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Country Report

Sri Lanka

May 2004

The Economist Intelligence Unit15 Regent St, London SW1Y 4LRUnited Kingdom

Sri Lanka at a glance: 2004-05

OVERVIEWIn the general election that took place in early April, the United Peoples!Freedom Alliance (UPFA) coalition, which is led by the president, ChandrikaKumaratunga, won the largest block of seats, but failed to gain a majority. TheUPFA, which comprises the People!s Alliance (PA) and the Janata VimukthiPeramuna (JVP, People!s Liberation Front), won a total of 105 seats, and thusremains eight seats short of a majority. As a result, the political scene isexpected to remain unstable. The prospects for a resumption of peacenegotiations between the government and the Liberation Tigers of Tamil Eelam(LTTE, Tamil Tigers), which have remained stalled since April 2003, haveimproved with efforts being made to restart the talks. The economy is expectedto grow by 5.7% in 2004, as a continued improvement in external demand willbe partly offset by weak domestic demand in the first half of the year. Abroader recovery in 2005 will raise growth to 6.4% in that year. Consumer priceinflation will moderate. The Sri Lanka rupee will depreciate in 2004-05,although at a below-trend rate. After widening to 3.6% of GDP in 2004 on theback of a larger trade deficit, the current-account deficit will narrow to 3.2% ofGDP in 2005.

Key changes from last month

Political outlook• Envoys from Norway and Japan have met the LTTE in an effort to restart the

peace process. Despite election promises to the contrary, the government hasnow stated that it will engage the LTTE in peace talks.

Economic policy outlook• The UPFA government has announced that it will adhere to fiscal targets

outlined by the previous government in its 2004 budget, despite the fact thatit has promised a host of subsidies and a slowdown in the privatisationprocess.

Economic forecast• The government has revised its fiscal deficit estimate for 2004 upwards to

7.3% of GDP (from 6.8%). The Economist Intelligence Unit had alreadyfactored a rise into its fiscal deficit forecast. As a result, our forecast for thedeficit in 2004 remains unchanged at 7.9%.

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Sri Lanka 1

Country Report May 2004 www.eiu.com © The Economist Intelligence Unit Limited 2004

Contents

Sri Lanka

3 Summary

4 Political structure

5 Economic structure5 Annual indicators6 Quarterly indicators

7 Outlook for 2004-057 Political outlook9 Economic policy outlook10 Economic forecast

13 The political scene

15 Economic policy

17 The domestic economy17 Economic trends20 Manufacturing23 Agriculture25 Infrastructure26 Financial and other services

29 Foreign trade and payments

List of tables10 International assumptions summary

12 Forecast summary

23 Tea production

29 Trade balance

30 Composition of exports

31 Composition of imports

List of figures

12 Gross domestic product12 Consumer price inflation27 Stockmarket performance

Sri Lanka 3


Sri LankaMay 2004

Summary

In the general election that took place in early April the United Peoples!Freedom Alliance (UPFA), led by the president, Chandrika Kumaratunga, wonthe largest number of seats, but failed to gain a majority. As a result, thepolitical scene is expected to remain unstable. The prospect for a resumption ofpeace talks between the government and the Liberation Tigers of Tamil Eelam(LTTE, Tamil Tigers), which have remained stalled since April 2003, haveimproved with efforts being made to restart the talks. The economy is expectedto grow by 5.7% in 2004, as a continued improvement in external demand willbe partly offset by weak domestic demand in the first half of the year. Abroader recovery in 2005 will raise growth to 6.4% in that year. Consumer priceinflation will moderate. The Sri Lanka rupee will depreciate in 2004-05. Afterwidening to 3.6% of GDP in 2004 on the back of a larger trade deficit, thecurrent-account deficit will narrow to 3.2% of GDP in 2005.

The UFPA has formed a minority government, which remains unstable. Tamiland Buddhist parties also made gains in the elections. The UFPA governmenthas pledged to resume talks with the LTTE and to undertake constitutionalreform. Norway has been asked to resume its peace initiative. The LTTE faced ashort-lived mutiny.

The new government has stated that, while continuing to pursue liberaleconomic policies, it will focus on the agricultural sector and develop ruralinfrastructure. The government has also backtracked on privatisation. Tax andtrade policies will remain largely unchanged. The estimate for the 2004 fiscaldeficit has been revised upwards. The Central Bank of Sri Lanka has continuedto maintain its loose monetary policy. The World Bank has approved a US$51mgrant to support the government!s efforts to reduce poverty in rural areas.

The economy grew by 5.9% in 2003, faster that expected. The service sector ledthe growth, whereas agriculture remained depressed. Efforts to increase exportsto India are being stepped up. Tourist arrivals grew by 17% year on year in thefirst two months of 2004. Two leading Indian airlines have commenced flightsto the Sri Lankan capital, Colombo. Tea production rose, but the stagnation inthe agricultural sector is having a political impact.

The external sector improved in 2003, and the current-account deficit hasnarrowed. The merchandise trade deficit expanded by 9.6% year on year;exports of industrial goods and tea have been rising.

Editors: Ravi Bhatia (editor); Caroline Bain (consulting editor)Editorial closing date: May 21st 2004

All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] report: Full schedule on www.eiu.com/schedule

Outlook for 2004-05

The political scene

Economic policy

The domestic economy

Foreign trade and payments

4 Sri Lanka


Political structure

Democratic Socialist Republic of Sri Lanka

Executive presidency based on the French model

The president is the head of state and exercises all executive powers. Elected for a periodof six years by universal adult suffrage, the president may dissolve parliament

Unicameral legislature; 225 members directly elected for five years by a system ofmodified proportional representation

Under the 13th amendment to the constitution, passed in November 1987, extensivepowers have been devolved to nine directly elected provincial councils, primarily with aview to meeting Tamil demands for greater autonomy. Elections scheduled for 1998 werepostponed, but were held in seven provinces between January and June 1999. The nextelections in these provinces were scheduled to take place in March 2004, but werepostponed to allow the parliamentary election to take place in April. As a result of theethnic conflict, elections in the remaining two provinces remain unscheduled

Presidential and parliamentary elections are held at six- and five-year intervalsrespectively; the next elections were originally due in October 2006 (parliamentary) andDecember 2005 (presidential). However, the parliamentary election took place in April2004, and it is possible that the president, Chandrika Kumaratunga, will succeed inextending her term to 2006

Mrs Kumaratunga won a second term in office as president in December 1999, andalthough her People!s Alliance (PA) lost the December 5th 2001 parliamentary election, itregained power at the April 2004 election. The United Peoples! Freedom Alliance (acoalition of the PA and the Marxist Janatha Vimukthi Perumena) won 46.4% of the vote,enough to gain 105 seats in the 225-seat parliament, but short of a majority; it currentlyforms a minority government. The United National Party (UNP), which led the previousgovernment, won only 82 seats, compared with its tally of 109 in the 2001 election.

Governing coalition: the UPFA, made up of the People!s Alliance (PA) and the JanathaVimukthi Peramuna ( JVP, People!s Liberation Front). Main opposition parties: the UnitedNational Party (UNP), the Sri Lankan Muslim Congress (SLMC) and the Tamil NationalAlliance (TNA). Armed opposition: the Liberation Tigers of Tamil Eelam (LTTE, TamilTigers)

President, also currently in charge of the ministry of defence & education Chandrika Bandaranaike KumaratungaPrime minister & minister of highways Mahinda Rajapakse (PA)

Agriculture, irrigation, livestock & land Anura Kumara Dissanayake ( JVP)finance Sarath Amunugama (PA)Fisheries & aquatic resources Chandrasena Wijesinghe (JVP)Foreign affairs Lakshman Kadiragamar (PA)Healthcare & nutrition Nimal Siripala De Silva (PA)Information & media Reginald Cooray (PA)Justice & judicial reform John Seneviratne (PA)Industry, tourism & investment promotion Anura Bandaranaike (PA)Ports & aviation Mangala Samaraweera (PA)Power & energy Susil Premajayanth (PA)Posts & telecommunications D M Jayaratne (PA)Trade, commerce & consumer affairs Jeyaraj Fernandopulle (PA)

Amarananda Jayewardena

Official name

Form of state

The executive

National legislature

Local government

National elections

National government

Main political organisations

Main members of the government

Key ministers

Central bank governor

Sri Lanka 5


Economic structure

Annual indicators1999 a 2000 a 2001a 2002 a 2003 b

GDP at market prices (SLRs bn) 1,106.0 1,257.7 1,407.4 1,584.8 1,791.6GDP (US$ bn) 15.7 16.3 15.7 16.6 18.6

Real GDP growth (%) 4.3 6.0 -1.5 4.0 5.9 a

Consumer price inflation (av; %) 4.7 6.2 14.2 9.6 6.3 a

Population (m) 18.4 18.6 18.8 18.9 19.1

Exports of goods fob (US$ m) 4,596.2 5,439.6 4,816.9 4,699.2 5,133.0Imports of goods fob (US$ m) 5,365.5 6,483.6 5,974.0 6,105.6 6,672.0

Current-account balance (US$ m) -561.4 -1,043.7 -264.8 -237.0 -101.0Foreign-exchange reserves excl gold (US$ m) 1,636.0 1,039.0 1,287.0 1,631.0 2,195.0Total external debt (US$ bn) 9.7 9.0 8.5 9.5 b 10.7

Debt-service ratio, paid (%) 10.9 10.1 9.7 9.4 b 9.3Exchange rate (av) SLRs:US$ 70.64 77.01 89.38 95.66 96.52 a

a Actual. b Economist Intelligence Unit estimates.

