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UNCLAS SECTION 01 OF 02 COLOMBO 000905 
 
SENSITIVE 
SIPDIS 
 
DEPARTMENT FOR EEB JENNIFER PETERSON AND TANYA SPENCER 
DEPARTMENT OF TREASURY FOR MALACHY NUGENT AND ATTICUS WELLER 
USTR FOR MICHAEL DELANEY AND VICTORIA KADER 
 
E.O. 12958: N/A 
TAGS: CE ECON EFIN IMF PGOV
SUBJECT: SRI LANKA IS MEETING IMF TARGETS 
 
REF: COLOMBO 724 
 
¶1.     (SBU)  Summary.  An IMF team conducting its first 
quarterly assessment has determined that Sri Lanka is meeting 
the targets of the July IMF standby agreement, and it appears 
that the IMF staff will recommend release of the second 
tranche of IMF funds in October.  The IMF agreement, combined 
with optimism from the end of Sri Lanka,s conflict and an 
improving external economic environment, has encouraged 
substantial inflows of foreign capital into Sri Lanka. 
Although the road forward will be challenging, the IMF 
believes that Sri Lanka is on track to build international 
foreign reserves, control expenditure, increase government 
revenue, and reform the banking sector.  The IMF will 
establish an office housed in the Sri Lankan Central Bank to 
monitor compliance. Overall, the IMF seems more optimistic 
than several local economists.  End Summary. 
 
IMF Mission Background 
 
¶2.    (SBU)  Sri Lanka reached an agreement in July to 
disburse $2.6 billion in eight separate tranches, with the 
provision that the IMF would conduct quarterly reviews of Sri 
Lanka,s progress toward IMF goals.  The IMF conducted the 
first such review September 8-22.  Brian Aitken, head of the 
IMF mission, met privately with econoff to discuss their 
findings on September 21, and then held a press conference 
September 22 with the GSL. Aitken commented that the GSL has 
been very transparent, posted the IMF letter of intent on its 
Central Bank website, and was very open during the review 
process.  The IMF mission will prepare a report for the IMF 
board in late October, and the board will decide whether to 
disburse the next tranche of $322 million.   The IMF will 
establish an office in the Central Bank to monitor Sri 
Lanka,s economic health. 
 
Sri Lanka is meeting the IMF Targets 
 
¶3.    (SBU)  There have been very large inflows of foreign 
exchange into Sri Lanka, which swelled Sri Lanka,s foreign 
exchange reserves from $1.2 billion in March (about one month 
of import cover) to $4.1 billion today.  The IMF agreement 
provided confidence to private investors that Sri Lanka is on 
the right track.  For instance, a U.S. based hedge fund has 
purchased $875 million in  two and four year Sri Lankan rupee 
denominated government bonds.  The hedge fund receives a high 
interest rate from these bonds, and even though they have 
taken on an exchange rate risk, several economists opined 
that the hedge fund,s bet is reasonable.  Similarly, the Sri 
Lanka Central Bank is preparing to issue $500 million in 
government bonds, and the IMF,s Aitken guessed that the bond 
issue would be oversubscribed.  Sri Lanka,s current account 
deficit declined by almost 60% in the first six months of 
2009, an 18% drop in exports was overshadowed by a 36% fall 
in imports, and remittances from workers abroad increased 
5.4%.  Finally, the Standard and Poor,s rating service has 
revised Sri Lanka,s sovereign ratings outlook from negative 
to stable. 
 
¶4.    (SBU)  Sri Lanka is having some success controlling its 
spending.  According to a local business journal,s analysis, 
total government spending  increased by 8% in the first half 
of 2009, a period including the end of their 30 year civil 
war.  After the conflict, the GSL told Aitken that military 
costs would remain stable.  The GSL has an ambitious plan to 
spend up to $2.4 billion on reconstruction of the war ravaged 
North and East, and the GSL hopes to receive substantial 
donor and private sector funding to cover much of these 
costs.  The Central Bank estimates that yearly GSL spending 
would average 0.8% of total GDP, or approximately $320 
million per year.  Interest rates have also fallen, which 
will help reduce government payments to cover its debt.   The 
real test will be the 2010 budget.  The GSL is scheduled to 
draw up the parameters of its spending in October and will 
present its budget in November. 
 
