IMI - INVESTMENT CLIMATE STATEMENT, 2006 ? SRI LANKA

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/>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



COLOMBO 00000321 012 OF 034





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



COLOMBO 00000321 013 OF 034





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



COLOMBO 00000321 017 OF 034







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.





COLOMBO 00000321 021 OF 034





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



COLOMBO 00000321 022 OF 034





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



COLOMBO 00000321 024 OF 034





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



COLOMBO 00000321 025 OF 034





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.



COLOMBO 00000321 029 OF 034





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.



COLOMBO 00000321 032 OF 034







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