirement packages to
reduce their workforce. Some foreign investors have
received political pressure to hire workers from a
particular constituency or a given list, but have
successfully resisted such pressure with no apparent
adverse effects.

50. Foreign investors who remit at least USD 50,000
can qualify for a one-year resident visa, which can be
renewed. Employment of foreign personnel is permitted
when there is a demonstrated shortage of qualified
local labor. Technical and managerial personnel are in
short supply, and this shortage is likely to continue
in the near future. Foreign employees attached to BOI-
approved companies usually receive preferential tax
treatment for an initial period and do not experience
significant problems in obtaining work or residence
permits.

--Investment Incentives

51. The Board of Investment has announced the
following investment incentives, with such investments
typically requiring prior approval of various
ministries:

Incentive Program I

Qualifying industries:
--Non-traditional manufacturing exports and companies
supplying to exporting companies. Minimum investment
of USD 150,000;
--Export oriented services. Minimum investment of USD
150,000;
--Manufacture of industrial tools and/or machinery.
Minimum investment of USD 150,000;
--Small-scale infrastructure. Minimum investment of
USD 500,000;
--Research and development. Minimum investment of USD
50,000;
--Agriculture and agro processing industries. Minimum
investment of USD 10,000;

Incentives: Above industries will qualify for a five-
year tax holiday initially. A preferential tax of 10
percent in the 6th and 7th years follows the tax
holiday. After the 7th year, a preferential tax of 15-
20 percent will apply. In addition, these industries
qualify for duty-free imports (generally, during the
life of the project for export-oriented projects, and
during the project implementation period for others).
Exporting companies and export-oriented services will
be exempted from exchange control regulations. They
will also qualify for free repatriation of profits and
dividends and free transferability of shares. A
recently introduced Economic Service Charge at 0.25
percent of income will be applicable to BOI approved
companies with tax holidays, from the fourth year of
operation. The tax applies even to existing companies.
There is no grandfather clause.


COLOMBO 00000321 014 OF 034


Incentive Program II

Qualifying Industries:
--Information technology services such as call centers,
data entry services, data centers, software development
services, host centers for e-governance and related
projects;
--IT training institutes;
--Regional operating headquarters providing the
following services to related businesses outside Sri
Lanka: sourcing raw materials, R&D, technical support,
financial and treasury management, marketing and sales
promotion;
--Any industrial, agricultural, service, or
construction activity approved by the BOI. Minimum
investment of USD 5 million.

(a) Minimum employment of 15 IT professionals is
required in IT companies
(b) Minimum 300 students required for IT training
institutes.

Incentives: Above industries will qualify for a 3-year
tax holiday period initially. A preferential tax of 10
percent will apply in the 4th and 5th years. From the
6th year onwards, a preferential tax of 15-20 percent
will apply. In addition, capital goods will be
exempted from import duty. A recently introduced
Economic Service Charge at 0.25 percent of income will
be applicable to BOI approved companies enjoying tax
holidays, from the fourth year of operation. The new
tax applies even to those companies already operating
in Sri Lanka.

--Incentives for Regional Development

52. The BOI has launched a new incentive program to
promote regional development with the aim of
establishing 300 new factories or service companies
(such as hotels, hospitals, training institutes) in the
regions outside the capital Colombo. The incentives
include 5-10 year tax holidays depending on the
location, with firms going to most difficult areas
eligible for a 10-year tax holiday. In addition,
imports of machinery and equipment would be exempted
from both customs duty and the value-added tax.

--Infrastructure development

53. Companies acquiring existing companies in
petroleum, power generation, transmission, development
of highways, sea ports, airports, railway, water
services, public transport, agriculture and agro
processing and other infrastructure projects approved
by the BOI will qualify for tax holidays ranging from 5
to 10 years depending on the magnitude of investment.
A preferential tax of 15 percent will follow after the
tax holiday period. These companies will also qualify
for duty free imports of capital goods. A minimum
investment of USD 12.5 million is required.

54. Large-scale new infrastructure projects in power
generation, transmission and distribution; development
of highways, seaports, airports, public transport and
water services; establishment of industrial parks, and
other infrastructure projects approved by the BOI will
qualify for tax holidays ranging from 6 to 12 years
depending on the size of the investment. A
preferential tax of 15 percent will follow the tax
holiday. They will also qualify for duty free imports
of capital goods. A minimum investment of USD 10
million is required.

COLOMBO 00000321 015 OF 034



--Trade Agreements to Make Sri Lanka a Gateway to South
Asia; ?GSP-Plus?.

55. A preferential trade agreement, the Indo Lanka
Free Trade Agreement (ILFTA) between Sri Lanka and
India, is now in operation. Under this agreement, most
products manufactured in Sri Lanka with at least 35
percent domestic value addition (if raw materials are
imported from India, domestic value addition required
is only 25 percent),qualify for duty free entry to the
Indian market. Tariff concessions for Sri Lankan
products include zero tariffs on 4,150 items; 50 to 75
percent reduction for tea and garments under quota; 25
percent reduction for 528 items, and no reduction for
429 items (negative list). Discussions are underway to
reduce the negative lists of both countries. The two
countries are discussing services sector
liberalization, under a proposed Comprehensive Economic
Partnership Agreement (CEPA). Other areas covered by
the CEPA are investment and economic cooperation.
Because production constitutes a portion of the value,
ILFTA and the proposed CEPA may be well utilized as a
mode of entry into the Indian market by U.S. companies.

56. Sri Lanka also signed a free trade agreement with
Pakistan that came into operation on June 12, 2005.
Under the Sri Lanka-Pakistan FTA (SLPKFTA)
(www.doc.gov.lk),Pakistan has offered duty free entry
to 206 items. Pakistan?s negative list contains 541
items with no duty concessions. Pakistan will phase
out tariffs on the balance of approximately 4,000 items
over a 3 year period. Under the agreement, Pakistan
would offer duty free entry to all Sri Lankan exports
by June 2008.

57. Sri Lanka and six other south Asian nations
belonging to the South Asia Association for Regional
Cooperation (SAARC) signed a South Asia Free Trade
Agreement (SAFTA) in January 2004. SAFTA was launched
on January 1, 2006 and will become operational on July
1, 2006. SAFTA will offer regionalized tariff
reductions for imports from member countries. Stated
goals of SAARC members under SAFTA are to reduce duties
for imports from member countries to between zero and 5
percent over a period of 7-10 years. These agreements
are seen as steps towards making Sri Lanka a regional
hub and a gateway to South Asia and the Middle East for
foreign investors
58. Sri Lankan exports to EU are also duty free under
the ?GSP-Plus? incentive scheme which came into force
on July 1, 2005. Under this program, 7,200 Sri Lankan
products meeting rules-of-origin criteria can enter the
EU duty free.
--Prospects for U.S. Investment under Indo Lanka Free
Trade Agreement (ILFTA) and Pakistan Sri Lanka Free
Trade Agreement (SLPKFTA).

