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RR RUEHLMC
DE RUEHLM #0076/01 0161158
ZNR UUUUU ZZH
R 161158Z JAN 08
FM AMEMBASSY COLOMBO
TO RUEHC/SECSTATE WASHDC 7569
INFO RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
RUEHNE/AMEMBASSY NEW DELHI 1775
RUEHKA/AMEMBASSY DHAKA 0691
RUEHIL/AMEMBASSY ISLAMABAD 7679
RUEHKT/AMEMBASSY KATHMANDU 5859
RUEHKP/AMCONSUL KARACHI 2320
RUEHCG/AMCONSUL CHENNAI 8286
RUEHLMC/MILLENNIUM CHALLENGE CORPORATION

UNCLAS SECTION 01 OF 03 COLOMBO 000076 
 
SIPDIS 
 
SENSITIVE 
 
SIPDIS 
 
STATE FOR SCA/INS AND EB/IFD/OMA 
TREASURY FOR LESLIE HULL 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EAID CE
SUBJECT: SRI LANKA: INFLATION 17.5% IN 2007; CENTRAL BANK SAYS 
10-15% IN 2008 
 
REF: A. 07 COLOMBO 1661  B. 07 COLOMBO 1639 
 
¶1. (SBU) Summary and comment:  Sri Lanka's inflation remained high 
in 2007, averaging 17.5% for the year after spiking to around 20% at 
times.  Consumers and business both felt the impact, with food and 
fuel prices rising most steeply.  Correspondingly high interest 
rates compounded the pain.  The government blames rising oil and 
other imported commodity prices, but the IMF states the government's 
high deficit spending was the primary driver of the inflation.  The 
Central Bank aims to bring inflation down to 10-11% by the end of 
2008, but concedes that continued high fiscal deficits or further 
oil price increases could make this impossible.  The government is 
trying to control prices rises by resuming subsidies it had recently 
stopped and by attempting to import and distribute "essential 
commodities" more cheaply than the market can.  These efforts are 
likely to add to the deficits that are driving much of the 
inflation.  End summary and comment. 
 
INFLATION 17.5% IN 2007 
-------------------------- 
 
¶2. (SBU) Sri Lanka experienced a second straight year of high 
inflation in 2007, with a 17.5% average 12-month increase in the 
Colombo Consumer Price Index.  The 2006 rise was 13.5%.  Both these 
figures exceed the 12% average annual inflation Sri Lanka has 
experienced over the last 30 years.  The government blamed high oil 
and imported commodity prices as the main causes of the high 
inflation.  However, according to both the Central Bank's research 
department and the IMF, inflation in Sri Lanka is largely a fiscal 
phenomenon with government deficit spending responsible for about 
half of the inflation.  The Central Bank calculated that rising 
prices of imported goods caused only about a quarter of the 
inflation.  Another major factor was Sri Lanka's removal or 
reduction of subsidies on fuel, cooking gas, and wheat.  A final 
factor was the government's imposition of increased taxes and other 
levies on most imported goods (ref A). 
 
CONSUMERS AND BUSINESSES BOTH HURTING 
------------------------------------- 
 
¶3. (U) In 2007, prices of most basic foodstuffs such as bread, wheat 
flour, rice, sugar, lentils and milk powder skyrocketed.  Prices of 
bread and wheat flour, now consumed as widely as rice, increased 
most -- by over 80%.  Energy and fuel prices have also increased, 
due to reduced subsidies.  Electricity went up by about 14%, 
gasoline by over 25%, and cooking gas by over 130%.  As a result of 
these increases, expenses such as bus fares, shipping, and 
construction costs also rose significantly in 2007. 
 
¶4. (SBU) Inflation and correspondingly high interest rates have hit 
businesses as well.  Lending rates to prime customers currently 
average 19.3%.  Other customers face higher rates.  To reduce their 
exposure to inflation, banks have begun limiting their commercial 
and personal loans to short durations, typically just a few months. 
According to a business confidence index published by Lanka Monthly 
Digest, 76% of companies surveyed in December 2007 reported declines 
in business in the previous three months.  Over 53% experienced a 
sales downturn in the previous twelve months.  Two major 
conglomerates reported sales declines in their retail, food, and 
agricultural products divisions.  The high interest rates have also 
hurt a previously hot real estate market, with condominiums 
especially seeing a severe drop in sales. 
 
¶5. (U) Inflation has also generated wage pressures throughout the 
economy.  Workers in several sectors including education, health 
care, apparel production, and plantations pressed for wage hikes in 
¶2007.  The President mandated a wage increase to plantation workers 
in October 2007.  A number of unions have stated they will strike in 
2008 if their members do not receive higher pay. 
 
NEW PRICE INDEX REGISTERS SIMILARLY HIGH INFLATION 
--------------------------------------------- ----- 
 
¶6. (U) The Government launched a new consumer price index, the 
Colombo Consumer Price Index-New (CCPI-N), in November 2007.  The 
old CCPI had tracked the same basket of goods since 1952 and was 
therefore no longer a good measure of inflation.  The new index is 
based on a 2002 consumer finance survey and has a lower weight for 
 
COLOMBO 00000076  002 OF 003 
 
 
food and a higher weight for electricity, fuel, and modern consumer 
items like cell phones.  Despite the revision, the CCPI-N, if 
applied retroactively for all of 2007, would have indicated 
comparably high inflation -- an average of 15.8% for the year versus 
the 17.5% using the CCPI.  (Note: Post will use the new index for 
reporting future inflation figures.) 
 
