VZCZCXRO5826
RR RUEHLMC
DE RUEHLM #0922/01 2811150
ZNR UUUUU ZZH
R 071150Z OCT 08
FM AMEMBASSY COLOMBO
TO RUEHC/SECSTATE WASHDC 8740
INFO RUCPDOC/DEPT OF COMMERCE WASHDC
RUEHC/DEPT OF LABOR WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
RUEHNE/AMEMBASSY NEW DELHI 2310
RUEHKA/AMEMBASSY DHAKA 1090
RUEHIL/AMEMBASSY ISLAMABAD 8091
RUEHKT/AMEMBASSY KATHMANDU 6289
RUEHCG/AMCONSUL CHENNAI 8716
RUEHLMC/MILLENNIUM CHALLENGE CORPORATION

UNCLAS SECTION 01 OF 03 COLOMBO 000922 
 
SENSITIVE 
 
SIPDIS 
 
STATE FOR SCA/INS AND EEB/IFD/OMA 
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:  ECONOMY GROWING, BUT PROBLEMS REMAIN 
 
REF: (A) COLOMBO 821 
(B) COLOMBO 730 
 
COLOMBO 00000922  001.2 OF 003 
 
 
¶1. (U) Summary:  Despite the war, Sri Lanka's GDP grew by a 
respectable 6.6% in the first half of 2008.  The Sri Lankan rupee 
(SLR) remains relatively steady due to Central Bank intervention. 
Other key macro indicators weakened.  Inflation remains high at 
24.3%.  The trade deficit expanded sharply due to high oil prices. 
The Central Bank increased foreign borrowing to shore up reserves 
lost on the trade front.  The Colombo Stock Exchange fell 15% from 
January to September, due to domestic concerns and as well as recent 
Wall Street woes.  Despite these concerns, business confidence, as 
indicated by a monthly Nielsen survey, surged to an 18 month high. 
 
 
6.6% GDP GROWTH IN FIRST HALF OF 2008 
------------------------------------- 
 
¶2.  (U) According to the Department of Census and Statistics, Sri 
Lanka's economy expanded by a strong 7% in the second quarter 2008 
against 6.4% in the second quarter 2007.  This brought GDP growth 
for the first half of 2008 to 6.6%, compared with 6.3% in the first 
half of 2007.  The Central Bank's published expected growth for 2008 
is 7%.  The Bank will likely revise its GDP growth forecast for 2008 
slightly downward.  The Asian Development Bank recently forecasted 
6% annual GDP growth in both 2008 and 2009. 
 
¶3.  (U) In the second quarter, agriculture grew by over 7% boosted 
due to increased rice production.  (Note:  The agricultural sector 
contributes approximately 12% of GDP.)  2007 witnessed a sharp drop 
in rice paddy cultivation due to the conflict in the East.  In 2008, 
good rains, the return of relative peace in the eastern province, 
and subsidized fertilizer helped to spur a recovery in rice 
production.  Services, the largest economic sector, grew by 6.9%. 
In particular, telecommunications continued its strong expansion, 
recording a 23% growth.  Other key contributors to services sector 
expansion were trade, transport, ports and banking.  Government 
services, which account for about 8% of GDP, grew by 7%.  Growth in 
the tourism sector was flat as the sector failed to recover from its 
sharp decline in 2007.  Tourist arrivals decreased by 4.3% in the 
first seven months.  Manufacturing sector growth slowed to 4.9% in 
2Q2008 from 7.1% in 2Q2007.  Textiles and apparel sector recorded a 
marginal increase of 0.1% compared with 8.2% growth over the same 
period in 2007. 
 
TRADE DEFICIT WIDENS SHARPLY 
---------------------------- 
 
¶4.  (U) According to the latest statistics, in the first seven 
months of 2008 Sri Lanka's trade deficit expanded an exceptional 88% 
to $3.5 billion.  Exports increased by 12% to $4.7 billion while 
imports swelled by 35% to $8.2 billion.  On the import side, oil 
imports rose 67% to $2 billion from $1.25 billion, food imports 
increased 60% to $957 million, and fertilizer imports also 
demonstrated a significant increase.  Capital goods, such as 
building material and machinery, rose during this period. 
 
¶5.  (U) Tea, which is experiencing a surge in prices, drove the 
export growth.  Tea exports earnings swelled by over 40%.  Garments, 
Sri Lanka's largest export category, rose by 4%.  Other manufactured 
exports also rose by about 4%.  Exports to the United States, Sri 
Lanka's second-largest market, recorded a 5.4% decline on top of a 
3.7% decline in 2007.  Exports to the EU, which enter duty free 
under the EU's GSP-Plus Program, increased. 
 
REMITTANCES CONTINUE TO INCREASE 
-------------------------------- 
 
¶6.  (U) Remittances, Sri Lanka's second largest source of foreign 
exchange after garment exports, increased by 20% to $1.7 billion in 
the first seven months of 2008.  Net private remittances financed 
over 40% of the trade deficit in the first half of 2008, compared 
with 70% in 2007.  The balance was primarily financed through 
government borrowings. 
 