¶5.    (SBU)  The most difficult challenge will be to increase 
revenue so that Sri Lanka escapes from chronic balance of 
payments crisis.  Government revenue fell by an estimated 6% 
 
COLOMBO 00000905  002 OF 002 
 
 
in the first half of 2009, reflecting declining imports (GSL 
derives a key segment of its revenue from import duties) and 
a weak domestic economy.  The GSL has targeted increasing its 
revenue by 2% of GDP by 2011, starting from the 14.9% 
collected in 2008.  Aitken was optimist that the GSL is ready 
to make fundamental reforms to increase revenue, and he noted 
that Sri Lanka has already increased its "nation building 
tax" from 1.5 to 3%.  Sri Lanka will also benefit from 
increased revenues as the economy improves and imports 
increase.   GSL has a Presidential Commission to examine ways 
to increase revenue, focusing on widening the taxpayer base 
rather than increasing tax rates.  Currently there are only 
650,000 taxpayers (out of a total 20 million population) but 
the GSL to start collecting from 1 million taxpayers by 2010. 
 
 
¶6.    (SBU)  The GSL could meet its IMF target for two key 
state owned enterprises (SOE) to break even financially by 
¶2011.  The Ceylon Petroleum Company (CPC) and Ceylon 
Electricity Board (CEB) chronically lose money, but the IMF 
team thought that the GSL has fully committed to reforming 
these SOEs to stop the drain on government finances.  The CPC 
has benefited from falling international oil prices, while 
they have kept domestic retail oil prices high.  Similarly, 
the CEB is building a coal fired electricity plant, so they 
could benefit from moving from high cost oil to cheaper coal. 
 It is not clear that the GSL has planned real reforms of 
either SOE. 
 
¶7.    (U)  The IMF assessment was that the Sri Lanka 
financial industry was in good shape.  Sri Lanka avoided much 
of the direct contagion of the global financial crisis 
because they did not delve deeply into sophisticated 
financial instruments like derivatives.  Although the level 
of non-performing loans is rising, reflecting weakness in 
certain domestic sectors, overall the financial system is 
well capitalized and the IMF did not foresee a systemic 
risk.  The IMF also thinks that the Central Bank supervision 
of the banking industry is good. 
 
¶8.    (U)  Sri Lanka,s GDP growth expectations are picking 
up.  The IMF increased its growth forecast from 3% to 3.5% in 
2009, within the range of the Central Bank,s forecast of 
3.5% to 4.5% growth.  The Central Bank forecasts growth to 
improve to 6% in 2010, and it could reach the 7% range 
thereafter. 
 
Will the GSL stick to the IMF fiscal medicine? 
 
¶9.    (SBU)  The big question is whether Sri Lanka will stick 
to the IMF targets and discipline.  Several private sector 
economists and business leaders were pleased with the IMF,s 
involvement, which they believe will encourage GSL fiscal 
discipline.  The GSL now has good international reserves, 
although the build up in reserves is predicated on confidence 
built on the IMF agreement.  Therefore, at least in the short 
term, it seems that the GSL has incentives to continue 
meeting its IMF targets. 
 
¶10.    (SBU)  Comment.  Econoff was surprised by the IMF,s 
optimistic assessment.  Although clearly the GSL has built up 
its reserves, and private capital is flowing into portfolio 
investments, many economists and businessmen are skeptical 
that the GSL will be able to continue to meet its spending 
and revenue targets.  The GSL plans to call Presidential and 
Parliamentary elections over the next six months, which could 
lead to excessive spending.  End Comment. 
BUTENIS