MONETARY POLICY TO REMAIN TIGHT, BUT CANNOT DO IT ALL 
----------------------- ----------------------------- 
 
¶7. (SBU) In a January 2 presentation to bankers, business leaders, 
and diplomats entitled "Road Map: Monetary and Financial Sector 
Policies for 2008," Central Bank Governor Cabraal spelled out the 
Bank's goals for 2008.  In this second annual road map presentation, 
the governor said this "new tradition," would assist the financial 
sector to "synchronize [its] economic decisions with...national 
goals."  He explained that the Central Bank uses monetary targeting 
-- attempting to control the growth of the money supply -- to 
achieve price and economic stability because it lacks the policy 
levers to conduct inflation targeting. 
 
¶8. (SBU) According to Cabraal, in 2007 the Central Bank raised its 
"repurchase" rate for overnight bank borrowing by 50 basis points to 
12%, one of the highest policy rates in the region.  Because this 
rate was below the rate of inflation, the Bank also attempted to 
contain market liquidity by limiting the number of times commercial 
banks could turn to the Central Bank for overnight or other 
short-term credit.  Despite these efforts, the money supply 
increased by 18% compared to a planned 14.8%.  This was primarily a 
result of heavy borrowing -- to cover deficits -- by government and 
government corporations from the Central Bank and from commercial 
banks.  The government borrowing both added to the money supply and 
drove market interest rates up to around 20%. 
 
2008 GOAL OF 10-11% INFLATION MAY BE HARD TO REACH 
-------------------------- ----------------------- 
¶9. (SBU) Cabraal stated that the Central Bank's 2008 monetary 
program was designed to accommodate real GDP growth of 7.0%.  (Note: 
The government's 2008 budget figures were based on projected 2008 
GDP growth of 7.5% (ref A).  Cabraal's was the first admission that 
the GDP projection was unrealistic.)  Reserve money is to increase 
by 15% and broad money by 17% in 2008.  The Bank expects a net 
repayment of loans by state entities and a decline in new credit to 
state corporations for the year -- in part, he stated, due to Iran's 
"highly welcome" extension of credit to Sri Lanka for seven months 
worth of oil purchases (ref B).  Credit to the private sector is 
expected to increase, but more slowly than it did in 2007.  These 
targets, according to Cabraal, would bring inflation down to 10-11% 
by the end of 2008.  He acknowledged that inflation could easily 
come in at 12-14% if oil prices remain over $90 per barrel, if Sri 
Lanka experiences an escalation of terrorism, or if the government's 
deficit is larger than planned. 
 
GOVERNMENT FISCAL RESPONSE - REINSTITUTE SUBSIDIES 
------------------------- ------------------------ 
 
¶10. (SBU) The government has responded to rising prices mainly by 
trying to control them administratively or with subsidies.  It has 
come to an agreement with the main association of commodity 
importers and traders to control wholesale prices of ten "essential" 
food items: the government will remove import taxes on these 
products in exchange for the dealers agreeing to hold down prices 
correspondingly.  The government also administers prices for a 
number of products like fuel, cooking gas, milk powder, and wheat 
flour; with inflation high, it routinely delays approval of sellers' 
requests for permission to increase prices in line with market 
prices.  The government has also resumed subsidizing fuel prices, 
abandoning its mid-2007 decision to permit prices to adjust with 
global market prices.  Finally, the government says it will revive a 
previously failed program for the state to import food and sell it 
at cost through state-run retail and wholesale outlets. 
 
POLITICAL REACTIONS -- BLAME THE GOVERNMENT 
------------------------------------------- 
 
¶11. (SBU) The opposition United National Party has sought to 
capitalize on public dissatisfaction with the high inflation.  In 
2007, the UNP organized several anti-government rallies around the 
 
COLOMBO 00000076  003 OF 003 
 
 
country, at which the cost of living increases were a central 
criticism.  The UNP has also started visiting village fairs 
distributing pamphlets about the rising cost of living.  The 
populist JVP has also held rallies against the rising cost of 
living. 
 
COMMENT: GOVERNMENT WON'T ADMIT IT IS THE PROBLEM 
--------------------------------------------- ---- 
 
¶12. (SBU) Sri Lanka's 2007 inflation far exceeded that of other 
South Asian countries, some of which are also heavy importers of 
essential commodities.  Also, prices of many locally produced 
commodities rose steeply.  For example, coconut rose 27% and rice 
over 20%.  These facts further reinforce the IMF's conclusion that 
the government's deficit spending, not just the worldwide rises in 
commodity prices, drove the high inflation.  The government's 
efforts to address the inflation problem -- subsidies, small tax 
reductions, and promises of government distribution channels -- have 
been designed for political value: to enable politicians to tell 
voters "we are doing something."  Worse, each of these will add to 
the persistent deficit, which is the main cause of the inflation, so 
will obviously not solve the problem.  Moreover, continued high 
government borrowing and increasingly entrenched expectations of 
inflation will keep interest rates high, crowding out private sector 
investment, which is more productive than government spending.  The 
result eventually will be lower real growth rates than the 
relatively healthy 6-7% growth Sri Lanka has been achieving lately. 
 
BLAKE