Origins of gross national product 2002 % of total Components of gross domestic product 2002 % of totalAgriculture, forestry & fishing 19.8 Private consumption 75.1Mining 1.7 Government consumption 9.1

Construction 6.9 Investment incl stockbuilding 22.5Manufacturing 16.7 Exports of goods & services 35.9

Services 53.6 Imports of goods & services 42.6

Principal exports 2002a US$ m Principal imports 2002a US$ mTextiles & garments 2,425 Textiles 1,322Tea 660 Machinery & transport equipment 792

Diamonds & jewellery 192 Mineral products 874Petroleum 73 Chemicals 155

Main destinations of exports 2002a % of total Main origins of imports 2002a % of totalUS 38.8 India 11.2

UK 12.8 Hong Kong 7.9Belgium-Luxembourg 4.6 Singapore 7.2Germany 4.4 Japan 5.2

a Customs basis. b Imports cif.

6 Sri Lanka


Quarterly indicators2002 2003 20042 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr

OutputGDP at constant 1996 prices (SLRs bn) 200.90 222.86 240.38 225.18 212.01 235.25 256.88 n/aWages & pricesWages, agriculturala (Dec 1978=100) 1,184.1 1,241.2 1,355.0 1,355.2 1,395.8 1,396.1 1,395.7 1,395.8Consumer prices, Colombo (1995=100) 193.7 194.4 197.3 207.3 205.8 202.1 206.1 210.0Consumer prices (% change, year on year) 9.7 9.4 9.5 10.8 6.2 4.0 4.5 1.3Financial indicatorsExchange rate SLRs:US$ (av) 96.10 96.19 96.50 96.85 97.14 96.52 95.57 97.97Exchange rate SLRs:US$ (end-period) 96.10 96.28 96.73 96.95 97.14 94.43 96.74 97.42Repurchase rate (end-period; %) 11.50 10.50 9.75 9.00 8.25 7.50 7.00 7.00Reverse repurchase rate (end-period; %) 13.75 12.75 11.75 11.00 10.25 9.50 8.50 8.50Lending rate (av; %) 13.77 12.87 12.39 11.39 11.02 9.97 9.00 n/aTreasury bill rate (av; %) 13.73 11.92 10.60 9.07 8.63 7.53 7.13 n/aM1 (end-period; SLRs bn) 125.51 129.43 139.36 141.20 142.21 n/a n/a n/aM1 (% change, year on year) 15.6 15.5 14.0 12.3 13.3 n/a n/a n/aM2 (end-period; SLRs bn) 584.34 601.47 622.50 643.06 655.01 n/a n/a n/aM2 (% change, year on year) 17.9 16.6 13.4 12.4 12.1 n/a n/a n/aCSE Milanka Index (end-period;

Dec 31st 1998=1,000) 1,222.0 1,463.9 1,374.6 1,259.6 2,062.5 2,394.8 1,897.8 2,021.0Sectoral trendsExports, tea ('000 tonnes) 68 78 70 66 75 78 79 n/aExports, rubber ('000 tonnes) 9 8 10 11 9 6 9 n/aTourist arrivals ('000) 80.1 104.2 115.8 120.5 95.6 121.9 162.6 n/a

Foreign trade & payments (SLRs bn)Exports fob 89.55 135.23 123.67 115.22 115.43 137.48 127.29 n/aTea 15.01 16.00 15.58 14.79 16.09 17.04 18.02 n/aImports cif -145.81 -143.38 -167.85 -148.53 -150.04 -160.63 -184.55 n/aTrade balance -56.26 -8.16 -44.18 -33.31 -34.61 -23.15 -57.26 n/a

Foreign payments (US$ m) .Merchandise trade balance -586.2 -85.0 -457.9 n/a n/a n/a n/a n/aServices balance 67.9 71.4 91.2 n/a n/a n/a n/a n/aIncome balance -58.1 -71.7 -62.2 n/a n/a n/a n/a n/aNet transfer payments 267.2 277.7 298.4 n/a n/a n/a n/a n/aCurrent account balance -309.3 192.5 -130.6 n/a n/a n/a n/a n/aReserves excl gold (end-period) _-1,378_- 1,446 1,631 1,684 1,931 n/a n/a n/a

a Minimum rates. b Nominal rates.

Sources: Central Bank of Sri Lanka, Bulletin; IMF, International Financial Statistics; Standard & Poor's, Emerging Stock Markets Review.

Sri Lanka 7


Outlook for 2004-05

Political outlook

At the parliamentary election that took place on April 2nd the United Peoples!Freedom Alliance (UPFA) secured 105 seats in the 225-seat legislature. The UPFAis led by the president, Chandrika Kumaratunga, and comprises the People!sAlliance (PA) and the Janata Vimukthi Peramuna (JVP, People!s LiberationFront). The former governing United National Party (UNP) won just 82 seats,compared with 109 in the 2001 election. The failure of any party to achieve amajority means that the short-term outlook will be dominated by the UPFA!sefforts to build a coalition in an attempt to secure the eight extra seats neededto control parliament. The difficulties it will face in doing this are likely toensure that the political scene will remain volatile throughout the forecastperiod. Furthermore, Mrs Kumaratunga campaigned partly on a platform oftaking a harder line in negotiations with the Liberation Tigers of Tamil Eelam(LTTE, Tamil Tigers) than did the UNP, although she has begun to backtrack onthis promise. Nevertheless, her negative platform with regard to the LTTE,coupled with the fact that the JVP in particular has in the past criticised thepeace process, means that the risk of the process resulting in failure remainshigh. At the same time, the conflicting agendas vis-à-vis the UPFA of the smallerparties, whose support is required to form a majority in parliament, means thatthe new government is unlikely to last out its full term, which ends in 2010.

The poor showing of the two main parties has resulted in the power of smaller,more extreme parties rising considerably. The JVP, for example, is a hardlineMarxist party that opposes any form of political devolution for Tamils. A newparty formed by the Buddhist clergy, the Jathika Hela Urumaya (JHU, NationalHeritage Party), won nine seats. The focus of its campaign was to criticisealleged corruption in the main parties. Although it has similar views towardsthe LTTE to those of the JVP"it opposes political compromise with the Tigers"ithas stated that it will neither support the new government, nor any attempts tobring it down. As a result, a prolonged political impasse is possible, with nogrouping able to gain a majority in parliament. An agreement with the JHUwould give the UPFA the majority it needs to govern, but the potential for asettlement with the LTTE would be further reduced.

At the same time, the PA accepts the need for continued negotiations, butbelieves that the UNP made too many concessions to the Tigers. Nevertheless,although Mrs Kumaratunga has dismissed the current ceasefire as invalid and athreat to national security, she has also indicated that she will abide by it (butthat she will at the same time seek to negotiate an extension of the ceasefirewith the LTTE). There is a concern that the president is using the formergovernment!s efforts to turn the election into a referendum on the peaceprocess as proof that the process in its current form has been rejected by thepublic.

Despite the fact that the Tamil National Alliance (TNA), an alliance of smallTamil parties that won 22 seats, is closer to the UNP, owing to the latter party!s

Domestic politics

8 Sri Lanka


greater commitment to peace talks with the LTTE, it has indicated that it iswilling to enter into negotiations with the UPFA. However, co-operation will bedifficult. The TNA is a proxy for the LTTE, and its support will remainconditional upon any government continuing negotiations with the Tigers, withthe final aim being some form of federal system. The TNA!s pro-Tamil agendaclashes directly with that of the JVP, making it extremely doubtful that the twoparties could work together. The UPFA is also trying to attract former allies ofthe UNP. The Sri Lanka Muslim Congress (SLMC) was part of the UnitedNational Front coalition government that was led by the UNP. However, it wononly five seats, and is too small to give the UPFA a majority. The CeylonWorkers! Congress (CWC), another Tamil party (which has in the pastcampaigned under the banner of the UNP), has also been approached by thenew government, although talks between the two sides have been onlylukewarm. Overall, the PA!s reliance on the chauvinistic JVP means that it willhave difficulty in winning the support of ethnic-based parties.

All of this will complicate efforts by the UPFA to form a working majority anda stable government. The UNP could add further uncertainty by trying to builda coalition of its own"if the UPFA fails to form a majority, the UNP mayattempt to form a government. (Under the constitution, if the largest party failsto form a majority government within the first month after the election, thenext largest party may try to form one.) This is unlikely in the short term, as theonly way for the UNP to achieve this would be to make an agreement with theJHU"which is unlikely, given the divergent views of the parties with regardboth to the peace process and to the economy. However, there are someelements in the PA that resent the alliance with the JVP. Should the peaceprocess appear to be breaking down, there is a possibility that some membersof the PA may support the UNP in order to prevent a return to war.

In focus

The peace process remains at risk

The election result has not improved hopes of a resolution of the ethnic conflict. Afailure to win a majority means that a unified stance towards the Liberation Tigers ofTamil Eelam (LTTE, Tamil Tigers) will be difficult for the new United Peoples!Freedom Alliance (UPFA) government to achieve. The LTTE has stated its willingnessto deal with any government that has the authority to accept its demands forpolitical devolution. However, the second-largest constituent of the UPFA, the JanataVimukthi Peramuna (JVP, People!s Liberation Front), opposes a federal solution.Given that the larger party in the UPFA, the People!s Alliance (PA), is reliant on theJVP, it will find it difficult to offer a solution involving devolution. Furthermore,despite the fact that the president and leader of the PA (and hence of the UPFA),Chandrika Kumaratunga, has stated on many occasions that she supports a politicalsolution, she has in the past condemned the United National Party (UNP), whichheaded the previous government, for making too many concessions to the Tamilrebels merely in order to keep the peace process going. Overall, the increasedinfluence of pro-Sinhalese forces in parliament makes peace less likely.

