SRI LANKA: MORE STIMULUS

UNCLAS SECTION 01 OF 02 COLOMBO 000215

SENSITIVE

SIPDIS

STATE FOR SCA/INS AND EEB/IFD/OMA
STATE PASS USTR FOR ADINA ADLER AND VICKY KADER
TREASURY FOR ANNE ALIKONIS

E.O 12958: N/A
TAGS: ECON EFIN PGOV KMCA CE
SUBJECT: SRI LANKA: MORE STIMULUS

Ref:(a) COLOMBO 22
(b) 08 STATE 134459
(c) 08 COLOMBO 1133
(d) 08 COLOMBO 1123
(e) 08 COLOMBO 922


1. (U) SUMMARY: In addition to a Rs 16 billion (USD 140 million)
stimulus package announced in December 2008 (ref a),the GSL
recently announced several steps to provide support to its economy,
introducing a Rs 4.2 billion (USD 36 million) stimulus package for
finance and leasing companies, interest rate cuts, and export
subsidies. While the interest rate cuts and the export "rebate
scheme" are intended to directly address problems arising from the
global economic crisis, the government hopes its actions to provide
assistance to the leasing and finance sector will restore public
confidence following major local scandals from unregulated finance
companies. End summary.

RATE CUTS
--------------


2. (U) Hoping to help stimulate the economy, on February 11 the
Central Bank (CB) reduced its key interest rates, lowering both the
repurchase rate and reverse repurchase rate by 25 basis points to
10.25 percent and 11.75 percent, respectively. This is the CB's
first interest rate cut in repurchase and reverse repurchase
instruments since February 2007. (Note: Borrowing is restricted to
three times per month. End note.) The Central Bank also cut its
penal interest rate from 17.0 percent to 16.5 percent. This cut
follows a 200 basis point rate cut in January. In its public
statement, the CB said its reductions are expected to "pass through
to other market interest rates soon and lead to significant
reductions in the cost of borrowing, resulting in economic activity
being stimulated in the face of adverse conditions brought on by the
global economic slowdown." On February 24, hoping to further
improve liquidity, the Central Bank announced a reduction in the
statutory reserve ratio (SRR). The SRR will be reduced by 75 basis
points to 7.0 percent starting on February 27. This move is
expected to add Rs 9 billion (USD 78 million) to the banking
system.


3. (U) Meanwhile, since January 1 Treasury bill rates have been
reduced by about 150 basis points to 15.76% (3 month) and 17.73% (1
year). Nevertheless, prime lending rates, at which banks lend to
key customers, continue to hover above 19%.

PRODUCTIVITY SCHEME TO MAINTAIN EXPORTS
--------------


4. (U) On February 19, the government announced a subsidy
arrangement for all exporters, expanding the coverage of an earlier
program that was restricted to apparel and leather products
exporters (ref a). Under the scheme, companies able to maintain
export earnings at 2008 levels will be given a government-funded 5%
rebate in Sri Lankan rupees (SLR). Companies maintaining earnings
between 90-99% will be given a 3% rebate in SRL. Exporters must
also maintain 2008 employment numbers (no lay offs) and meet
yet-to-be-determined value addition criteria for each industry.
Companies' performance will be reviewed, and "rebates" given, on a
quarterly basis. Rebates will be free of corporate tax. Businesses
with a three-year track record of exports are eligible to
participate.

SUPPORT FOR FINANCE AND LEASING COMPANIES
--------------


5. (U) Acknowledging waning public confidence in registered finance
companies and leasing companies following local scandals involving
unregulated companies, on February 20 the Central Bank announced a
Rs 4.2 billion (USD 36 million) package for the sector. The
package, which is to be implemented "soon," aims at addressing
liquidity and funding problems in this sector, which accounts for
around 9% of the overall financial sector in country. The package
contains two key features. First, finance and leasing companies
will be able to sell part of their land stock to a government bank
(Rs 2 billion). The government-owned Lankaputra Bank will offer to

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purchase land from finance and leasing companies at a maximum of 67%
of the land value. Payment will be in government bonds, which may
then be discounted in the secondary market to raise cash. Second,
the Central Bank will guarantee credit provided by commercial banks
to finance and leasing companies (Rs 2.2 billion).


6. (U) At the same time, the CB also announced plans to reduce the
liquidity requirement of finance companies. In return, the finance
and leasing companies will be asked to reduce interest and lending
rates by 2%. (Note: The Central Bank proposed that vehicles and
equipment seized by these companies be returned to the original
customers; however, it did not detail this as a requirement.) The
Central Bank plans to strictly monitor companies receiving
assistance under this package and to impose restrictions on
incentive payments to top management. As is too often the case,
there was no clear indication as to how the government will fund the
package, although a CB press release said that it will consider the
release of funds available in a medium and long term credit facility
to support the package.

COMMENT
--------------


7. (U) The above financial sector assistance measures are likely to
ease the local liquidity shortage. In particular, the finance and
leasing sector package is viewed as a lifeline to the sector.
According to finance industry sources, about 75 percent of the
companies in the finance and leasing sector are facing difficulties
and will take the Central Bank offer. This action will also help
restore confidence in a sector badly damaged due to major scandals
in unregulated finance houses.


8. (SBU) The effectiveness of the export subsidy scheme remains
uncertain. Exporters report it will be difficult to maintain export
incomes when both export volumes and prices are falling. As a
result, few will likely be able to reap the benefits on offer. Some
see the subsidy as an attempt to make up for the overvalued rupee.
Although the SLR has depreciated by about 6 percent against the
dollar in the last twelve months, it appreciated sharply against
most other currencies, lowering the competitiveness of Sri Lanka's
exports. (Note: According to a Central Bank index, Sri Lanka's
real effective exchange rate has appreciated by 22 percent in the
twelve months to November 2008.) Exporters face a tough year ahead
as many try to determine if and how they can maintain profitability
in the current economic downturn.