59. Foreign investors in Sri Lanka can enjoy
preferential access to the Indian and Pakistan markets
under the ILFTA and SLPKFTA. The BOI hopes to attract
foreign joint ventures to Sri Lanka under these
agreements. The BOI has picked several product sectors
for promotion under the agreements, and targets its
investment promotion efforts to countries and companies
manufacturing them. The selected products, if
manufactured in Sri Lanka and meet rules of origin
criteria, are eligible for duty free entry into India.
The products targeted for Pakistan will qualify for a
34 percent duty reduction immediately and will see
duties coming down to zero over three years. The BOI
has identified the following sectors for investment

COLOMBO 00000321 016 OF 034


promotion under the ILFTA and SLPKFTA:

--ILFTA: confectionary and cocoa products, rubber
products, plastic, footwear, ceramic, jewelry,
machinery and mechanical appliances, electronics and
electrical products, automobiles and spares parts,
medical instruments and furniture and doors.

--SLPKFTA: rubber products, ceramic, machinery and
mechanical appliances, electronics and electrical
appliances, medical instruments and automobiles and
spare parts.

60. Some US companies currently avail themselves of
the ILFTA by adding at least 35 percent value in Sri
Lanka and getting import duties into India reduced from
as much as 40 percent to as little as zero.

61. For further information on investment incentives
and other investment-related issues, potential
investors are encouraged to contact the Board of
Investment directly. The BOI can be found at
www.boi.lk, or reached via e-mail at info@boi.lk. The
BOI is planning to create an investor matchmaking
service via the BOI website. Information regarding
this service could be found on www.boi.lk/partnership.

RIGHT TO PRIVATE OWNERSHIP AND ESTABLISHMENT
--------------

62. Private entities are free to establish, acquire,
and dispose of interests in business enterprises.
Private enterprises enjoy benefits similar to those
granted to public enterprises, and there are no known
limitations to access to markets, credit, or licenses.
Foreign ownership is allowed in most sectors. Private
land ownership is limited to fifty acres per person.
The government owns about 80 percent of the land in Sri
Lanka, including the land housing most tea, rubber, and
coconut plantations. The government has leased most of
these plantations to the private sector on 50-year
terms. Although state land for industrial use is
usually allotted on a 50-year lease, 99-year leases may
also be approved on a case-by-case basis, depending on
the nature of the project.

63. While foreign investors can purchase land from
private sellers, the government recently imposed a 100
percent tax on land transfers to foreigners. It also
imposed a definition of foreign investment to include
corporations with as little as 25 percent foreign
ownership ? a definition that can be particularly
difficult for companies listed on the Colombo Stock
Exchange since on any particular day, their ownership
characteristics may vary. Apartments above the third
floor of condominium buildings, land for the
development of large housing schemes, hospitals and
hotels with a minimum investment of USD 10 million,
exporting companies with a minimum investment of USD 1
million, and large infrastructure projects with a
minimum investment of USD 50 million are to be exempted
from the tax. Foreigners maintaining USD 150,000 in a
bank account in Sri Lanka will be given concessionary
treatment. Regulations regarding these exceptions have
been published in Gazette No 1386/18 dated March 30,
2005.


PROTECTION OF PROPERTY RIGHTS
--------------

--Property rights: problematic but may be improving

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64. Secured interests in property are recognized and
enforced. A fairly reliable registration system exists
for recording private property including land,
buildings and mortgages. However, there have been
problems due to fraud and forged documents. The
Government has begun to address these issues under a
World Bank-sponsored judicial reforms project. The
legal system is nondiscriminatory and protects and
facilitates acquisition and disposition of property
rights by foreigners, although it has recently become
subject to political influence.

65. Private farmers generally work state-owned lands
under varying tenure agreements, ranging from
restrictive tenures to land grants, although the
property rights to these lands are frequently ill-
defined. Changes to the legal framework covering land
titling have been proposed under a World Bank-funded
project. These changes aim to establish land tenure,
remove restrictions related to the sale, leasing and
transfer and mortgaging of rural lands previously
distributed to farmers by the Government. The project
has also implemented a model computerized land titling
system in a few villages. The Government has sought
World Bank assistance to extend the system to cover the
entire country. Such a project, yet to be designed and
approved, would take about 6 years to implement.

--Intellectual Property Rights Protection

66. Sri Lanka is a party to major Intellectual
Property Agreements including the Berne Convention for
the Protection of Literary and Artistic Works, the
Paris Convention for the Protection of Industrial
Property, the Madrid Agreement for the Repression of
False or Deceptive Indication of Source on Goods, the
Nairobi Treaty, the Patent Co-operation Treaty, the
Universal Copyright Convention, and the Convention
establishing the World Intellectual Property
Organization (WIPO).

67. Sri Lanka and the US signed a Bilateral Agreement
for the Protection of Intellectual Property Rights in
1991, and Sri Lanka is also a party to the Trade
Related Intellectual Property Rights (TRIPS) Agreement
in the World Trade Organization. Enforcement of these
agreements, however, is in its infancy.

68. A new intellectual property law came into force in
November 2003. It meets both US-Sri Lanka bilateral
IPR agreement and TRIPS obligations to a great extent.
The IPR law governs copyrights and related rights,
reproduction rights, public distribution rights,
industrial designs, patents for inventions, trademarks
and service marks, trade names, layout designs of
integrated circuits, geographical indications, unfair
competition, databases, computer programs, and
undisclosed information. The law also covers the
rights of performers, producers of sound recordings,
and broadcasting organizations. All trademarks,
designs, industrial designs and patents must be
registered with the Director General of Intellectual
Property.

69. Infringement of Intellectual Property Rights (IPR)
is a punishable offense under the law. Intellectual
Property Rights come under both criminal and civil
jurisdiction. Relief available to owners under the new
law includes injunctive relief, seizure and destruction
of infringing goods and plates or implements used for
the making of infringing copies, and prohibition of

COLOMBO 00000321 018 OF 034


imports and exports. Police can take ex-officio action
to enforce the law. Aggrieved parties can also, on
their own, seek redress for any IPR violations through
the courts, though this can be a frustrating and time-
consuming process.

70. Although the legal system is well-established and
non-discriminatory, it is fraught with long delays.
IPR enforcement was a serious problem under the old
law, and public awareness of IPR continues to be
limited. Under the old law, domestic implementation
legislation was very weak and the government did not
act as an enforcer of IPR laws.

71. With the passage of the new law, Sri Lanka has
begun to enforce IPR laws. However, it will take time
before new procedures and court precedents are
established. In October 2004, Sri Lankan Police raided
an illegal CD manufacturing plant owned by Malaysian
nationals. In December 2005, the courts fined a
Malaysian employee of the company (the only person
arrested for the crime),Rs 40,000 (USD 400) for
illegal possession of CDs and DVDs and handed down a
suspended prison sentence of 24 months. The Police
carried out additional raids of counterfeit CD/VCD
stores as well as counterfeit garment sellers in 2005.
Customs has also seized counterfeit consumer goods,
mainly cigarettes. Vendors of pirated CDs, DVDs and
garments were fined and received suspended jail
sentences in Sri Lanka?s courts, suggesting minor
progress in the enforcement of the new law. Meanwhile,
local agents of reputed US and other international
recording companies, software development companies,
motion picture companies, clothing companies and
consumer product companies continue to complain that
lack of IPR protection is damaging their businesses.
Further, CD/VCD stores that were raided in early 2005
again sell pirated goods and a ?trade association? to
look after the interest of pirates and distributors was
established. The association claims that IPR
enforcement violates its members? right to generate
business. The Embassy, along with key industry players
including the IFPI, continues to lobby the government
to improve Sri Lanka's IPR regime.