At the same time, the new government faces the problem of potentially having todeal with the LTTE on two fronts. In early March, one of the leaders of the group,

Sri Lanka 9


V Muralitharan, commonly known as Karuna, split from the main group,complicating the already precarious peace process. Karuna cannot be ignored, as hecontrols approximately 6,000 troops in the east (out of an estimated total of 15,000LTTE fighters). Although having affirmed his commitment to the peace process,Karuna has requested separate talks with the government and a separate cease fireagreement. Karuna has hinted that the Tamils under his control will not start fightingwith those in the north, recognising that a unified front is needed against the partiesin the capital. However, conflict between the two sides remains possible"there wereseveral skirmishes between them in early April. Karuna rejected an offer of amnestyfrom the leader of the LTTE, Velupillai Prabhakaran, made soon after the rift becamepublic, and has been expelled from the LTTE. The LTTE command has also steppedup criticisms of Karuna in recent weeks. The political establishment in the south hasbeen unsure as to how to respond to the situation. Dealing with Karuna wouldanger Mr Prabhakaran, endangering the current peace process. However, a failure totake Karuna seriously could prove equally fraught with risk. The Sri Lankan armyhas been put on high alert, but does not wish to be dragged into a conflict involvingtwo factions of the LTTE. The biggest worry for the parties is the accusation byKaruna that the LTTE command could be planning a return to war. This has beendenied by representatives of Mr Prabhakaran, but cannot be ruled out.

International support for the peace process has remained strong. However, thedelay in the disbursement of substantial foreign aid tied to a resolution of theconflict has become a concern for some foreign governments and donoragencies. Relations between Sri Lanka and its major donor countries may sufferunder Mrs Kumaratunga and her party. Although Mrs Kumaratunga recognisesthat she needs donor funds, the UPFA has spoken against foreign interference inthe peace process, and during the election campaign the alliance accusedseveral countries of providing funding to help the UNP and its allies to returnto power.

Economic policy outlook

Although the new alliance between the PA and the JVP has stated that it willcontinue with broad economic reforms, the increased strength of the MarxistJVP in parliament could result in a slowdown in economic liberalisation. Partof the reason for the party!s success during the election campaign was itscriticism of the government!s failure to contain the cost of living. It is likely tooppose privatisation and labour reforms. At the same time it will encouragehigher subsidies, raising the possibility of a reversal in the progress made by theformer government in freeing administered prices. Furthermore, although thePA is more market-friendly than the JVP, it is also ideologically left-leaning, andso is less likely than the UNP to pursue market-friendly measures. Theeconomic policymaking environment will also be undermined in the shortterm by the new government!s concentration on building a working majority inparliament. Of equal concern is the possible loss of donor support owing to thepolitical impasse.

Policy trends

International relations

10 Sri Lanka


Sri Lanka!s persistent problem with revenue collection has once again led to anovershoot of the government!s fiscal deficit target. Despite a perceptibleimprovement in curbing expenditure and trimming debt, a revenue shortfallhas led the government to raise its estimate for the 2003 budget deficit(excluding grants and privatisations) to 7.8% of GDP, from its original target of7.5%. The Economist Intelligence Unit expects the final figure to be 7.9% of GDP.The government has revised its 2004 deficit upwards to an estimated 7.3% ofGDP. This too is likely to prove optimistic, particularly as the new governmentis likely to follow populist policies. Nevertheless, assuming that the peaceprocess holds"limiting defence spending"stronger GDP growth should result inthe budget deficit falling from 7.9% in 2004 to 7.3% of GDP in 2005.

Since the beginning of 2003 there has been a progressive decline in money-market interest rates. This has helped to exert downward pressure oncommercial bank interest rates. A more efficient functioning of financialmarkets, particularly state banks, together with increased competition, hashelped to exert downward pressure on commercial interest rates, allowingprime lending rates to remain on a declining trend during 2004-05. However, adeterioration in fiscal performance"which could result from a lower thanexpected rate of GDP growth, from populist spending, or from a rise in defenceexpenditure should the ethnic conflict resume"will force some tightening inmonetary policy.

Economic forecast

International assumptions summary(% unless otherwise indicated)

2002 2003 2004 2005Real GDP growthWorld 2.9 3.8 4.7 4.1US 2.2 3.1 4.5 3.2EU 1.0 0.7 1.8 2.0Exchange rates¥:US$ 125.3 115.9 105.3 106.5US$:� 0.945 1.132 1.270 1.357SDR:US$ 0.772 0.714 0.665 0.646

Financial indicatorsUS$ 3-month commercial paper rate 1.70 1.10 1.15 2.69¥ 2-month private bill rate 0.10 0.03 0.03 0.10

Commodity pricesOil (Brent; US$/b) 25.0 28.8 29.8 22.8Tea (US$/kg) 1.5 1.5 1.5 1.5Food, feedstuffs & beverages (% change in US$

terms) 12.7 6.6 6.4 2.5Industrial raw materials (% change in US$ terms) 2.2 12.7 20.3 -2.7

Note. Regional GDP growth rates weighted using purchasing power parity exchange rates.

The US economy is estimated to have grown by 3.1% in 2003. US growth willstrengthen to an average annual rate of 4.5% in 2004, driven by a broad-basedrecovery, before decelerating to 3.2% in 2005 as the economy stabilises. Thereare signs of a tentative economic recovery in Europe, but growth there,

International assumptions

Monetary policy

Fiscal policy

Sri Lanka 11


although picking up, will remain relatively weak until the end of 2004. TheJapanese economy"another leading market for Sri Lanka!s exports"is alsorecovering strongly. Economic recovery in the OECD as a whole will result inhigher demand for Sri Lanka!s exports in 2004-05. However, global oil pricescontinue to be extremely high (at an average of US$29.8/barrel for 2004) andwill add to Sri Lanka!s import bill in the year. Oil prices are expected to fall in2005 to US$22.8/b.

Real GDP growth is estimated to have been 5.9% in 2003, driven largely byhealthy services growth. Growth in 2004, forecast at 5.7%, will be underminedduring the first half of the year by political instability. Investment will suffer asboth domestic and foreign investors adopt a "wait and see" attitude. Tourismcould also be affected if the political crisis persists. There are other risk factorsthat will militate against higher GDP growth in 2004. The ongoing drought willhit agricultural production. Power supplies look increasingly uncertain, and ifrains do not materialise the resultant power shortages could adversely affectindustrial production.

Assuming that the ethnic conflict does not resume and that the political scenestabilises, the economy should recover more strongly in 2005, growing at 6.4%,as investment and private consumption rise in line with growing confidence.The industrial sector will continue to be supported by a sustained recovery indemand for Sri Lanka!s industrial exports, with exports of goods and servicesgrowing by 9.6% (in national accounts terms). As a consequence, capitalspending in the export sector will result in overall investment growing by 9.6%in 2005, supported by the start of public-sector infrastructure projects. Lowerunemployment and expectations that output in the agricultural sector, whichstill supports the majority of the population, will grow more strongly in 2005than in 2004, will enable year-on-year growth in private consumption to risefrom 5.3% in 2004 to 6.4% in 2005.

Several factors will prevent a significant deceleration in consumer priceinflation in 2004. Drought will affect agricultural production and hencesupplies of key food commodities. Power shortages are likely to lead toincreased tariffs and will inevitably also exert upward pressure on consumerprices, as will a rise in domestic petroleum prices. The rupee is likely todepreciate faster in 2004, raising prices of imports. The increase in value-addedtax from the lower rate of 10% to 15% for several goods will be reflected inhigher prices. Wage-induced inflationary pressures will also contribute: theweak position of political parties will encourage trade unions to step up wagedemands. Against this backdrop, we expect consumer price inflation to average5.4% in 2004. It will moderate slightly to 5.3% in 2005, owing to improved foodsupplies and a declining budget deficit.

The rupee depreciated by an average of just 0.9% year on year in 2003. The rateof depreciation will rise in 2004. Lower capital inflows owing to the unstablepolitical situation will reduce US-dollar liquidity in the market and the USdollar will stabilise against other major currencies. In the short term, until thepolitical crisis is resolved, there will be additional speculative pressure on the

Economic growth

Inflation

Exchange rates

12 Sri Lanka


rupee. Nevertheless, barring a dramatic deterioration in the political andsecurity climate, we expect market fundamentals to keep the rate ofdepreciation in the rupee broadly below its historical trend. Overall, the rupeewill depreciate gradually from an annual average of SLRs96.5:US$1 in 2003 toSLRs105.1:US$1 in 2005.

We expect export growth to strengthen in 2004 in line with a recovery in theOECD countries generally. However, imports will also rise. Increased demandfor crude oil as the country resorts to greater use of thermal generation,coupled with a sustained recovery in exports, will lead to a rise in imports ofintermediate goods. The drought, if it leads to lower agricultural production,will necessitate increased imports of food. However, political instability will puta brake on investment goods imports in the short term. Higher revenue fromtourism and port services (provided that the ceasefire holds and that thepolitical climate stabilises in the second half of the year), coupled withsustained increases in private remittances, will help partially to offset the highertrade deficit. Overall, the current-account deficit will rise to 3.6% of GDP in2004. Although the current-account deficit in US-dollar terms is expected toremain stable in 2005, stronger economic growth will lead to a narrowing ofthe deficit relative to the size of the economy, to 3.2% of GDP.

