VZCZCXRO6267
RR RUEHBI RUEHLMC
DE RUEHLM #1133/01 3501115
ZNR UUUUU ZZH
R 151115Z DEC 08
FM AMEMBASSY COLOMBO
TO RUEHC/SECSTATE WASHDC 9055
INFO RUCPDOC/DEPT OF COMMERCE WASHDC
RUEHNE/AMEMBASSY NEW DELHI 2465
RUEHKA/AMEMBASSY DHAKA 1190
RUEHIL/AMEMBASSY ISLAMABAD 8192
RUEHKT/AMEMBASSY KATHMANDU 6408
RUEHKP/AMCONSUL KARACHI 2419
RUEHCG/AMCONSUL CHENNAI 8835
RUEHBI/AMCONSUL MUMBAI 6220
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RUEHLMC/MILLENNIUM CHALLENGE CORPORATION

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 
---------------------------- 
 
¶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 
 
COLOMBO 00001133  002 OF 003 
 
 
government projections that remittances will increase in 2009. 
 
INFLATION 
---------- 
 
¶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 
------- 
 
¶11.  (SBU) Significant expenditure restraint in the new year, in 
 
COLOMBO 00001133  003 OF 003 
 
 
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.