72. Sri Lanka needs to ratify and conform to the WIPO
Performances and Phonograms Treaty (WPPT) and the WIPO
Copyright Treaty (WCT). Ratification of these two
treaties will support electronic commerce, protect the
rights of performers and producers of phonograms and
the rights of authors in their literary and artistic
works, and offer an adequate basis to fight
international piracy in view of new technological
developments. Sri Lanka lacks provisions to deal with
electronic transactions, electronic signatures, and
computer crimes and evidence, although draft laws to
deal with these matters have been finalized. The IPR
law does not cover protection of new plant varieties.

--Patents, Copyrights and Trademarks

73. Patents are granted for inventions, with the
following exceptions: discoveries, scientific theories
and mathematical methods, plant or animal varieties
(other than micro biological processes) and essentially
biological processes for the production of plants and
animals (other than non biological and microbiological
processes),business rules and methods, methods of
treatment by surgery or therapy, and diagnostic methods
practiced on a human or animal body. The law also
permits compulsory licensing and parallel imports of
pharmaceutical products. Compulsory licensing will

COLOMBO 00000321 019 OF 034


allow the government to grant licenses to manufacture
certain patented drugs, overruling patent licenses in a
national emergency. The parallel imports will allow
the import of a branded drug from an alternative
source.

74. A patent is valid for 20 years from the date of
application but must be renewed annually.

75. Copyrights are not registered. A work is
protected automatically by operation of law. Original
literary, artistic, and scientific works including
computer programs and databases are protected under the
new law. There are enforcement limitations applying to
copyrights, including software.

76. Sri Lanka recognizes both trademarks and service
marks. The exclusive right to a mark is acquired by
registration. A mark may consist of words, slogans,
designs, etc. Protection also is available to well
known marks not registered in Sri Lanka. For instance,
the Supreme Court of Sri Lanka recently held that a
local company did not have a right to use the MTV
trademark owned by Viacom International of the U.S.
Registered trademarks are valid for ten years and
renewable. The law also recognizes both certification
marks and collective marks.


TRANSPARENCY IN THE REGULATORY SYSTEM
--------------

77. The BOI strives to inform potential investors
about laws and regulations that may affect operations
in Sri Lanka. Laws pertaining to tax, labor and labor
standards, exchange controls, customs, environmental
norms, and building and construction standards are in
place. However, some of the laws and regulations are
not freely available and are difficult to access.
Foreign and domestic investors often complain that the
regulatory system allows far too much leeway for
bureaucratic discretion. Outdated regulations and
rigid administrative procedures imposed by public
sector institutions have been identified as impediments
to private sector growth. Effective enforcement
mechanisms are sometimes lacking, and coordination
problems between the BOI and relevant line agencies
frequently emerge. Lethargy and indifference on the
part of mid- and lower-level public servants compound
transparency problems. Lack of sufficient technical
capacity within the government to review financial
proposals for private infrastructure projects also
creates problems during tendering. In late 2005, the
Government awarded several key infrastructure projects
to Chinese companies, outside the tender process. They
include a 300 megawatt coal power project and a
bunkering project.

78. Although many foreign investors, including US
firms, have had positive experiences in Sri Lanka, some
have encountered significant problems with government
practices and regulations. Some multinational firms
have experienced extensive unexplained delays in trying
to reach agreement on investment projects. Others have
had contracts inexplicably canceled without
compensation, even though the Sri Lankan Cabinet had
approved those contracts.


EFFICIENT CAPITAL MARKETS AND PORTFOLIO INVESTMENT
-------------- --------------


COLOMBO 00000321 020 OF 034


--Availability of financial resources

79. Retained profits finance about 70 percent of
private investment, with short term borrowing financing
a further 20 percent of investment. The stock market
and corporate securities market have not been
significantly used to raise capital. FDI finances
about 4 percent of investment.

80. The State consumes over 50 percent of the
country's domestic financial resources and has a
virtual monopoly on the management and use of long-term
savings in the country. This inhibits the free flow of
financial resources to product and factor markets. In
the past, high interest rate volatility, due to
excessive use of short term borrowing by the state,
increased intermediate costs, which led to higher costs
to other borrowers. Since 2002, government policy has
supported a low interest rate regime and has given
impetus to increased credit, which has contributed to
increased domestic investment as well as inflation.
The investment/GDP ratio rose to 26 percent in 2005,
compared with 22 percent in 2001. The prime lending
rate currently averages 12 percent. Foreign investors
are allowed to access credit on the local market. They
are also free to raise foreign currency loans.

81. A total of Rs 12.3 billion (approx. USD 123
million) was raised in the primary market by way of new
equity and debt in 2004, reflecting the potential for
companies to raise funds through the market.

--Credit Instruments

82. Commercial banks and two development finance
institutions, the National Development Bank (NDB) and
the Development Finance Corporation of Ceylon Bank
(DFCC),are the principal source of bank finance. Bank
loans are the most widely used credit instrument for
the private sector. Financial institutions such as the
DFCC Bank and some commercial banks also raise
syndicated bank loans to fund large-scale investment
projects undertaken by the private sector.

83. The domestic debt market in Sri Lanka is still at
a very nascent stage. The first credit rating agency,
Fitch IBRC (www.fitchratings.lk) opened an office in
Colombo in 1999, which has helped companies to raise
funds through debt markets. Fitch Ratings Lanka Ltd,
is a joint venture between Fitch IBRC, IFC, the Central
Bank of Sri Lanka, and several local financial
institutions. Credit ratings are now mandatory for all
deposit-taking institutions and for all varieties of
debt instruments.

--Accounting Standards

84. There is an active and fairly competent accounting
profession, based on the British model. The source of
accounting standards is the Institute of Chartered
Accountants of Sri Lanka (ICASL),and standards are
constantly updated to reflect current international
accounting and audit standards. Sri Lanka carried out
a major revision of accounting and auditing standards
in September 1997. Since then, the standards have been
periodically updated to meet new international
standards adopted by the International Accounting
Standards Board (IASB). Due to the lack of an adequate
enforcement mechanism, however, problems with the
quality and reliability of financial statements still
exist.


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85. Sri Lanka accounting standards are applicable for
all banks and stock exchange listed companies and all
other large- and medium-sized companies in Sri Lanka.
Accounts of such business enterprises are required to
be audited by professionally qualified auditors holding
ICASL membership. ICASL has recently published
accounting standards for small companies as well. The
Accounting Standards and Monitoring Board (ASMB) is
responsible for monitoring compliance with Sri Lankan
accounting and auditing standards. There is an active
presence of British professional accounting bodies in
Sri Lanka. The Chartered Institute of Management
Accountants (CIMA),a leading professional accounting
body based in the UK and spread over the Commonwealth
has its largest overseas presence in Sri Lanka.