Forecast summary(% unless otherwise indicated)

2002a 2003 b 2004c 2005c

Real GDP growth 4.0 5.9 a 5.7 6.4

Gross industrial growth 1.0 5.5 8.0 8.4Gross agricultural production growth 2.5 1.5 1.0 2.5

Unemployment rate (av) 9.2 8.4 7.8 7.4Consumer price inflation (av) 9.6 6.3 a 5.4 5.3Consumer price inflation (year-end) 11.2 5.1 a 5.6 5.2

Short-term interbank rate 12.2 9.3 9.0 8.8Government balance (% of GDP) -7.8b -7.0 -6.9 -6.3Government balance, excl grants & privatisation

(% of GDP ) -8.9 -7.9 -7.9 -7.3Exports of goods fob (US$ bn) 4.7 5.1 5.7 6.3Imports of goods fob (US$ bn) 6.1 6.7 7.5 8.0

Current-account balance (US$ bn) -0.2 -0.1 -0.7 -0.7Current-account balance (% of GDP) -1.4 -0.6 -3.6 -3.2

External debt (year-end; US$ bn) 9.5b 10.7 11.6 12.2Exchange rate SLRs:US$ (av) 95.66 96.52 a 100.86 105.06Exchange rate SLRs:¥100 (av) 76.32 83.28 a 95.78 98.65

Exchange rate SLRs:� (av) 90.39 109.29 a 128.09 142.62Exchange rate SLRs:SDR (av) 123.9 135.2 a 151.7 162.7

a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts.

External sector

Sri Lanka 13


The political scene

The United Peoples! Freedom Alliance (UPFA), which consists of the People!sAlliance (PA) coalition that ruled the country from 1994 to 2001, together withthe Marxist Janatha Vimukthi Peramuna (JVP, People!s Liberation Front), wonpower in the April 2nd parliamentary election, sweeping aside the UnitedNational Front (UNF) government of Ranil Wickremasinghe. The UPFA wasformed with the express intention of defeating the UNF, after the president,Chandrika Kumaratunga, exacerbated a power struggle between thegovernment and herself by taking over three key ministries in November lastyear. (February 2004, The political scene). The mid-term election (the UNF waselected to power in December 2001), one of the least violent conducted inrecent times, gave the UPFA, the single largest party, 105 of the 225 seats,resulting in a hung parliament and a minority government. The strength of theUnited National Party (UNP), the main component of the UNF, was reduced to82 seats in parliament.

The result of the election could be interpreted as a resurgence of nationalism;the UNF government!s perceived excessive concessions to the Liberation Tigersof Tamil Eelam (LTTE, Tamil Tigers) and its failure to stem the escalating cost ofliving were also major factors in its defeat. The UNP!s re-election campaignrelied heavily on its efforts while in government to negotiate a peace with theLTTE"a message that failed to strike a chord among the vast majority of theelectorate. The PA and the JVP had been critical of the UNF!s accommodationof the Tamil rebels, with whom the government had held six rounds of peacetalks (negotiations were suspended in April 2003). The JVP is fundamentallyopposed to the devolution of power as a solution to the ethnic conflict, and itssupport for the relatively moderate PA was the decisive factor in the UPFAvictory.

Another significant outcome of the election was the strong showing of twoequally nationalistic groups representing the two major communities. TheIllankai Tamil Arasu Kachchi (successor to the Tamil National Alliance in thelast parliament, and a virtual proxy of the LTTE) won 22 seats, emerging the

The UPFA forms a minoritygovernment

Tamil and Buddhist partiesmake gains in new parliament

14 Sri Lanka


third-largest group in parliament, while the Jathika Hela Urumaya (JHU), aparty that fielded only Buddhist monks as candidates, won nine. These partieshave chosen to vote independently in the assembly instead of joining either theUPFA or the UNP. The Sri Lanka Muslim Congress, which won five seats,remains allied with the UNP, but could switch its allegiance at any time.

The extent of the UNP!s defeat was the biggest surprise of the election. In justtwo years the party had lost the groundswell of support and goodwill it earnedby entering into an internationally monitored ceasefire with the LTTE andcommencing peace talks. Ironically, the fact that the ceasefire continued to beobserved even after the suspension of the talks was one of the factors thatfacilitated the conduct of a largely peaceful and fair election. The UNP!s maincampaign theme"that it was the only party that enjoyed the trust andconfidence of the LTTE necessary to pursue the peace initiative to aconclusion"appears to have found little resonance with the electorate. TheUPFA, which campaigned mostly on issues such as the cost of living andpromised to increase subsidies, protect farmers and create jobs, secured 46.4%of the vote, compared with the UNP!s 37.8%. Only the proportionalrepresentation (PR) system, introduced by a UNP government in 1978, saved theparty from a rout.

The PR system also denied the new government stability in parliament. Whatwould, under the first-past-the-post system, have been an electoral landslideand delivered a two-thirds majority in parliament (the requirement for majorconstitutional amendments), translated into less than a simple majority (113seats) for the UPFA under the PR system. The new government received anearly taste of what life could be like in the months ahead when the newparliament convened for the first time. Its first act, to elect a speaker, saw unrulyscenes and three rounds of voting. Finally, after nine hours of chaos and asuspension of sittings, the UNP!s candidate, W J M Lokubandara, was electedspeaker, defeating the government candidate by one vote. Bitterly disappointedat this setback, UPFA members blamed the monks of the JHU for swinging thevote in favour of the UNP, leading to more ugly scenes in the house.

If the difficulty it faced on the opening day of the new parliament is anyindication, passing legislation or constitutional reforms that are not supportedby the opposition will be a severe challenge for the new government. Anequally serious threat to stability is the divergence of opinions on many keyissues between the two main constituents of the UPFA, the PA and the JVP.These differences surfaced even before the first session of the new parliament,at the appointment of the new prime minister and the selection of the cabinet.The JVP opposed the appointment of Mahinda Rajapakse, the SLFP!s popularnominee for prime minister, but Mrs Kumaratunga was compelled to make theappointment in order to prevent a split in the PA. Following this, a disputearose about the allocation of portfolios in the new cabinet, with the JVPmembers declining to be sworn in until they had received the appointmentsthat they had demanded. A compromise was finally reached, and the fullcabinet was sworn in three weeks after the first appointments wereannounced.

The new government'sstability is challenged

Sri Lanka 15


Despite its lack of stability, the UPFA government has pledged to resume thestalled peace talks with the LTTE and amend the constitution as a matter ofpriority. Mrs Kumaratunga, who is serving her second and final term aspresident, wants to abolish the presidency and revert to a parliamentary-stylesystem so that she can return to parliament and continue to lead thegovernment. In the absence of the two-thirds majority in parliament requiredfor such a move, the president has indicated that she will treat victory in theelection as a mandate to convene a constituent assembly to introduce a newconstitution. However, the appointment of an opposition candidate as speakercould be a serious setback to these plans. It is also unlikely at this stage thatTamil parliamentarians will support the UPFA in such a course.

In a bid to allay fears (fuelled by the UNP during the election campaign) thatthe UPFA victory could be a setback to the peace process, Mrs Kumaratunga hasinvited the Norwegian government to explore the possibility of an earlyresumption of peace talks with the LTTE. In early May a Norwegian team calledon the president and met rebel representatives. The president also dispatchedher foreign minister for talks with the government Indian government, whichshe hopes will play a greater role in the peace effort and in reconstruction ofthe war-affected areas.

The LTTE, which faced a rare and much-publicised (but short-lived) mutiny inthe run-up to the April 2nd election, has said that it will talk to any party thatemerges with a mandate to form a government. The rebels are likely, however,to insist that talks focus on the framework for an autonomous body, which theyproposed in October 2003 as an interim measure while the search for a finalsolution to the conflict proceeds. Although the UNP will find it difficult not tosupport this position since the proposal was made while the UNP wasspearheading the peace initiative, opposition could come from within the UPFAand from the monks in parliament.

The indications are that the new government would like to resume peace talksby June. This could also help its campaign for elections to several provincialcouncils due around that time. The UPFA has already convincingly won controlof one such regional assembly, the North-Western Provincial Council, whichwent to the polls three weeks after the general election.

Economic policy

The new government is still in a state of transition and thus has yet to articulatea firm economic policy. The overall indication is that the government willcontinue to pursue liberal economic policies, but that there will be a shift inpriorities. Based on the manifesto of the United Peoples! Freedom Alliance(UPFA, the new governing alliance) and from various pronouncements madeby the Ministry of Finance, policy will include a determined effort to revampthe agricultural sector (including fisheries) and develop rural infrastructure,with the aim of drawing into the mainstream of the economy the hithertoexcluded regions outside Western Province (where most development hasoccurred). Emphasis will also be given to developing small- and medium-scale

Major constitutional reform iscontemplated

Norway is asked to resume itspeace initiative

Emphasis on agriculture andthe rural economy

16 Sri Lanka


industries. Another priority is to step up the implementation of infrastructure(power and road) projects for which foreign funds have already beencommitted.

With regard to privatisation, the stated policy of the new government is toretain state ownership in strategic sectors such as railways, bus transportcompanies, electricity, ports and airports, water and state banks, but to grantthem greater commercial autonomy. This is to be done by a new law onstrategic enterprise management, where these enterprises will be regulatedthrough a Strategic Enterprise Management Agency. The privatisation of non-strategic state-owned enterprises (for example, hotels and plantationcompanies) is to continue.

The new government!s stance on tax and trade policies is similar to that of theprevious government, and is also in line with the recommendations ofinternational lending agencies. The primary thrust remains an improvement intax administration and a further simplification of the tax and trade regimes.The principal departure from existing policy is the cancellation of the previousgovernment!s proposed amalgamation of the three revenue-collectingauthorities (Customs, the Inland Revenue and the Excise Department) into asingle Revenue Authority. The new government plans instead to focus onstrengthening administration in each of the separate departments. The value-added tax will be retained (the proposed extension of coverage to the retailsector is uncertain), but the debit tax imposed by the previous regime is likelyto be reconsidered. The priority appears to have shifted to a more determinedeffort to improve revenue collection.

