SRI LANKA: FINANCING HARDSHIPS IN NEW YEAR

UNCLAS SECTION 01 OF 03 COLOMBO 001133

SENSITIVE

SIPDIS

STATE FOR SCA/INS AND EEB/IFD/OMA
STATE PASS USTR FOR ADINA ADLER AND VICKY KADER
COMMERCE FOR EROL YESIN, BRIAN WILLIAMS
DOL/ILAB FOR TINA MCCARTER
TREASURY FOR ANNE ALIKONIS

E.O 12958: N/A
TAGS: ECON EFIN PGOV KMCA CE
SUBJECT: SRI LANKA: FINANCING HARDSHIPS IN NEW YEAR

REF: (A) COLOMBO 1127
(B) COLOMBO 1107


1. (SBU) Summary: Sri Lanka's macroeconomic outlook for 2009 is
weakening. In November Central Bank reserves declined, for the
fourth straight month, to around $2 billion, or less than 2 months
of imports. The trade deficit in the first ten months expanded by
78%, and the Central Bank (CB) expects a balance of payments (BOP)
deficit of about $500 million in 2008. Analysts argue for a
depreciation of the rupee to boost exports and reign in the trade
deficit. Sri Lanka will face external debt servicing costs of over
$1 billion in the new year. Although Sri Lanka has not defaulted on
loan payments in recent times, the possibility of default in 2009
cannot be ruled out. End Summary.

DEFENDING THE RUPEE,
DEPLEATING FOREIGN RESERVES
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2. (SBU) The Sri Lankan rupee is under severe pressure due to a
large trade deficit and foreign bond holders exiting the market.
GSL external debt service payments are expected to rise in 2009,
adding additional pressure. To date, Central Bank sources report
that the CB has spent around USD one billion defending the rupee in
2008 in order to keep the rupee-dollar exchange rate relatively
stable. (Note: On October 30, the rupee was marginally devalued
from 108 to 110. The rupee is currently trading at 111 to a
dollar.) The rupee nevertheless appreciated against most other
major currencies in 2008 (to date 10% against the Euro, 18% against
the Indian rupee).


3. (SBU) Although Sri Lanka recorded a BOP surplus of $173 million
at end September, according to Assistant Central Bank Governor H. N.
Thenuwara the CB expects a BOP deficit of about $500 million by year
end. Sri Lanka's official reserves dwindled to around $2 billion in
November, down from $3.06 billion in January. According to
documents released with the 2009 budget, Sri Lanka's external debt
service cost (interest and amortization) will be over $1 billion in

2009. In previous years, the government easily rolled over the
debt; that will be difficult in 2009 given the global credit crunch.
The government will also be called on to payback an Iranian credit
line used to import oil.

NO IMF, WE CAN DO IT OURSELVES
--------------


4. (SBU) Despite concerns about foreign reserves, the GSL is not
willing to accept condition-based foreign aid, and it (at present)
rejects the possibility of IMF facilities in 2009. The GSL
continues to resort to commercial loans to finance its deficit. In
2008 the Central Bank raised approximately $550 million through a
variety of commercial sources, including state banks, two-year Sri
Lanka Development Bonds, and a syndicated loan. However, the
government's last attempt to raise $300 million in October failed,
and in December an Indian bank withdrew plans to provide a $25
million loan to the GSL.




5. (SBU) As a result, the Central Bank is trying to curb fund
outflows. It introduced controls on forward contracts of foreign
exchange, prohibited prepayment of import bills, and imposed a 100
percent margin on letters of credit when importing non-essentials.
The margin requirement on the import of cars has been increased to
200%. (Note: Imported cars are taxed at between 206% - 503%.) The
government also increased taxes on non-essentials in an effort to
curb imports.


6. (SBU) On the bright side, remittances increased by more than 22%
in the first nine months of 2008. However, while remittances
traditionally help to finance about 70% of the trade deficit, they
could not keep pace with the trade deficit increase in 2008. The
possibility of decreasing remittances as employment opportunities
shrink in oil producing countries remains a concern, despite

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government projections that remittances will increase in 2009.

INFLATION
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7. (SBU) Inflation declined to 16.3% in November after decelerating
gradually since its peak of 28.2% in June 2008. The 2008 annual
average inflation is now trending now more slowly at 23%. The slow
down in inflation was due primarily to the fall in world prices of
oil and food. However, the Central Bank's tight monetary policy
also helped to moderate inflation; the CB cut its money supply
target thrice in 2008 to reduce money in circulation. Citing a
liquidity short fall in the money markets, the Central Bank eased
monetary policy in late November by reducing reserve requirements
for commercial banks. The bank said its actions will not pose any
threat to the inflation outlook since inflation is decelerating "at
a faster rate than expected."

TRADE DEFICIT INCREASES 78%
--------------


8. (SBU) Total exports through end October increased 9%. Total
imports increased a staggering 31% during the same period, primarily
due to higher oil prices earlier in the year. Consequently, the
ten-month trade deficit widened by 78% to $5.2 billion in 2008 from
$2.9 billion in 2007. Despite an overall increase in exports to
date, the initial effects of the global recession are apparent in
Sri Lanka's exports sector. Demand for Sri Lanka's major
agricultural products, such as tea, rubber and coconuts, has
weakened. Tea and rubber are hurting the most as prices, which
reached record highs in early 2008, have decreased by 30% and 50%,
respectively, since mid-September. Other manufactured items, such
as rubber, ceramic, and leather products dropped sharply in
September-October. Apparel exports may be a bright spot; although
exports recorded a sharp decline in September, they increased by 13%
in October (year on year).

CONCERNS FOR THE NEW YEAR
--------------


9. (SBU) Experts agree that Sri Lanka will have trouble meeting its
external funding requirements in 2009. On December 9, ADB Country
Manager Dr. Richard Vokes publicly underscored his doubts about the
ability of the government to raise commercial loans in 2009. Vokes
is not alone. In November, S&P categorized Sri Lanka as
significantly at risk of a credit rating downgrade due to a global
recession and scarce funds, underlining that Sri Lanka is facing
risks due to high short term commercial debt and high fiscal
deficits. In mid October, the IMF said in its annual Article IV
review that reliance on foreign debt to finance the deficit could
destabilize the Sri Lankan economy. IMF also said that amid
increasing international risk aversion, raising external finance
will become increasingly challenging. According to Saman Kelegama
of the Institute for Policy Studies (a well-respected local economic
think tank),if Sri Lanka faces a sharp recession in 2009, it will
not be able to fund a stimulus package because the country has been
running huge budget deficits for too long and the macro economic
fundamentals are already too weak.


10. (SBU) Many economists argue for the depreciation of the rupee.
Local economic analysts and businesses argue that the rupee is
overvalued -- some say by 20% -- and must be depreciated
immediately. Vokes said Sri Lanka should seriously consider
depreciating the rupee in light of the worsening trade deficit and
depleting reserves. Advisors to the Central Bank are pleading for
depreciation (ref b). Kelegama notes that although deprecation will
likely fuel inflation, the right time for a depreciation is now as
inflation is on the decline and world commodity prices are at low
levels.

COMMENT
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11. (SBU) Significant expenditure restraint in the new year, in

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light of the ongoing conflict and President Rajapaksa's commitment
to the public sector, is extremely unlikely. Although the
government continues to reject the possibility of IMF facilities, if
commercial options are unavailable, hoped-for increases in
remittances and Diaspora investment fail to materialize, and/or
bilateral friends fail to give the GSL a helping hand, the
government will be forced to reconsider this position in 2009.