--Securities and Exchange Commission

86. The Securities and Exchange Commission (SEC)
regulates the securities market in Sri Lanka. The SEC
law was revised in 2003, enhancing its coverage and
investigative powers. The SEC now covers stock
exchanges, unit trusts, stock brokers, listed public
companies, margin traders, underwriters, investment
managers, credit rating agencies and securities
depositories.

87. Foreign investors can freely purchase up to 100
percent of equity in Sri Lankan companies in numerous
permitted sectors. In order to facilitate portfolio
investments, country funds and regional funds are also
allowed to invest in Sri Lanka's stock market. Such
funds must first receive Ministry of Finance approval
to operate in Sri Lanka. These funds make transactions
through share investment external rupee accounts
maintained in commercial banks.

88. Sri Lanka?s SEC was rocked by a scandal in early
2003, tarnishing the image of the market watchdog. The
SEC Chairman and another leading businessman were
implicated for insider dealing at a blue chip local
conglomerate where they were both directors. Initial
attempts by the SEC secretariat to institute legal
actions against the two were blocked by the SEC Board
of Directors. Later, the Attorney General ruled that
the SEC Board had acted improperly, casting doubt on
the board members? credibility. The SEC Chairman
resigned and later pleaded innocence. The two parties
subsequently came to an out-of-court settlement.

89. The SEC scandal has caused many to call for
increased corporate governance and accountability in
the private sector. Some business consultants have
asked for laws such as the US Sarbanes-Oxley Act to
regulate financial services and professional services
organizations.

--Colombo Stock Exchange

90. The Colombo Stock Exchange (CSE),while small by
"big emerging market" standards, is one of the most
technologically sophisticated in the region. The CSE
has fully automated trading, clearing and settlement
systems. The CSE has a rolling settlement period of
five days for buyers and six days for sellers. Fifteen
local and foreign joint venture brokers currently
operate at the CSE. Foreign stockbrokers are permitted
to hold up to 100 percent equity in stock brokerage
firms operating at the CSE. SEC has a settlement
guarantee fund with an initial capital of Rs 100
million (USD 1 million) which aims to guarantee the
settlement of trades between clearing members of the

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exchange. The Chartered Financial Analysts (CFA)
program is conducted in Sri Lanka.

91. Acquisition of companies through mergers and
takeovers is governed by the Takeovers and Mergers Code
of 1995 made under the Securities and Exchange
Commission of Sri Lanka Act. This law applies only to
companies listed on the Colombo Stock Exchange. It is
modeled on the lines of the London City Code on
Takeovers and Mergers. Acquisition of more than a 30
percent stake of a listed company requires the buyer to
make an offer to all other shareholders. The articles
of association of a few listed companies restrict
foreign equity to certain levels.

92. There are 242 companies listed on the stock
exchange with the top ten positions by market
capitalization held by banks and food and beverage
companies. In 2003-2005, CSE was one of the best
performing markets in the world. The Cease-Fire
Agreement between the Government of Sri Lanka and the
LTTE has helped to boost investor confidence.
Following the November 17, 2005 election of President
Mahinda Rajapaksa, the CSE has fluctuated in part
depending on the level of violence in the northern and
eastern provinces and hopes for improvement due to the
cease-fire talks. During 1998-2001, the Colombo Stock
Market experienced a sharp downturn due to a variety of
local and international factors. As a result, the CSE
was removed from the Morgan Stanley Capital
International (MSCI) Index in 2001. It has not been
reclassified in the MSCI yet, despite recent surge
driven mainly by locals. Meanwhile, the California
Public Employees? Retirement System (CalPERS),a large
public pension fund for the state of California, which
designated Sri Lanka a permissible country for
investments in 2005, lowered its overall score for Sri
Lanka in its latest review in 2006 to 1.8 from 2.00 in
2005. The threshold for inclusion in CalPERS is 2.00
and Sri Lanka?s position is to be reviewed after one
year. The index is based on political stability,
transparency, labor productivity, market liquidity,
capital market openness, investor protection, and
transaction cost.

93. The single overriding factor inhibiting the
sustainable development of the stock market has been
the conflict in the North and East and its effect on
investor confidence and the economy as a whole. Other
broader issues include lack of liquidity and limited
market size. Improvements are also needed in corporate
governance, accountability, and public disclosure in
companies. The Accounting and Auditing Standards
Monitoring Board, the Ceylon Chamber of Commerce, the
Colombo Stock Exchange, and professional accounting
bodies are taking initiatives in these areas.

--Banking System

94. Sri Lanka has a fairly well diversified banking
system. There are 23 commercial banks, consisting of
eleven local banks and twelve foreign banks. In
addition, there are thirteen local specialized banks.
Citibank NA is the only US bank operating in Sri Lanka
and has expanded its operations recently. ICIC Bank of
India is the newest foreign bank in Sri Lanka and
commenced operations in January 2006. In 2001-2003,
Mashreq Bank, American Express Bank, Nova Scotia Bank
and ABN Amro Bank all sold their banking operations in
Colombo to existing banks. Sri Lanka experienced its
first bank failure in December 2002 when the Central
Bank took action to revoke the license of a small

COLOMBO 00000321 023 OF 034


licensed specialized bank as its financial condition
deteriorated to insolvency. There has not been any
fallout for other banks from this incident. Two other
small troubled banks were restructured under Central
Bank guidance. In April 2005, the Central Bank
introduced higher capital requirements for commercial
banks in an effort to enhance the banking system
stability, promote consolidation and facilitate entry
of larger banks.

95. The Central Bank is responsible for supervision of
all banking institutions. Wide-ranging improvements
have been made in banking regulations and in public
disclosure of banking sector performance. In 2002 the
Monetary Law Act (MLA) was amended to provide the
Central Bank broader supervisory powers and greater
independence. The Bank also issued a code of corporate
governance for banks and financial institutions in
2002. In addition, rules on classification and
provisioning were improved significantly from January
2004. Further, the Banking Act was amended in 2005 to
give additional supervisory powers to the Central Bank
and to introduce guidelines to check the suitability of
bank directors. The amended Banking Act outlaws
pyramid-type programs. Further amendments to the laws
are also expected in the next two years under ongoing
financial and legal reforms programs. The Central Bank
however still suffers from lack of autonomy, especially
with regard to the large state owned banks.

96. In 2004, the Central Bank introduced technical
improvements to facilitate banking sector efficiency by
establishing a Real Time Gross Settlement (RTGS) system
and a Scriptless Securities Settlement (SSS) system.
They have improved the efficiency and the safety of the
country?s payment and settlement systems and will
facilitate trade in government securities.

97. Central Bank supervision as well as auditing
practices of private audit firms came under criticism
after the 2002 specialized bank failure mentioned
above. The Central Bank obtained the services of an
international expert to strengthen bank supervision in
2004.

--State Owned Banks

98. Total assets of commercial banks stood at Rs 1,028
billion (USD 10 billion) as of December 31, 2004. The
two state-owned commercial banks, Bank of Ceylon and
People?s Bank with assets of Rs 266 billion (USD 2.7
billion) and Rs 224 billion (USD 2.2 billion)
respectively in 2004, still dominate banking,
accounting for about 45 percent of all assets.