INFLATION 24.3% IN SEPTEMBER 2008; 
 
COLOMBO 00000922  002.2 OF 003 
 
 
CENTRAL BANK CLAIMS SUCCUESS ON MONETARY POLICY 
--------------------------------------------- -- 
 
¶7.  (SBU) Inflation, as measured by the New Colombo Consumer Price 
Index (CCPI-N), was 24.3% in September (year-on-year).  Inflation, 
which hit a record 28.2% earlier this year due to both demand and 
supply side pressures, has eased somewhat since then.  The Central 
Bank has followed a tight monetary policy since January in an 
attempt to reign in inflation.  The Central Bank reports that its 
monetary tightening has worked well to control money supply.  Food 
prices, which skyrocketed in the first half of 2008 due to a 
shortage, are easing due to increased production locally and the 
fall in the rate of global food price increases.  In a statement 
issued September 30, the Central Bank said "Supported by continued 
containment of demand pressures as well as improvements on the 
supply side, inflation is expected to moderate further during the 
months ahead."  Whether that is true remains to be seen.  Some 
allege that the new CCPI index does not truly reflect inflation as 
it removed an entire sub group (alcohol and tobacco) from review. 
The government statistics office was also caught spreading some 
price increases across more than one month. 
 
¶8.  (U) On September 30, the Central Bank relaxed its monetary 
policy in response to the global financial crisis.  The bank eased 
conditions for financial institution access to Central Bank 
financing in an effort to improve liquidity.  As a result, 
commercial bank and primary dealers' access to the Central Bank's 
discount window increased to six times per year (vice three times 
per year).  The bank expects the move to contain volatility in 
interest rates. 
 
RUPEE STEADY AGAINST THE DOLLAR 
BUT APPRECIATES ELSEWHERE 
-------------------------------- 
 
¶9.  (U) The Sri Lankan Rupee has been steady against the U.S. dollar 
in 2008; it is currently trading around 108 against the dollar. 
However, since January the rupee appreciated 9% against the 
sterling, 4% against the Euro, and 15% against the Indian Rupee. 
Exporters continue to complain about the rupee's appreciation amid 
high inflation and the growing current account deficit.  They blame 
Central Bank intervention for the appreciation, as the Central Bank 
increased short term foreign borrowing to shore up reserves.  (Note: 
 The Bank also relaxed foreign investment in government bond 
markets, and commercial banks are now permitted to accept deposits 
from foreigners.)  The Central Bank disagrees and maintains the 
exchange rate is determined through market forces. 
 
¶10.  (U) The Bank, in particular the Governor, continues to urge 
businesses to improve productivity to stay competitive rather than 
counting on a depreciating currency.  Reiterating the Central Bank's 
exchange rate policy, the Governor recently stated that "Under the 
floating rate regime, the Sri Lankan currency can no longer be 
regarded as a steadily and continuously depreciating currency...The 
stabilization of the SL rupee utmost underlines the need for the 
export and import competing sectors to focus more on productivity 
improvements and market access in order to maintain external 
competitiveness.  Instead of waiting for the exchange rate to 
depreciate and then for our businesses to become competitive, it's 
time for all of us to improve our productivity in whatever manner we 
can." 
 
POOR STOCK MARKET PERFORMANCE 
------------------------------ 
 
¶11.  (U) The Colombo Stock Exchange (CSE) is performing poorly in 
¶2008.  The escalation of war in the north and bomb blasts in and 
around Colombo are main contributors to the CSE's weak performance. 
The failures on Wall Street contributed to sharp declines in 
September.  The market was also affected by high nominal interest 
rates, falling profits of Telecom giant Dialog and an August 2008 
Supreme Court judgment against John Keells Holdings (JKH), Sri 
Lanka's largest blue chip conglomerate (see reftel B).  CSE's all 
share price index fell 15 percent (400 points) between January 1 and 
September 30.  The index lost 6% prior to the U.S. stock market 
failures in mid-September; since then it lost a further 9%.  The 
 
COLOMBO 00000922  003.2 OF 003 
 
 
downturn wiped Rs 125 billion (over USD 1.1 billion) off CSE's 
market capitalization in 2008.  As of September 30, the All Share 
Price Index (ASPI) stood at 2,142 points, the lowest level since the 
resumption of war in April 2006.  Performance in early October 
remains weak. 
 
AND YET, BUSINESS CONFIDENCE INDEX SURGES 
----------------------------------------- 
 
¶12.  (U) The Lanka Monthly Digest-ACNielsen Business Confidence 
Index (BCI), which surveys 100 senior top executives in Colombo, 
surged to an 18-month high in September.  Nearly one third of the 
respondents to the poll have said the economy will improve, the most 
confident they have been about the economy since October 2006.  The 
Lanka Monthly Digest, quoting pollsters, said expectations of an end 
to the war in the not too distant future and the downward slide in 
oil prices may be among the principal reasons for the sudden surge 
in confidence in the last two months.  (Note: The survey took place 
in early September, prior to the Wall Street failures.) 
 
COMMENT 
--------- 
 
¶13. (SBU) Despite the government's efforts to tout its tight 
monetary policy, economic analysts warn that the government's 
ongoing attempts to keep the rupee pegged to the dollar are 
misguided and damaging, and will ultimately undermine efforts to 
date.  Increasing efforts by the military to push forward against 
the LTTE in the North could also put additional strain on government 
resources, forcing tough policy choices if the President insists on 
additional revenues in the next budget to fund the war effort.  The 
government's new budget is scheduled to be presented on November 6.