The UPFA government has announced that it will broadly adhere to the fiscaltargets outlined by the previous government in its 2004 budget. In line with theFiscal Management (Responsibility) Act, which mandates the publication of thestate of the country!s public finances prior to an election, the previousgovernment issued a statement on March 1 2004. According to the report, theestimate for the 2004 fiscal deficit has been revised upwards, to 7.3% of GDP,compared with an original estimate of 6.8% of GDP. The upward revision isowing to increased expenditure by way of subsidies (for drought relief, fertiliserand essential commodities), as well as to a possible revenue shortfall as actualincome is now expected to equal 15.8% of GDP, compared with thegovernment!s earlier estimate of 16.4%. The reasons cited by the previousgovernment for the revenue shortfall were the disruption in revenue streamscaused by delays in setting up the Revenue Authority, and the reduction in theduties levied on several commodities that were introduced to moderate the risein the cost of living. The new government has emphasised that it will notcompromise on capital spending in a bid to adhere to the fiscal deficit, addingthat its first priority will be hitting the revenue targets contained in the 2004budget, which will help to compensate for increased expenditure.

In its most recent monetary policy statement, released in mid-April, the CentralBank of Sri Lanka announced that it was retaining its current loose monetarypolicy stance, with its key indicative interest rates remaining unchanged. The

Tax and trade policies remainbroadly unchanged

The estimate for the 2004fiscal deficit has been revised

The central bank maintainsloose monetary policy

The new governmentbacktracks on privatisation

Sri Lanka 17


reasons it cited were the downward trend in inflation, a liquid money market,relative stability in the exchange rate and preliminary indications of broad-based growth in key sectors of the economy. However, the bank cautioned thatthe persistent drought, coupled with rising international prices that could addan upward twist to inflation, and also further increases in the budget deficit(higher spending without a matching increase in revenue), could lead to arevision in monetary policy.

The World Bank has approved a US$51m grant to support the government!sefforts to reduce poverty in Sri Lanka!s rural areas. The first phase of the project,entitled "Gemi Diriya" (Strong Villages), will cover 1,000 villages in the southernparts of the island. The principal aim of the project, which will be community-driven, is to empower the poor and lift them into sustainable income-generating activities. The main components of the project are: the strengtheningof village organisations and the funding of priority projects at the communitylevel; building up the capacity of local institutions to respond effectively tocommunity needs; a seed fund to promote innovation and experimentationwith creative ideas at the community level; and the funding of projectmanagement and monitoring. The grant is the first of a three-phase programme,which will eventually encompass 4,000-5,000 villages over a twelve-yearperiod. The World Bank has already initiated a pilot self#help villagedevelopment programme in the Polannaruwa district.

On April 21st the UPFA government delivered on a key election promise byraising the fertiliser subsidy by an additional SLRs200 (US$2), which in effectcut the price of a 50-kg bag of urea from SLRs800 to SLRs600. The previousgovernment had raised the subsidy on each bag from SLRs300 in 2003 toSLRs450 in January 2004 in response to higher international prices. Theadditional subsidy being paid out by the new government will cost SLRs1bn(US$9.9m), raising the total budgeted allocation for the fertiliser subsidy in 2004by 50% to SLRs3bn, from an original budget of SLRs2bn.

The grant of the fertiliser subsidy was followed by fulfilment of another pre-election promise"the granting of employment to university graduates.According to the public announcement, 27,000 graduates will be recruited tostate institutions as management trainees. During the two-year training period,they will receive a monthly stipend of SLRs6,000. According to the Treasury, theemployment project, estimated to cost SLRs1bn, will be financed by redirectingfunds allocated to the Youth Corps in the 2004 budget.

The domestic economy

Economic trends

Real GDP grew faster than anticipated, by 5.9%, in 2003. Growth was drivenlargely by the services sector, but industry and agriculture also recordedincreases in production. The acceleration in the economy!s growth rate was thecombined result of a number of factors. The continuation of the peace process

The World Bank approves agrant for village development

The fertiliser subsidy has beenraised

A project to employ 27,000graduates is announced

The economy grew faster thanexpected in 2003

18 Sri Lanka


boosted investor and consumer confidence, which in turn lifted aggregatedemand (as reflected by the increase in real consumption and investment).There was a perceptible improvement in macroeconomic management,underscored by a lower fiscal deficit, moderating inflation and a stableexchange rate. This facilitated a gradual relaxation in monetary policy, whichexerted mild downward pressure on interest rates. The recovery in externaldemand raised export growth, and this, combined with increased capitalinflows, led to a further improvement in the overall balance of payments.

For the second consecutive year the services sector emerged as the leadinggrowth sector. Output expanded by a robust 7.7% year on year, generating 70%of the increase in GDP. Growth was led by the transport, storage andcommunications subsector (the second-largest subsector after trading), whichexpanded by 10.3%. Telecommunications grew impressively, by 24.5%, whileport services output expanded by 10.8%. Wholesale and retail trading, thelargest sector (accounting for 22% of GDP and one-third of services output) grewby 7.3%, underpinned by the expansion in exports, imports and domestictrading activity. Improved access to the north and east, thanks to the ceasefire,contributed particularly strongly to increased domestic trading. Financialservices grew by 10.6% year on year, slightly slower than the 11.1% growth in2002; a booming equity market, expansion in insurance and leasing, higherdemand for credit stemming from increased business activity and widerinterest rate margins continued to sustain growth in this sector. Record touristarrivals resulted in an impressive 22% growth in the hotel and restaurantsubsector.

Growth in the industrial sector (comprising manufacturing, mining constructionand electricity) expanded to 5.5%"a significant improvement on the 1% growthrecorded a year earlier. This was primarily attributable to an expansion inconstruction activities"output rose by 5.5%, as against a 0.5% contraction in2002. After two consecutive years of contraction, the output of the electricitysubsector rose by 25.3% in 2003, thanks to increased hydro-power generation.The output of the mining and quarrying sector expanded by 3.6% in real termsin 2003.

The manufacturing sector, which generates 62% of industrial output, recoveredto grow by 4.4% in 2003"more than double its growth rate of 2.1% the previousyear. Growth in factory and associated activity, which predominates(accounting for 81% of manufacturing), picked up to 4.6% in 2003, from 2.8 % in2002, anchored by a recovery in both export- and domestic-oriented industries.The recovery in international demand facilitated faster growth in all keymanufactured exports, while stronger consumer demand, a recovery ininvestment and improved market penetration and distribution to the north andeast of the country facilitated higher growth in industries catering to thedomestic market.

In line with the established trend, growth in the agricultural sector, althoughpositive, was well below that recorded by the other parts of the economy.Despite a record rice harvest and a recovery in coconut production, real growth

The services sector was thestar performer

Industrial growth is driven byconstruction and electricity

Agricultural growth remaineddepressed

Manufacturing has accelerated

Sri Lanka 19


in agriculture (which includes fishing and forestry) was just 1.5% year on year"afurther drop on the rather modest 2.5% increase recorded in the previous year.Factors that depressed agricultural production included a flood-induced drop intea output, weather conditions that restricted the increase in rubber productionto a mere 1.6% year on year and a drop in fisheries output. Ironically, althoughthe agricultural sector!s share in overall GDP has been on a declining trend (itfell to 19% in 2003, from 20.5% in 2002), its impact in social and political termsremains significant, since it accounts for over one-third of total employmentand remains the major economic activity in rural areas where over 80% of thepopulation live.

Domestic consumption grew by 6.1% in real terms in 2003. Increased consumerconfidence, buttressed by additional demand from the previously deprivedwar-torn regions of the north and east and by the growth in tourism, whichboosted income per head, helped to raise real consumption. According to theCentral Bank of Sri Lanka (CBSL), the rise in consumption was generatedentirely by private consumption as real government consumption declined inline with the reduction in government expenditure. The most encouragingdevelopment was the 17% year-on-year real increase in investment"more thandouble the 6.7% growth recorded a year earlier. As a result, investment rose as apercentage of GDP to 22.3%, from 21.3% in 2002. In 2003 investment growth wasstimulated by increased investor confidence as a consequence of the continuedceasefire, a more proactive economic policy environment and an increase inpublic investment, primarily in reconstruction work in the war-affected areas.The principal areas to benefit from higher investment were telecoms, roads,construction and, to a lesser extent, power. Exports of goods and servicesexpanded in real terms by 4.8% year on year.

The downward trend in consumer price inflation continued in the first fourmonths of 2004. The annual average rate of the Colombo Consumers! PriceIndex declined progressively from 5.4% in the year to January 2004 to 4.4% inthe 12 months to February, decelerating further to 3.9% and 3.7% in the years toMarch and April 2004 respectively. Apart from seasonal factors (prices generallytend to rise more slowly in the first quarter in tandem with the productioncycle), improved supplies of key food commodities supplemented by importshave stemmed an increase in prices of locally produced goods and services.Although the main 2004 rice harvest has been affected by the drought, excesssupplies from a record harvest in 2003 have helped to keep a lid on prices.Rising domestic coconut production has also exerted downward pressure onretail coconut prices. Both rice and coconuts have a high weight in theconsumer food basket. A relatively stable exchange rate has contributed to themoderation in inflation. The annual average rate of increase in the recentlyintroduced Colombo District Consumers! Price Index (CDCPI) was significantlyslower than that in the CCPI, averaging 0.9% in the year to April 2004. TheCDCPI covers the lowest 40% of income-earning households in the Colombodistrict, and uses September 1996-October 1997 as its base year.