99. The financial profiles of both state banks have
deteriorated over the years, mainly as a result of
direct lending and operating inefficiencies. Since
most of the bad debts of the two banks were implicitly
guaranteed by the state, these problems did not affect
the credibility of the banking system in Sri Lanka.
The weaknesses in the state banks, however, make it
possible for other inefficient banks to operate and for
the more efficient banks to make higher profits than
they would otherwise. The World Bank and IMF have
identified the dominance of the inefficient state banks
as a main constraint to developing the financial
sector. The government re-capitalized the state banks
during the 1990?s without success. The government has
been trying to reorganize the banks. Top management at
both Bank of Ceylon and People's Bank now contains
private sector personnel, and the banks were granted

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greater autonomy. Further, asset classification and
provisioning norms have been progressively
strengthened. While Bank of Ceylon has met most of the
restructuring targets and shows substantial
improvements in its financial profile, the situation at
People?s Bank remains weak. In particular, the
provisioning has left the bank with a large negative
equity affecting its operations. In addition, the
failure to restructure large state owned utilities such
as the Ceylon Electricity Board and the Ceylon
Petroleum Corporation, and the failure to adjust prices
in a timely manner, have recently forced these agencies
to borrow from state banks, leading to a possible
deterioration of asset quality in state banks.

100. In early 2005, the Cabinet approved new business
development plans for the two state banks to make them
more viable. The plans were developed under the
guidance of the Strategic Enterprise Management Agency
(SEMA),the high-powered restructuring agency of the
Government. The plan for Bank of Ceylon aims to
increase its profitability and efficiency. In the case
of People?s Bank, the state is to re-capitalize the
bank, for the third time, to meet a capital shortfall
of Rs 10 billion. The latest capitalization is to be
supported by an ADB program, which will include equity
funding of about Rs 6 billion (USD 60 million) over 3
years. ADB funding will be required to meet
performance targets on non-performing loans and
demonstrate profitability, cost, and capital adequacy.
The new plan signifies a departure from the earlier IMF
agreed plan to sell the bank under a restructuring
program.

--Private Commercial Banks and Foreign Banks

101. Private commercial banks and foreign banks
operating in Sri Lanka generally follow more prudent
credit policies and, as a group, are in better
financial shape. Nonetheless, the private banking
sector also remains trapped with a high level of non-
performing loans, despite high margins. In 2004, the
average rate of non-performing loans to total loans was
10 percent for domestic private banks and 14.2 percent
for state banks. Foreign banks reported a much better
ratio of 3.3 percent. There are concerns regarding
inadequate loan loss provisioning and low operational
efficiency in some local private banks. The banks are
expected to improve provisioning with the introduction
of new rules by the Central Bank in 2004. Foreign
banks tend to make provisions in line with
international best practices, as most foreign bank
branches are subject to host country supervision in
addition to that of the Central Bank of Sri Lanka. To
help improve bank performance, an Asset Management
Company Law is being prepared with World Bank and IMF
assistance to provide troubled banks with a mechanism
to effectively deal with their non-performing loans.

102. Credit ratings are mandatory for all banks
operating in Sri Lanka from January 2004.

--Capital Adequacy

103. Sri Lanka adopted capital adequacy standards set
by the Basel Committee on banking regulations and
supervisory practices in 1993. In 2003, the Central
Bank raised the minimum capital adequacy standards from
4.5 to 5 percent for core capital (Tier I) and from 9
to 10 percent for risk weighted assets (Tier I and Tier
II). Further enhancing banking sector stability, the
Central Bank has also imposed capital adequacy

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standards on foreign currency banking units. In line
with Basel Core Principles on effective banking
supervision, compliance with Capital Adequacy on a
consolidated basis was introduced in 2003.

104. People?s Bank currently does not meet Capital
Adequacy Requirements (CAR),but it has a Ministry of
Finance guarantee for funds required to meet its
obligations. The ADB funded capital infusion is
expected to help the bank meet its minimum capital
requirements. Bank of Ceylon Tier I CAR was about 12.1
percent in 2003. Risk based capital adequacy at
domestic commercial banks was 11.1 in 2004. CAR at
foreign commercial Banks was 12.4 in 2004.


POLITICAL VIOLENCE
--------------

105. Since early 2002, there has been a marked
improvement in the business climate due to the
relatively peaceful atmosphere prevailing in the
country. This is in contrast to the period between
1983-2001, when the country was plagued by ethnic
conflict and related urban terrorism. The fighting
between the Liberation Tigers of Tamil Eelam (LTTE) and
the Sri Lankan military was primarily in northern and
eastern Sri Lanka, but other parts of the country
suffered sporadic terrorist attacks. Since 1997, the
LTTE has been a US-designated Foreign Terrorist
Organization (FTO). Terrorist activities of the LTTE
declined since the LTTE and the Government signed a
formal open-ended Cease-Fire Agreement in February
2002. Following six rounds of peace talks with the
government of Norway acting as facilitator, the LTTE
suspended its participation in the negotiations in
April 2003.

106. Since April 2003, there have been numerous
cease-fire violations, particularly in the eastern part
of the country, primarily related to fighting between
the LTTE and anti-LTTE Tamil groups, including a
faction that split from the LTTE in 2004. Government
of Sri Lanka intelligence officials, military and
informants have also been targeted. In July 2004, a
suicide bomb exploded in a Colombo police station
following an assassination attempt against an anti-LTTE
Tamil minister. Five people (including the bomber)
were killed. In August 2005 suspected LTTE snipers
shot and killed Foreign Minister Lakshman Kadirgamar at
his Colombo residence. In December 2005 a Sri Lanka
Navy bus was struck by an LTTE-command detonated mine,
killing 13 soldiers?the highest number of casualties in
a single incident since the beginning of the cease-fire
in 2002. In January 2006, there were several
additional troubling cease-fire violations, including
the sinking of a Navy patrol boat, killing 13. The GSL
and the LTTE have agreed to meet in Geneva in February
2006 to discuss ways to strengthen cease-fire
implementation.

107. During almost 19 years of war, tourists and
foreign business representatives have not been
terrorist targets, but they have suffered collateral
injuries during attacks on other targets. On July 24,
2001, the LTTE attacked the international airport and
destroyed both commercial and military aircraft.
Several military personnel were killed in the attack,
military and airport employees were injured, and Sri
Lankan civilians were caught in the crossfire. Sri
Lankan Airlines, jointly owned by the Government of Sri
Lanka and Emirates Airlines of Dubai, lost several

COLOMBO 00000321 026 OF 034


commercial aircraft in the attack. The LTTE has also
attacked several commercial ships prior to 2001 flying
foreign flags in the waters off the north and east of
the country. In response to these attacks, insurers
imposed war risk insurance surcharges on aircraft and
ships using Sri Lankan seaports and airports. These
surcharges have been lifted since the cease-fire went
into effect. During the conflict, the LTTE also
detonated several large bombs in Colombo?s financial
and business districts, causing numerous casualties and
extensive damage to property. Very few foreigners were
injured in these terrorist incidents due to the LTTE?s
policy of targeting local interests.

