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RR RUEHLMC
DE RUEHLM #1305/01 2631036
ZNR UUUUU ZZH
R 201036Z SEP 07
FM AMEMBASSY COLOMBO
TO RUEHC/SECSTATE WASHDC 6844
INFO RUCPDOC/DEPT OF COMMERCE WASHDC
RUEHC/DEPT OF LABOR WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
RUEHNE/AMEMBASSY NEW DELHI 1384
RUEHKA/AMEMBASSY DHAKA 0421
RUEHIL/AMEMBASSY ISLAMABAD 7408
RUEHKT/AMEMBASSY KATHMANDU 5535
RUEHCG/AMCONSUL CHENNAI 8001
RUEHLMC/MILLENNIUM CHALLENGE CORPORATION

UNCLAS SECTION 01 OF 03 COLOMBO 001305 
 
SIPDIS 
 
SENSITIVE 
 
SIPDIS 
 
STATE FOR SCA/INS AND EEB/IFD/ODF 
STATE PASS USTR FOR DARLA BROWN AND ADINA ADLER 
DOL/ILAB FOR TINA MCCARTER 
MCC FOR S. GROFF, D. TETER, D. NASSIRY AND E. BURKE 
TREASURY FOR LESLIE HULL 
 
E.O 12958: N/A 
TAGS: ECON EFIN ETRD KMCA CE
SUBJECT: SRI LANKA: 6.2% GDP GROWTH IN FIRST HALF OF 2007 AMIDST 
CONTINUED HIGH INFLATION AND DECLINING EXCHANGE RATE 
 
REF: COLOMBO 1056 
 
¶1. (U) Summary and comment: Sri Lanka's GDP grew at an annual rate 
of 6.2% for the first half of 2007.  The trade deficit narrowed as 
export growth significantly exceeded import growth.  Growing 
remittances compensated for much of the trade deficit and boosted 
foreign exchange reserves to a level sufficient to cover three 
months of imports.  Average annual inflation returned to the 17% 
range after moderating somewhat earlier in the year, as the Central 
Bank continued to finance the government's deficit spending and 
imported commodity prices rose.  The high inflation drove the Sri 
Lankan Rupee to historic lows against the dollar, Euro, and Indian 
Rupee.  The Colombo Stock Exchange recovered somewhat from a large 
drop following Tamil Tiger attacks in March and April, but remains 
down 5% for the year.  Business confidence, as indicated by a 
monthly Nielsen survey, is at a three-year low. 
 
¶2. (SBU) The 6.2% growth rate is respectable for a country in the 
midst of a long civil conflict, but it suggests Sri Lanka won't see 
the 7.5% growth the government has been predicting for 2007.  High 
inflation is a more serious liability for the populist Rajapaksa 
government, with public concern growing over the rising cost of 
living.  However, the government has avoided the sacrifices 
necessary to reduce inflation.  Its projected 2007 budget deficit is 
7.8% of GDP, despite recently instructing all ministries to defer 
capital spending.  The Central Bank likewise is ducking tough 
choices -- instead of raising interest rates enough to dampen still 
strong consumer demand and investment, it has tried to use 
administrative measures and "moral suasion" to discourage banks from 
lending.  Beyond all this, the one measure that could improve all 
the economic trends would be for the government to decisively pursue 
a peaceful solution to the conflict.  End summary and comment. 
 
6.2% GDP GROWTH IN FIRST HALF OF 2007 
------------------------------------- 
 
¶3. (U) The Sri Lanka Department of Census and Statistics reported 
September 13 that second quarter 2007 GDP growth was 6.4%.  This 
brought GDP growth for January-June 2007 to 6.2% -- below the 
government's target of 7.5-8% and below the 7.8% growth registered 
in the first half of 2006.  Services, the largest sector, grew by 
6.5%, boosted by rapidly expanding telecommunications and strong 
growth in banking and finance.  These outweighed a 19% decline in 
the tourism-driven hotel and restaurant category.  The manufacturing 
sector grew by 7.5% with textiles and apparel expanding strongly by 
12.7%.  In the agricultural sector, which grew by 3.5%, both tea and 
rice production contracted, the latter by 7.6% due to a reduction in 
cultivation in the east caused by the conflict. 
 
TRADE DEFICIT NARROWS 
--------------------- 
 
¶4. (U) Exports increased strongly by 13% to $3.56 billion and 
imports increased by 4% to $5.15 billion in the first half of 2007. 
Consequently, Sri Lanka recorded a trade deficit of $1.58 billion 
compared with $1.79 billion in 1H2006.   Textiles and garments, Sri 
Lanka's largest export category, rose 15%.  Other manufactured 
exports were also strong.  Exports to the United States, Sri Lanka's 
largest market, recorded a marginal decline however.  Exports to the 
EU increased sharply, on the growth of duty-free garment sales under 
the EU's GSP Plus program.  Agriculture products, which account for 
about a fifth of total exports, grew by 9%. 
 
¶5. (U) Sri Lanka's January-June petroleum import bill decreased by 
8%, helping to contain the overall increase in imports.  This was 
not due to reduced consumption, however.  Instead, Sri Lanka had 
higher than normal petroleum stocks at the beginning of 2007; total 
oil import costs are expected to pick up again in the second half of 
the year.  Consumer and capital goods imports each increased by 9%. 
Imports of intermediate goods were flat, mainly due to lower oil and 
fertilizer imports.  In the capital goods category, building 
materials and transport goods increased strongly. Machinery imports 
recorded a marginal decline of 1 percent. 
 