Consumer price inflation hascontinued to moderate

Real consumption andinvestment improve further

20 Sri Lanka


Despite the political uncertainty that prevailed in the run up to the April 2ndelection, the rupee has remained fairly stable. Since the end of February theexchange rate has hovered around SLRs98:US$1, strengthening slightly toapproximately SLRs97.5:US$1 from mid- to end-March. There has been a slightdepreciation since the April election, with the Sri Lankan rupee standing atSLRs99:US$1 on May 22nd. The rupee also been partly propped up by centralbank intervention"in January US-dollar sales by the bank in the foreign-exchange market amounted to US$13m, followed by sales of more than doublethis amount, at US$30.8m, in February. In March net sales by the bank wereagain approximately US$30m.

Manufacturing

A concerted drive to tap the huge Indian market has been launched. As a firststep, in late February Sri Lanka!s Export Development Board (EDB) opened thecountry!s first dedicated trade centre in one of the largest shopping malls inChennai, India. The trade centre showcases some of Sri Lanka!s leading exportcompanies, and, depending on the success of this pioneering venture, similarcentres in Mumbai and the Indian capital, New Delhi, are planned. Among thecompanies displaying their products are Sri Lanka!s top biscuit manufacturers,Maliban and Munchee, two leading garment exporters, MAS Holdings andBrandix, and a footwear giant, the DSI Samson Group. Other participantsinclude exporters of jewellery, herbal products, porcelain ware and tea.Although since the free-trade agreement with India became operational therehas been some growth in Sri Lanka!s exports to India, they still account for lessthan 5% of total Sri Lankan exports and a minuscule 0.01% of all Indianimports. India is, however, Sri Lanka!s largest supplier, meaning that there is alarge imbalance in trade between the two countries.

In a related development, two Sri Lankan exporters have set up shop in Indiain a bid to access directly the retail Indian market. In late February a footwearexporter, DSI, opened its first foreign retail outlet in Chennai, in a pilot projectto test the response to its products. Although the company already exports itsrubber slippers to India, it believes that direct access to customers via the retailchain will enable it to gain a stronger foothold in the Indian market. Given thestrong competition it faces in leather footwear from Indian manufacturers, thecompany plans to concentrate on its niche of natural rubber products, including20-odd products such as car mats, garden hoses, hot water bottles, and slippersand fashion shoes. Dankotuwa Porcelain, an exporter of ceramic ware, alsoplans to launch its products in South India. The firm is eyeing non-traditionalmarkets to build its brand, with a new line of products including anexperimental line of cookware and a specific range for the hotel sector.

Despite the political uncertainty, tourist arrivals continued to surge, rising to93,534 in the first two months of the year"a 17.3% increase on the correspondingperiod one year earlier. The number of tourists visiting the island rose year onyear by 22.9% to 49,950 in January. In February the number of arrivals slowedto 43,584, up 11.5% year on year. The UK retained its top slot as the largest

Tourist arrivals grew by 17% inthe first two months of 2004

Efforts to increase exports toIndia are being stepped up

The rupee remains fairly stable

Sri Lanka 21


market, with the number of British tourists rising year on year by an impressive31% to 18,600. India was the second-biggest market, with 14,050 tourist visitorsto Sri Lanka in the first two months of 2004, up 14% year on year. Arrivals fromSweden and the Netherlands also recorded substantial increases, but traditionalmarkets such as France and Germany saw respective 8% and 14% declines inthe number of tourists. Growth in tourist arrivals from Japan, a high valuemarket, remained healthy as arrivals rose by 12% year on year to 4,026 in thetwo-month period.

Sri Lanka!s tourism potential and the political stability that has prevailed in theisland for the past two years have encouraged several new airlines tocommence operations there. In particular, an agreement between India and SriLanka in late 2003, incorporating the "fifth freedom clause" (whereby an airlineregistered in one country can pick up passengers from another country anddrop them off in a third state without passing through home territory) has ledto a sharp increase in flights between the two countries. On March 25th two ofIndia!s leading private airlines, Sahara Airlines and Jet Airways, commencedoperations to the Sri Lankan capital, Colombo. Both airlines currently operatedaily flights between Chennai and Colombo; combined with the flightsoperated by Sri Lanka!s national carrier, SriLankan, this has raised to 90 thenumber of weekly flights between the two countries. Jet, India!s leadingdomestic airline with a 46% share of the market, plans, in addition to leisuretravel, to make a concerted pitch to business travellers, as well as to promote SriLanka to Indian companies as the ideal destination for meetings, incentives,conventions and exhibitions. Sahara has announced plans eventually todevelop Colombo as a hub for its international services. The airline plansinitially to target other South Asian Association for Regional Co-operation(SAARC) countries, offering flights to Nepal, Bangladesh and the Maldives viaColombo, tapping into the growing demand from both business and leisuretravellers in these countries.

Also in early March, Etihad Airways, the national airline of the UAE, launchedservices between the UAE capital, Abu Dhabi, and Colombo. The thrice-weeklyservice is planned to meet the significant demand that exists for travel betweenthe Middle East and Sri Lanka. The Middle East is the largest employer ofmigrant Sri Lankan workers. Currently this sector is serviced primarily by SriLankan airlines and the largest UAE carrier, Emirates. By the end of March,Etihad had also opened a cargo office in Colombo. The airline plans to establisha daily air service by the end of the year. Sri Lanka has also signed amemorandum of understanding with Qatar Airways allowing unlimitedpassenger and cargo flights between Sri Lanka and Qatar. Qatar Airways hasalso been accorded rights to fly from Sri Lanka to four other destinations"Australia, South Korea, Singapore and Indonesia.

Another development that portends well for the air transport industry was thelaunch by Singapore Airlines Cargo at the end of March of a dedicated freighterservice from Colombo. The initial cargo capacity reserved for Colombo is30-40 tonnes, but there are plans to increase capacity depending upon demandfrom Sri Lanka. In addition to the dedicated service, Sri Lanka will also be able

Two leading Indian airlinescommence flights to Colombo

Etihad Airways also beginsservices to Colombo

Singapore Airlines haslaunched a cargo service

22 Sri Lanka


to take advantage of hub facilities to most international markets via Singapore.The service will benefit Sri Lankan apparel exporters as well as exporters ofperishable commodities, and will ease the current space constraints.

Lanka Indian Oil Company (LIOC), the second player in Sri Lanka!s recentlyderegulated petroleum industry, plans to expand its operations in the country.In March the company finalised a US$25m loan jointly financed by a SriLankan bank, Bank of Ceylon, the world!s largest bank, Citibank, and India!slargest bank, State Bank of India, to fund its expansion plans. The five-year loanwill be used to further modernise the outlets that the company bought fromthe state-owned Ceylon Petroleum Corporation (Ceypetco), as well as torenovate the storage facility in Tricomalee acquired by the company from thegovernment on a 35-year lease. The renovation to the Trincomalee tank farmincludes the construction of 6,000 kilolitre floating-roof tanks for petroleum, anew 12-bay tanker-lorry filling shed, and the construction of a new pumphouse and fire hydrant system, as well as the overhaul of existing pipelines andthe construction of new ones. The company also plans a formal listing on thestockmarket, with an initial public offering slated before end-2004.

Competition in the lubricants market is set to intensify further in the secondhalf of the year, with the ending in June of the monopoly on local lubricantblending and manufacturing currently held by Caltex, the local subsidiary of aUS oil company, ChevronTexaco. Caltex currently has an edge over otherlubricant importers and blenders as, under an agreement with the government,it is protected by a 10% duty imposed on finished products imported into SriLanka. The liberalisation of the retail fuel market, marked by the entry of LIOCand its takeover of 100 petrol sheds previously owned by Ceypetco, in effectresulted in Caltex losing exclusive distribution rights in one-third of thepetroleum market. LIOC has been aggressively marketing its own brand of fueloil, and is estimated to have garnered 15% of the market. LIOC has announcedplans to construct a lubricant plant in Sri Lanka in order to expand its market.With an increasing number of motor vehicles being imported every year, thedemand for lubricants has grown by an estimated 4% annually.

Noritake Lanka Porcelain, one of Sri Lanka!s leading exporters of tableware,plans to invest SLRs100m (approximately US$1m) to expand its manufacturingcapacity. The company, a joint venture between Noritake Japan and LankaPorcelain, has been in operation for over 30 years, and was one of the pioneersof the country!s foray into the export of ceramic tableware. Noritake Lanka,which employs over 1,200 employees, exports fine-china dinner sets to leadingmarkets including the US, the UK, China, Japan and Australia. The additionalinvestment, primarily in new machinery, will augment the company!s currentproduction capacity by 15% or about 1.2m pieces per month.

A third player will soon enterthe petroleum industry

Lanka Oil is set to expand itsoperations

Competition in the lubricantsmarket will intensify

Noritake invests US$1m toexpand export capacity

Sri Lanka 23


Agriculture

Tea production in the first quarter of 2004 reached 72.3m kg, up by 1.9%compared with the same period in 2003. Dry weather conditions that haveprevailed since November 2003"underscored by poor and uneven rainfall in allplanting districts"have depressed production. Output in January dipped by2.6% year on year. However, there was a recovery in February, with a 6.9%month-on-month rise in production more than offsetting the losses incurred inJanuary. The gains were largely erased in March, with production falling yearon year by 1.1%: the March 2004 crop of 23.3m kg was the lowest recorded since1999. The increase in overall tea output was entirely owing to low-grown teas,production of which rose by 6.9% year on year in the first quarter. The outputof high- and medium-grown teas fell by 6.8% and 5.8% respectively. Althoughoutput of these teas generally dips in the first quarter as a result of the "qualityseason", the declines were sharper than expected. The general election and theextended holiday period in April are also likely to have kept a lid onproduction in that month.