CORRUPTION
--------------

108. The country has fairly adequate laws and
regulations to combat corruption, but they are unevenly
enforced. US firms identify corruption as a constraint
on foreign investment, but, by and large, it is not a
major threat to operating in Sri Lanka ? at least once
a contract has been won. Corruption appears to have
the greatest effect on investors in large projects as
well as government procurement and tendering.
According to Transparency International (TI),
corruption is perceived as most pervasive in terms of
political appointments to government institutions and
in government procurement awards, as well as in high
frequency/low value transactions. The police force and
the judiciary are perceived to be the most corrupt
public institutions. Corruption is also a persistent
problem in customs clearance and enables wide-scale
smuggling of certain consumer items, to the detriment
of legitimate manufacturers and importers.

--The Bribery Commission is not very effective.

109. The Bribery Commission is the main body
responsible for investigating allegations of bribery
and corruption. The Commission?s most recent term
expired in December 2004, and a new Commission was
appointed after a 3-month delay in March 2005. The
previous Commissions were not effective in dealing with
bribery or corruption. The function of the Commission,
under Act No 19 of 1994, is to investigate allegations
brought to its attention and to institute proceedings
against responsible individuals in the appropriate
court. The law states that a public official?s offer
or acceptance of a bribe constitutes a criminal offense
and carries a maximum sentence of seven years
imprisonment and a fine at the discretion of the
courts. A bribe by a local company to a foreign
official is not covered by the Bribery Act.

110. Few have been found guilty of corruption in
recent years. Although highly publicized, efforts to
investigate bribery and corruption have failed,
damaging public confidence in such processes. While
corruption charges have been leveled against
politicians and top officials in charge of key
government corporations, none of the accused has been
convicted of bribery yet.

111. Sri Lanka ratified the UN Anti-corruption
Convention in March 2004. Sri Lanka has signed but not
ratified the UN Convention against Transnational
Organized Crime. Sri Lanka is not a signatory to the
OECD-ADB Anti-Corruption Regional Plan.

112. Transparency International (TI),an international
"watchdog" organization promoting anti-corruption

COLOMBO 00000321 027 OF 034


strategies, runs a national chapter in Sri Lanka. In
TI?s Corruption Perception Index for 2005, Sri Lanka
was 78th among 158 countries with a score of 3.2 out of
a clean score of 10, reflecting a relatively high
perceived level of corruption among politicians and
public officials. Sri Lanka?s corruption ranking and
score deteriorated in 2005 from 67th and 3.5
respectively in 2004. TI?s 2003 National Integrity
Systems Country Report recommends creating an
independent anti-corruption authority with sufficient
powers as a top priority to combat corruption. TI has
asked the international donor community to ensure
transparency and clear lines of accountability in the
disbursement of donor aid for post war reconstruction
and post tsunami reconstruction. In response, the
Government?s tsunami reconstruction agency (now known
as Reconstruction and Development Agency (RADA) with
the assistance of the United Nations (UN) has created a
web based Development Assistance Database (DAD)
(www.dad.tafren.gov.lk) for tracking information
regarding tsunami aid disbursement and project
implementation.

113. In terms of Economic Freedom, Sri Lanka is ranked
92 out of 157 countries in the Heritage Foundation?s
2006 Index of Economic Freedom. Countries receive a 1-
5 rating - with one being the best - on 10 broad
measures of economic freedom: trade policy, government
fiscal burden, government intervention in the economy,
monetary policy, foreign investment, banking and
finance, wages and prices, property rights, regulation
and informal market activity. Sri Lanka?s overall
rating score worsened in 2006 to 3.19 from 3.03 in
2005.


BILATERAL INVESTMENT AGREEMENTS
--------------

114. The Government of Sri Lanka has signed Investment
Protection Agreements with the United States (which
came into force in May 1993) and the following
countries:

1. Belgium
2. People?s Republic of China
3. Denmark
4. Egypt
5. Finland
6. France
7. Germany
8. Indonesia
9. India
10. Iran
11. Italy
12. Japan
13. Korea
14. Luxembourg
15. Malaysia
16. Netherlands
17. Norway
18. Romania
19. Singapore
20. Sweden
21. Switzerland
22. Thailand
23. United Kingdom


--Taxation



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115. A bilateral treaty between Sri Lanka and the
United States to avoid double taxation was ratified and
entered into force on June 12, 2004.

116. Foreign investors not qualifying for Board of
Investment incentives such as tax and exchange control
exemptions or concessions are liable to pay taxes on
corporate profits, dividends, and remittances of
profits. They are also liable to pay a Value Added Tax
on goods and services. The government has also imposed
a tax of 0.1 percent on debits to any current or
savings account maintained at any bank in Sri Lanka.
Debits made to accounts of government and international
organizations are excluded. Accounts maintained at
Foreign Currency Banking Units, accounts maintained for
stock exchange transactions (SIERA),and resident and
non-resident foreign currency accounts are exempted
from the tax. The Embassy encourages prospective US
investors to contact an international auditing firm
operating in Sri Lanka to assess their tax liability.


OPIC AND OTHER INVESTMENT INSURANCE PROGRAMS
--------------

117. The US and Sri Lanka concluded in 1966 (and
renewed in 1993) an agreement that allows the Overseas
Private Investment Corporation (OPIC) to provide
investment insurance guarantees for US investors. OPIC
currently provides coverage to banking and power sector
investments in Sri Lanka. Sri Lanka's membership in
the Multilateral Investment Guarantee Agency (MIGA)
offers the opportunity for insurance against
non-commercial risks.

118. The US Embassy and other US Government
institutions spend over USD 21 million annually in Sri
Lanka. This amount can potentially be utilized by OPIC
to honor an inconvertibility claim; however, no such
claims have been made to date in Sri Lanka. The
Embassy purchases local currency at the financial rate.
The Sri Lankan Rupee has fluctuated against major
foreign currencies during past 12 months. The currency
is not expected to fluctuate by more than 10 percent
relative to the US dollar over the next year.


LABOR
--------------

--Labor Force

119. Sri Lanka's labor force is literate (particularly
in the local language) and trainable, although weak in
certain technical skills and the English language.
More computer and business skills training programs and
English language programs are becoming available. But
the demand for these skills still outpaces supply, and
many qualified workers seek employment overseas. The
average worker has eight years of schooling.

120. Two-thirds of the labor force is male. In the
third quarter of 2004, the unemployment rate
(employment is defined as one who worked for pay,
profit, or unpaid family gain for one or more hours
during the survey week) was 8.5 percent, or an
estimated 678,600 of a total labor force of 8 million
out of work. (Labor force data excludes some areas in
the Northern Province, armed forces personnel deployed
away from home, and Sri Lankan migrant workers abroad.)
If one does not count unpaid family workers as
employed, the unemployment rate is higher.

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Underemployment is also a major problem, with thousands
of university graduates seeking places in the already
bloated public sector, yet lacking skills needed in the
private sector. Youth and entry-level unemployment
remains a critical problem. Nearly 80 percent of
unemployed persons are in the 15-29 year age range.
Over 50 percent of unemployed young people are educated
at the Ordinary-Level (British System equivalent of US
10th grade) or higher.