REMITTANCES CONTINUE TO INCREASE 
 
COLOMBO 00001305  002 OF 003 
 
 
-------------------------------- 
 
¶6. (U) Remittances, Sri Lanka's second largest source of foreign 
exchange after garment exports, increased by 18.4% to $1.3 billion 
in the 1H2007.  Net private remittances financed nearly 70% of the 
trade deficit in the first half of 2007.  According to estimates of 
the Sri Lanka Bureau of Foreign Employment, 1.5 million Sri Lankans 
were working abroad as of 2006. 
 
INFLATION REMAINS HIGH 
---------------------- 
 
¶7. (U) Inflation, as measured by the Colombo Consumer Price Index 
(CCPI), was high, with prices in August 17.3% higher than a year 
earlier.  Since 2006, inflation has been driven by both demand and 
supply side pressures.  On the demand side, government deficit 
spending has been partially financed by the Central Bank and 
partially from local and international borrowing.  Low real interest 
rates have fed continued private sector credit expansion.  Growing 
remittances have also contributed to strong consumer spending.  On 
the supply side, prices rose for imported commodities including oil, 
fertilizer, wheat, and milk powder.  Reduced government subsidies on 
petrol, diesel and kerosene caused these prices to rise. 
Depreciation of the Sri Lankan Rupee also contributed to the rising 
local prices of imported commodities. 
 
EXCHANGE RATE DECLINES DESPITE CENTRAL BANK VIEWS 
--------------------------------------------- ---- 
 
¶8. (U) The Sri Lankan Rupee has depreciated 5.7% against the U.S. 
dollar so far this year, setting record low rates almost daily in 
recent weeks.  Currently, the Rupee is trading around 113.5 against 
the dollar, down from 107.7 at the beginning of the year.  The rupee 
has depreciated even more strongly against the Pound, Euro, and 
Indian Rupee.  Forward rates for the Rupee indicate markets expect 
it to decline further: the six month forward rate is currently 
around 120 Rupees to the dollar.  The depreciation has been driven 
by a combination of high inflation, the trade deficit, and high 
demand for dollars -- both by speculators and importers hedging 
against expected continued declines in the Rupee. 
 
¶9. (U) Because the depreciated Rupee makes both imports and debt 
service more costly, the Central Bank has sought to shore up its 
value.  In July and August the Bank spent about $150 million in 
reserves to buy Rupees, which slowed but did not reverse the slide. 
Giving up this approach, the Bank issued a statement on August 30 
saying the "undue depreciation of rupee" was "not based upon any 
fundamental macroeconomic factors."  The Bank's intervention did not 
substantially reduce reserves: at the end of August, gross official 
reserves were $2.67 billion, providing an import cover of three 
months, having risen from $2.52 billion at the beginning of the 
year. 
 
STOCK MARKET DOWN 5% SO FAR THIS YEAR 
------------------------------------- 
 
¶10. (U) The Colombo Stock Exchange, which was on a steady downward 
trend since the March and April Tamil Tiger air attacks near 
Colombo, bottomed out in mid-July and has recovered somewhat since 
then.  Currently, the All Share Price Index is down 5% since the 
beginning of the year and 14% from the all-time high it reached in 
February.  Stock brokers attribute the upturn to the relatively 
stable security environment since April, the government's military 
gains in the Eastern Province, and attractive price-to-earnings 
levels at the market's ebb.  Top listed companies have reported 
declining net profits as a result of inflation, high interest costs, 
and rising taxes.  On a sectoral basis, telecoms, banks, and 
conglomerates have done well, as have tourism companies that have 
investments in Maldives. 
 
BUSINESS CONFIDENCE INDEX AT A THREE-YEAR LOW 
--------------------------------------------- 
 
¶11. (U) The Lanka Monthly Digest-ACNielsen Business Confidence Index 
(BCI), which surveys 100 senior top executives in Colombo, has 
 
COLOMBO 00001305  003 OF 003 
 
 
fallen for five straight months to a 35-month low.  In the August 
survey, 85% of respondents viewed Sri Lanka's investment prospects 
as being poor or very poor and 53% expected sales volumes to get 
worse in the coming twelve months. 
 
COMMENT: NO SILVER BULLET, EXCEPT FOR PEACE 
------------------------------------------- 
 
¶12. (SBU) The 6.2% growth rate is certainly respectable for a 
country in the midst of a long civil conflict, but it is less than 
the government hoped to see after frequent public statements by 
ministers and the Central Bank governor that the economy is on track 
for 7.5% growth this year (reftel).  The high inflation rate is a 
more serious liability for the Rajapaksa government, as daily 
headlines and opposition criticism reflect real public concern over 
the rising cost of living.  However, the government has not been 
willing to make sufficient sacrifices to bring inflation down.  It 
has made some easy choices, such as trying to limit its projected 
$2.6 billion budget deficit by instructing all ministries to defer 
capital spending.  The harder choices would be for the government to 
cut electricity and kerosene subsidies, and for the Central Bank to 
raise interest rates enough to dampen still strong consumer demand 
and investment.  Perhaps the hardest of all, but the one measure 
that could improve all the economic trends, would be for the 
government to decisively pursue a peaceful solution to the 
conflict. 
BLAKE