Tea exports have continued to buck production trends, however, with exportedvolumes rising year on year by a healthy 14% to 48.5m kg in the first twomonths of 2004, as against 41m kg in the year-earlier period. In rupee terms,export earnings rose by 21% to SLRs11.3bn (US$111.9m) in January and February,from SLRs9.4bn one year earlier. However, the percentage of value addedexports, which rose to 41% in 2003, dropped to 37% in the first two months of2004. This is almost entirely attributable to a contraction in value addedexports to the leading destinations, Russia and the CIS, and probably reflectsthe impact of the duty imposed by Russia recently on value added teas. Theresultant price increase in Sri Lankan value added teas in Russia could result incheaper substitutes gaining market share.

Tea production(Jan-Mar; m kg)

2003 2004 % changeHigh-grown 19.68 18.34 -6.8

Medium-grown 12.71 11.97 -5.8Low-grown 39.20 41.93 7.0Total 71.59 72.24 0.9

Source: Asia Siyaka Commodities.

Sri Lanka has secured an order to supply 1.6m kg of tea to Iraq in the firsttender floated by the UN World Food Programme in early March. The totalquantity on offer was 20m kg, of which Sri Lanka!s allocation amounts to lessthan 10%. The bulk of the order (15m kg) has been awarded to Vietnam. Therelatively small quantity awarded to Sri Lanka has been attributed to tough andcomplicated conditions, with which exporters found difficult to comply. Pricesquoted by Sri Lanka were also the highest, since superior-quality teas wereoffered. The Iraq war in 2003 saw Sri Lanka!s tea exports to Iraq more thanhalve to just 6.3m kg, from 17.7m kg in 2002.

Export volumes and earningsshow healthy growth

Sri Lanka secures a 1.6m-kgexport order to Iraq

Tea production rose by 1.9% inthe first three months of 2004

24 Sri Lanka


John Keells Holdings (JKH), one of Sri Lanka!s top conglomerates and aprominent player in the plantation sector, has ended its involvement inplantations by selling its 50% stake in Maskeliya Plantations (which producestea) and Kegalle Plantations (rubber) to its joint-venture partner, Richard Pierisand Company, and its 59% stake in Namunukula Plantations for SLRs400m(US$3.96m) to Misty Mountain. This has reduced JKH!s participation in teaplantations to a minor presence through its small shareholding in the TeaSmallholders Factory. JKH was one of the pioneers in the tea industry, and theplantations sector traditionally contributed 30-40% of the company!s totalrevenue. However, in recent years, as the company has moved into hotels, portsand financial services, the contribution to its income from tea has diminished.

The stagnation and low productivity levels in Sri Lanka!s agricultural sectorremain a critical concern, with deep social and political implications. Theperformance of the agricultural sector is closely intertwined with the levels ofpoverty prevailing in the country. Nearly 80% of Sri Lanka!s population live inthe rural areas, and more than 45% of rural households are dependent onagricultural and rural non-farm activities. Agricultural households also tend tobe the poorest: an income survey conducted in 2000 found that agriculture-dependent households constituted about one-half of the lowest 40% of theexpenditure quintiles. The new government is strongly committed to payingmore attention to the agricultural sector. It is probably its perceived neglect ofthe farming community (which also constitutes the largest share of the votingpopulation) that cost the old government its votes and propelled into power(with more than double the previous number of seats) the Janat VimukthiPeramuna (JVP) party, which is seen as being strongly committed to farmersand a revival of growth in the agricultural sector.

A few private companies have, however, not only succeeded in boostingagricultural productivity, but have also proved that the way forward for SriLanka!s agricultural sector lies in diversifying into non-traditional agriculturalcrops. Hayleys, one of the country!s leading conglomerates, is one of the largestprivate investors in agriculture. The company, which accounts for 4% of SriLanka!s total agricultural exports, is a leading exporter of gherkins, with a USfast-food company, McDonald!s, being one of its principal customers. Hayleysrecently ventured into the production of bell peppers, and within the space ofless than two years not only tripled yields from 1.5 kg to 4.5 kg per plant, butalso exceeded the average Indian yield of 3 kg per plant. The company has nowturned to experimenting with the cultivation of vegetables (traditionally grownin wet areas) in the dry zones of the country, with the aim not only ofencouraging diversification from the traditional paddy cultivation in theseareas, but also reducing domestic market prices by focusing on higher yieldsand increased productivity.

Master Divers, which in 2003 purchased a state-owned company, PelawatteSugar Industries, has boosted domestic sugar production. Total production roseto a record 500,000 tonnes in 2003. This was achieved by productivityimprovements, and also by additional planting of 3,250 ha in the Moneragaladistrict. The company plans to extend sugar cultivation further by drawing in

The stagnation in agriculturehas a political impact

Hayleys profits fromagriculture

Privatisation has boosteddomestic sugar production

John Keells Holdings hasexited from plantations

Sri Lanka 25


another 1,200 ha in the Hingurana district. Master Divers is confident that, withthe correct incentives in place, Sri Lanka could move towards self-sufficiency insugar, and has urged the government to revive two defunct state-owned sugarfactories to expand capacity. Sugar is a key food import. In 2002 the countryspent US$125m on sugar (23% of all food imports), although this fell to US$112min 2003, primarily as a result of lower international prices.

The Ministry of Fisheries and Ocean Resources has announced plans toconduct an inventory of the island!s fish stocks"the first step in a master planto develop the country!s fishing industry. The first stock-take was conductednearly 23 years ago in 1979 with Norwegian assistance, and identified 517,000sq km of ocean as Sri Lanka!s Exclusive Economic Zone. Preliminary work onthe study has already been initiated, with Norwegian and Swedish expertsgathering all available data on fish and fisheries. The study, scheduled to becompleted in a year, will be followed by a comprehensive physical stock-take.The ministry is scouting for donor financing for the project, which is expectedto cost US$20m. Norway, which has been an active supporter of the Sri Lankanfishing industry, is likely to lend additional support in the form of transport andstorage facilities. Currently nearly one-third of fish output is lost, owing to poorstorage conditions.

Infrastructure

In April the Asian Development Bank (ADB) approved a US$15m technicalassistance loan as a contribution to preparing and executing a master plan forSri Lanka!s road network. The principal aims of the US$20m project"thebalance US$5m will be borne by the government"are to take stock of theprojects required to develop the country!s road network, and to assist thegovernment in managing the early stages of road projects more efficiently inorder to avoid delays in implementation. Technical assistance will initially focuson identifying necessary road projects, and then funding pre-feasibility studies,environmental and social impact studies, resettlement plans and detaileddesign and bid documents. The ADB will also lend assistance to thegovernment in bid evaluation, structuring financial arrangements andconcession agreements for privately financed projects. More than 20 roadprojects are planned, including the Southern Expressway, a highway linking theKandy hill station with Colombo, and the stalled Colombo KatunayakeExpressway. The project will also focus on upgrading and widening existingroads and rehabilitation of bridges.

Celltel Lanka, the first company to launch a mobile phone service in Sri Lanka,is gearing up for a significant expansion of its network. In March the companyfinalised a US$21m syndicated loan to fund its expansion plans. The four-yearloan was co-financed by Sri Lanka!s largest commercial bank, Hatton NationalBank (which was also the lead arranger), and state-owned National SavingsBank. Celltel!s parent company, US-based Millicom International Cellular, alsoplans to inject more capital by raising US$75m in equity. Celltel plans to use thenew funding to raise its coverage by 250% within the next five years, which

The ADB will assist the roadsector

A mobile phone operatorplans to extend coverage

An inventory of fishingresources is to be launched

26 Sri Lanka


includes extending its network to the north and east of the country. Thecompany aims to attract 20,000 new subscribers under its expansion plan.

Sri Lanka Telecom (SLT) has committed an investment of SLRs3bn (aroundUS$30m) to the construction of the fourth SEA-ME-WE (South East Asia-MiddleEast-Western Europe) cable system. The US$500m project, to be commissionedin 2005, will significantly enhance bandwidth and global connectivity for itsusers. The additional bandwidth will assist Sri Lanka in its efforts to positionitself as a regional business hub. In April SLT also announced plans to raiseUS$100m from foreign banks to fund a proposed network expansion pro-gramme that includes employing wireless technology to connect rural areas.The funds raised will also be partly used to retire the company!s existing debt.SLT!s bid to acquire a majority stake in Lanka Bell (one of the two privatewireless-loop operators) is in limbo following the change in government. SLT isstill the dominant operator, accounting for over 85% of the fixed-line marketand 15% of the mobile phone market through its fully owned subsidiary,Mobitel. Increased competition in the international call network following thelifting of SLT!s monopoly in 2002 has trimmed SLT!s revenue by 3% fromSLRs25.2bn in 2002 to SLRs24.4bn in 2003.

The power situation remains precarious. Although there has been some rainfall,it has been inadequate to raise hydro-power reservoirs to comfortable levels. Toadd to the power crunch, on March 23rd a fire broke out in one of the mainthermal generating plants. The 160 mw combined-cycle plant, located inKelanitissa on the outskirts of Colombo, is estimated to have lost one-third ofits generating capacity as a result of damage caused by the fire.

Sri Lanka plans to open up its shores to foreign companies for oil and gasexploration. Preliminary studies indicate that the island could possess potentialoil reserves of 10-15m barrels off Mannar on the east coast in the CauveryBasin. Initial seismic studies carried out by a Norwegian-based company, TGSNopec, showed evidence of hydrocarbon accumulations in the Cauvery Basinoff the western coastal belt. The country has embarked on an internationalroadshow to solicit foreign interest, with the first step being its participation atthe Annual Convention of the Association of American Petroleum Geologists,held in Texas on April 21st. Five blocks have been identified for potentialexploration, of which Indian government entities have already reserved two.The Ministry of Power and Energy has already prepared model petroleum-resource agreements and development licences. Legislation to facilitatepetroleum-resource development is already in place.