121. A significant proportion of unemployed people
seek "white collar" jobs, and most sectors seeking
employees offer manual or semi-skilled jobs or require
technical or professional skills such as management,
marketing, information technology, accountancy and
finance, and the English language. Following pledges
during April 2004 parliamentary elections and recently
concluded Presidential elections, the government has
initiated several programs to expand state sector
employment. For instance, a graduate employment
program provided about 42,000 new jobs in the
government sector in 2005. A further 10,000 new jobs
are to be created in 2006 and the Government has
promised to hire into its bulging bureaucracy an
additional 10,000 each year thereafter.

122. The government has recognized the challenge of
reformulating the educational system to meet the needs
of the private sector better, but it will take time
before the mismatch of skills to requirements is
addressed. USAID, the Asian Development Bank and the
World Bank have recently approved projects to improve
distance learning and tertiary education. The private
sector is offering various professional study courses
accredited to local and foreign professional institutes
and foreign universities. However, access to these
courses is limited due to the high fees involved.
Additionally, a fair number of Sri Lankans study
abroad.

--Migrant Workers Abroad

123. There are an estimated 970,000 Sri Lankan workers
abroad. Remittances from migrant workers, at around
$1.5 billion, is one of Sri Lanka?s largest sources of
foreign exchange. The majority of this labor force is
unskilled (housemaids and factory laborers) and located
primarily in the Middle East. But Sri Lanka is also
losing many of its technically and professionally
qualified workers to more lucrative jobs abroad. The
Government has pledged to promote programs aimed at
increasing overseas employment opportunities for Sri
Lankans.

--Low Cost of Labor; Fair to Growth-Limiting Labor
Regulations

124. Labor is available at a relatively low cost,
though it is priced higher than in other South Asian
countries. Child labor is prohibited and is virtually
nonexistent in the organized sector, although child
labor occurs in informal sectors. The minimum legal
age for employment is set at 14. Most permanent
full-time workers are covered by laws pertaining to
maximum hours of work, minimum wage, leave, the right
of association, and safety and health standards. The
Termination of Employment of Workmen Act (TEA) makes it
difficult to fire or lay off workers who have been
employed more than six months for any reason other than
serious, well-documented disciplinary problems.
Disputes over dismissals can be brought to a labor
tribunal administered by the Ministry of Justice. The

COLOMBO 00000321 030 OF 034


labor tribunals have large backlogs of unresolved
cases. Certain labor disputes founded upon fundamental
rights (allegations of termination/transfers based upon
discrimination, etc.) can be brought directly to the
Supreme Court. Productivity lags behind other countries
in Asia.

125. There is widespread belief that Sri Lanka?s labor
laws and its plethora of holidays dampen productivity.
The full moon day of each month (sacred in the Buddhist
faith),if it falls on a weekday, is a paid holiday.
There are also eight other public holidays. The public
sector and banks enjoy additional holidays. These
statutory holidays are in addition to 21 days of
annual/casual leave and approximately 21 days of sick
leave (the number of days for sick leave is at the
discretion of the management). Further, female
employees are entitled to 84 days fully paid maternity
leave for the first two pregnancies. The 2005 budget
proposed additional maternity leave benefits, but they
are yet to be implemented. Female workers are
permitted 60 hours of overtime work per month.

126. The Government continues to interfere with private
sector wage setting. In October 2005, the Government
through an act of Parliament took steps to mandate a
wage increase (of approximately Rs 1,000) to private
sector workers. The private sector is concerned about
such interference in wage setting, which could damage
competitiveness in certain sectors.

--Termination laws

127. While the Termination of Employment of Workmen
Act (TEA) described above makes it difficult to fire or
lay off workers, Parliament, through the UNF
government?s labor reform agenda, passed amendments in
January 2003 to the TEA and the Industrial Disputes Act
(IDA) to improve labor mobility. The amendments to TEA
seek to facilitate termination and provide for a
standard compensation formula and an unemployment
benefit scheme. Amendments to the IDA include labor
dispute resolution rules to expedite the dispute
process. The new termination rules became operational
with the establishment of a new compensation formula in
March 2005. The compensation formula takes into
account the number of years of service and offers 2.5
months salary as compensation for 1 year of service,
12.5 months salary for 5 years of service; 38 months
for 20 years and up to a maximum of 48 months salary
for 34 years service. This of course assumes that the
government will approve such a termination, which
frequently is not the case. The proposed unemployment
benefit insurance scheme to provide an additional
payment has not yet come into effect. According to a
recent IMF report, Sri Lanka?s firing cost for 20 years
of service, at 38 months, is among the highest in Asia
compared with Pakistan and Nepal?s 22.5 months, India?s
19.6 months, Malaysia?s 18.5 months, China?s 13.2
months and Bangladesh?s 11.7 months. Under the new
arrangements, the Labor Commissioner?s approval or the
affected employee?s consent is required to fire
workers. Employers complain that the package is
excessive, especially compared to international norms.
They have also pointed out that higher compensation
could adversely affect companies requiring
restructuring, and discourage investment.

128. Other planned reforms include amendments to the
Shop and Office Act to allow female employees in the IT
sector to work at night. A more systematic overhaul of
the TEA and IDA would help to bring labor laws in line

COLOMBO 00000321 031 OF 034


with international norms.

--Trade Unions

129. About 15 percent of labor in the industry and
service sector is unionized. Labor in free trade zone
enterprises tends to be represented by non-union worker
councils.

130. Unions have complained that the BOI and some
employers, especially in the BOI-run export processing
zones (EPZ),prohibit union access and do not register
unions on a timely basis. Employers allege that the
JVP, a Marxist political party against private
ownership, could provoke labor to strike in the guise
of trade union activity. Due to the JVP?s violent
past, employers are generally not in favor of it or its
trade union arm, the Inter-Company Trade Union.

131. The Government continues to take steps to improve
enforcement of labor regulations inside EPZs. In BOI
enterprises, including those in the EPZs, worker
councils composed of employees generally engage in
labor and management negotiations. These worker
councils have functioned well in some companies in
providing for worker welfare. The BOI has requested
that companies recognize trade unions and accept the
right to collective bargaining. According to the BOI,
where both a recognized trade union with bargaining
power and a non-union worker council exist in an
enterprise, the trade union will represent the
employees in collective bargaining.

132. The ILO Freedom of Association Committee has
observed that Sri Lankan trade unions and employee
councils can co-exist, but advises that there should
not be any discrimination against those employees
choosing to join a union. The right of employee
councils to engage in collective bargaining has been
held as valid by the ILO. The ILO has, however, noted
weaknesses in rules governing operation of employee
councils and low prevalence of collective bargaining
agreements and requested that the Government carry out
improvements.

133. In response to these observations, the BOI
revised its labor manual in March 2004, requesting that
companies located in EPZs allow union access to zones
and provide official time off to union members to
attend meetings. Along with this revision, the BOI
also issued new guidelines for the formation and
operation of employee councils, giving powers to
employee councils to negotiate binding collective
agreements.

134. In 2002, the American Federation of Labor and
Congress of Industrial Organizations (AFL-CIO)
submitted a petition to the United States Trade
Representative seeking suspension of Generalized System
of Preferences (GSP) benefits for Sri Lanka due to
labor rights violations in some factories in the EPZs.
This petition was not acted upon. A similar submission
was made to the European Union (EU) by a local trade
union when Sri Lanka applied for benefits under the
special incentive arrangements of the GSP. After an
audit, the EU, in January 2004, granted significant
benefits to Sri Lanka under EU GSP in recognition of
the country?s efforts to implement core labor standards
because the audit did not find serious problems with
regard to those standards. The EU, however, observed
the need for further improvements in freedom of
association.

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135. In the plantation sector, union participation
rates are as high as 75 percent, though unionization
levels are reportedly on the decline. Key public
sector entities such as the Ceylon Electricity Board
and Sri Lanka Ports Authority also have large unions
which stage protests, often to obtain pay hikes and
sometimes to protest anticipated moves towards
privatization or restructuring. Most of the major
trade unions are affiliated with political parties,
creating a highly politicized labor environment.
Several trade unions with affiliations to major
political parties have formed themselves into an
organized group, the National Association for Trade
Union Research and Education (NATURE),to promote
education and training among trade unionists.

136. The growing strength of Marxist parties in active
politics and in parliament has increased politicized
union activity, especially in government institutions.
State agencies with large unionized workforces have
become vulnerable to politically motivated strikes in
response to restructuring and privatization.

--Collective Bargaining

137. Collective bargaining is not yet popular. While
more than half of the Employers? Federation of Ceylon?s
(EFC?s) 435-strong membership is unionized, currently
only about 50 of these companies (including a number of
foreign-owned firms) have collective agreements and use
them to conduct negotiations on their behalf. Civil
servants other than officers in the police, armed
forces, and prison service, also have a right to
strike.

--Labor-Management Relations

138. Labor-management relations in the past have
typically been confrontational. The attitude of
employers towards workers has changed considerably in
the last few years. Employers are becoming more
conscious of the need to look after their human
resources, and more effort is taken to ensure that
workers feel motivated and cared for. While labor-
management relations vary from organization to
organization, managers who emphasize communication with
workers and offer training opportunities generally
experience fewer difficulties. US investors in Sri
Lanka (including US garment buyers) generally promote
good labor management relations and labor conditions
that exceed local standards. Work stoppages and
strikes in the private sector are on the decline.

--ILO conventions

139. Sri Lanka is a member of the International Labor
Organization (ILO) and has ratified 39 international
labor conventions. The labor laws of Sri Lanka are
laid out in almost 50 different statutes. The Ministry
of Labor has published a Labor Code, consolidating
important labor legislation. Sri Lanka has ratified
all eight of the core labor conventions included in the
1998 ILO Declaration on Fundamental Principles and
Rights at Work. ILO Convention 138 on minimum age for
admission to employment and Convention 182 on worst
forms of child labor were ratified during 2000-2001.
Sri Lanka ratified ILO convention 105 on Forced Labor
in 2003. The ILO, EFC and the AFL-CIO-sponsored
American Center for Labor Solidarity are working to
improve awareness about core labor standards. The ILO
also promotes its Decent Work Agenda program in Sri

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Lanka.


FOREIGN TRADE ZONES
--------------

140. Sri Lanka has 10 free trade zones, also called
export-processing zones, administered by the BOI. The
oldest, the Katunayake and Biyagama Zones, located
north of Colombo near the Bandaranaike International
Airport, are fully occupied. The third zone is located
at Koggala on the southern coast. Several new mini
export-processing zones were opened in the provinces
during the last few years. There are nearly 200
foreign export processing enterprises operating in
these zones. There are also two industrial parks that
have both export-oriented and non-export oriented
factories. They are located in Pallekelle, near Kandy
in central Sri Lanka and in Seethawaka in Avissawela
about 60 kilometers from Colombo.

141. In the past, industrialists preferred to locate
their factories in close proximity to Colombo harbor or
airport to reduce transport cost and save time. The
excessive concentration of industries around Colombo
has created problems such as scarcity of labor,
inadequate infrastructure, environmental pollution,
escalation of real estate prices, and congestion in the
city. The BOI actively encourages the establishment of
export-oriented factories in the newly developed
industrial zones. The BOI also finds it easier to
provide infrastructure facilities and security, as well
as to monitor enterprises, when they are located in the
zones. However, the limitations of transportation
infrastructure may make some distant zones somewhat
less appealing.


FOREIGN DIRECT INVESTMENT
--------------

--US Investments

142. Major US companies with investments in Sri Lanka
include: Energizer Battery, Mast Industries, Smart
Shirts (a subsidiary of Kellwood Industries),Chevron,
Citibank, Caterpillar, 3M, Cargill, Coca Cola,
Celetronix, Inc, Paxar Corporation, Pepsi Co, Sportif,
Worldquest, Fitch IBCR, AES Corporation, American
International Group (AIG),American Premium Water,
Virtusa, Avery Denison, North Sails, and Amsafe
Bridport. In addition, IBM, Lanier, NCR, GTE,
Motorola, Procter & Gamble, Liz Claiborne, Tommy
Hilfiger, J.C. Penney, the Gap, Sun Microsystems,
Microsoft, Bates Strategic Alliance, McCann-Erickson,
Pricewaterhouse Coopers, Ernst and Young, and KPMG all
have branches, affiliated offices or local
distributors/representatives. Kentucky Fried Chicken,
Pizza Hut, Federal Express, UPS, and McDonald?s are
represented in Sri Lanka through franchises. Numerous
other American brands and products are represented by
local agents.

143. US investment in Sri Lanka is estimated to be in
the range of USD 200 million. A recent investor in the
power sector is AES Corporation. AIG insurance entered
Sri Lanka in 1999. Other foreign companies in Sri
Lanka are expanding, such as Celetronix Inc (memory
boards),Virtusa and Citibank. During the past few
years, several US companies have formed joint ventures
or other partnerships with Sri Lankan companies in the
IT sector, mainly in software development.

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--Non-US Investments

144. Major non-US investors include: Unilever, Nestle,
British American Tobacco Company, Mitsui, Pacific
Dunlop/Ansell, Prima, FDK, Telekom Malaysia Bhd, S.P.
Tao and HSBC. Leading US and foreign investors that
have acquired significant stakes in privatized
companies include Chevron, Norsk Hydro of Norway,
Hanjung Steel of Korea, Nippon Telephone and Telegraph,
Mitsubishi Corporation and C. Itoh (A.K.A. Itochu) of
Japan, Emirates Airlines of United Arab Emirates, Shell
Oil of the UK, P&O Netherlands, and the Indian Oil
Corporation (IOC)

145. Reliable statistics on foreign investment by
country are not available. Leading sources of foreign
investments are Singapore, United Kingdom, Japan, South
Korea, Hong Kong, and Australia. FDI in 2005 was about
USD 150 million.

146. Note: 2005 data are estimates.

Entwistle