Financial and other services

The Colombo Stock Exchange (CSE) has continued to fluctuate in response topolitical developments. In the days leading up to the April 2nd election,speculation regarding a possible United National Front victory saw sharp risesin both the exchange!s indices, but subsequent falls were equally sharp, withthe news of a United Peoples! Freedom Alliance-led minority government

Sri Lanka Telecom announcesfurther increases in investment

The precarious powersituation worsens

Sri Lanka has opened itsshores for oil exploration

The stockmarket slumps in thewake of the political crisis

Sri Lanka 27


wiping some SLRs21bn (US$208m) off the market between April 1st and April8th. The All Shares Price Index (ASPI), which had risen to 1,284 points, fell to1,197 points, while the Milanka Price Index (MPI, which tracks the mostsensitive stocks) fell from 2,021 points to 1,828 points in the same one-weekperiod. The market has remained fairly subdued since, and on a gentlydeclining trend overall, reflecting investor uncertainty over political andeconomic developments. Nevertheless, between January 2nd and April 30ththe ASPI gained around 150 points, whereas the MPI has remained at the 1898level. Market capitalisation grew in the same period to SLRs296.5bn fromSLRs263bn.

For the second consecutive year, the state-owned People!s Bank recorded netprofits exceeding SLRs1bn. According to the bank!s annual performance results,released in March, net profits (after tax) rose by a spectacular 57.4% year on yearin 2003 to SLRs1.6bn, from SLRs1bn in 2002. This was achieved after providingfor a massive SLRs2.3bn in bad debts. The success of its restructuring exercisehas enabled the bank to trim the ratio of its operating expenses to net incometo 70% in 2003, from 89% in 2002. Revenue rose by 1% to SLRs24.4bn, fromSLRs24.6bn in 2002. A significant portion of the increase in profits was owingto Treasury operations (which grew by 52% year on year, thanks to increasedinvestment in government securities and foreign-exchange income). Moredemand from credit-card operations also netted SLRs35m in revenue. However,despite these impressive achievements, the People!s Bank has a current networth of just SLRs2bn. It needs an estimated capital infusion of SLRs12bn inorder to comply with the Central Bank of Sri Lanka!s capital adequacyrequirement. Although a US consultancy, PriceWaterhouseCoopers, wasengaged by the previous government to formulate a privatisation plan for thebank, the new government has indicated that it is not in favour of privatisingstate banks, but would rather grant them greater operational and commercialautonomy.

The performance of the largest state-owned bank, the Bank of Ceylon, has alsoimproved significantly, as indicated by an upgrade in April 2004 of its rating forits long-term unsecured senior debt from "SL AA minus" to "SL AA". The rating,

The People's Bank makes overSLRs1bn in profits

The Bank of Ceylon's creditrating has been upgraded

28 Sri Lanka


issued by the country!s only credit-risk agency, Fitch Ratings Lanka (FRL),denotes a very low expectation of credit risk and a very strong capacity fortimely payment of financial commitments. According to FRL, the upgradereflected the significant improvement in the bank!s financial profile in recentyears, underscored by growth in profits and asset quality and a build-up inreserves to cover loan losses. The agency further stated that the bank!sprovisioning standards and its net non-performing loan position wereconsiderably stronger than those of most other domestic banks. The rating alsounderscored the bank!s status as the largest bank in the country, its leadingshare of customer deposits, its high systemic importance and the fact that it wasstate-owned. The most encouraging development, however, was the sharpreduction in the bank!s exposure to government and state-owned enterprises:loans to the government and state enterprises, which accounted for 60% of totalloans in April 2002, had nearly halved to 37% by December 2003. This is partlyattributable to the sustained improvement in the bank!s risk-managementsystems and its greater functional autonomy.

The culture of procuring credit ratings is now gaining ground and has assumedgreater importance as more companies and financial institutions opt to floatnew financial instruments to raise funds. In late March a consumer electronicsgiant, Singer Sri Lanka, received an "SL A" rating for its proposed issue of2004-08 SLRs400m unsecured redeemable debentures. The rating, whichdenotes a low expectation of credit risk, is based on the company!s history ofprofitable performance, its extensive distribution network, its strong franchisesand the leading position of its product lines.

People!s Leasing Company (PLC), a fully owned subsidiary of the People!s Bank,has also sought and received an "SL A" rating from FRL, to back the launch ofan innovative leasing instrument. The unique instrument, launched in Marchand termed Lease Backed Trust Certificates (LBTC), is to be issued by a special-purpose vehicle, the People!s Leasing Trust, under the firm!s asset-backedborrowing programme. The instrument has been structured in such a way thatinitially PLC will pledge the receipts from a pool of lease contracts to a Germanbank, Deutsche Bank, in its capacity as the trustee for a special-purpose vehicletrust. The trust will in turn finance the loan to PLC by issuing LBTCs to thevalue of SLRs500m. The LBTCs are backed by a pool of 585 lease contracts witha principal outstanding of SLRs629m.

Commercial banks have come under mounting criticism for maintaining highinterest spreads despite the relaxation in monetary policy. Although bothdeposit and lending rates have declined, deposit rates have fallen faster thanlending rates, increasing the interest rate spread. According to the central bank,the interest rate spread (as measured by the difference in the average yield onearning assets and the average cost of interest-bearing liabilities) declined onlymarginally from 4.6% at end-2002 to 4% by end-2003. Using a narrowermeasure, the difference between the interest received on loans and the interestpaid on deposits, the respective figures are 7.3% and 6.8%. Some of the factorscited as leading to the high spreads are: high operating costs (including heavyinvestment on information technology and highly paid employees); high non-performing loan portfolios (resulting in a need for provisioning); legal

Interest rate spreads remainhigh

Credit rating is becoming morepopular

Sri Lanka 29


bottlenecks, such as delays in loan recovery; the domination by a few banks inthe market (which restricts effective competition); and market stability, whichtends to add a risk premium to the interest rate structure.

Foreign trade and payments

The external sector!s performance strengthened further in 2003. A slightwidening in the merchandise trade deficit was largely offset by animprovement in net services receipts, healthy growth in private remittances anda narrowing in the income deficit. These factors combined to reduce thecurrent-account deficit substantially to US$101m in 2003, from US$237m in2002. As a percentage of GDP the current-account deficit declined to 0.6% from1.4% a year earlier. Higher capital inflows by way of foreign direct investment,portfolio investment and long-term loans to the government (reflectingincreased aid utilisation) facilitated a surplus for the third consecutive year inthe country!s overall balance of payments. The surplus rose to US$502m in2003, from US$338m a year earlier.

Sri Lanka!s merchandise trade deficit stood at US$1.5bn in 2003"a 9.5% increaseon the US$1.4bn deficit recorded in 2002. US-dollar-denominated exportearnings rose by 9.2% to US$5.1bn, while imports grew slightly faster by 9.3% toUS$6.7bn. A seasonal burst in import demand in December"imports grew yearon year by 20% during the month"raised the overall rate of import growthfrom 8% in the first 11 months of 2003 to 9.3% by the end of the year.

Trade balance(SLRs m; US$ m in brackets)

2002 2003 % changeExports fob 449,855 495,426 10.1

(4,699) (5,133) 9.2

Imports 532,964 643,750 10.1(6,106) (6,672) 9.3

Trade deficit 134,706 148,324 -10.2(1,406) (1,539) -9.5

Source: Central Bank of Sri Lanka, Annual Report 2003.

Approximately 80% of the incremental growth in exports in 2003 wasgenerated by industrial exports, which grew by an annual rate of 10%. Earningsfrom textiles and garments"the leading export category"rose by 6.3% year onyear to US$2.6bn, owing to a 3% increase in both unit prices and volumes. Withthe exception of petroleum products, where earnings contracted by 11%,revenue from all other principal categories of industrial exports recordedgrowth. Earnings from machinery, mechanical and electrical equipmentexports"the second-largest export category"grew by 9%; diamonds andjewellery exports rose by 14% and rubber products expanded by an impressive27%. A sharp increase in exports of prawns and other shellfish (20.1%) and freshfish (15%) helped to raise combined earnings from food exports by 17.8% yearon year.

Industrial goods drive an 80%increase in export earnings

The external sectorstrengthened further in 2003

The merchandise trade deficitexpanded by 9.6%

30 Sri Lanka


Record earnings from tea, combined with price-induced increases in earningsfrom rubber exports, facilitated a 2.9% increase in earnings from agriculturalexports in 2003. Earnings from tea exports, which began recovering in May(after the end of the Iraq war), rose to US$683m"the net result of a 2.1%increase in exported volumes and a 1.3% rise in US-dollar prices. The sharp 49%increase in the international price of rubber more than offset the 5.4% drop inexported volumes, to generate US$39m in export revenues. The value ofcoconut exports rose by 17% in 2003, owing to increased export volumes.Together the three export crops contributed over 80% of incremental growth inexport revenue from agricultural products.

Composition of exports(US$ m)

2002 2003 % changeAgricultural exports 938 965 2.9 Tea 660 683 3.5 Rubber 27 39 44.4 Coconut 41 48 17.0Industrial exports 3,631 3,977 9.5 Textiles & garments 2,424 2,575 6.3 Leather & rubber 266 289 8.6 Petroleum products 73 65 -11.0 Other industrial products 868 1,048 20.7Mineral exports 90 84 -7.1Total incl others 4,699 5,133 9.2

Source: Central Bank of Sri Lanka, Annual Report 2003.

Imports grew by a massive 20% year on year in December 2003, raising theoverall growth in import payments to 9.3% in 2003. This sharp growth was notonly the result of seasonal demand, but also reflected pre-emptive buying byimporters before the upward revision of tariffs and value-added tax,announced in the 2004 budget, which took effect by end-March 2004. Notsurprisingly, the sharpest increase occurred in consumer goods imports, whichrose by nearly 35% year on year in December. Imports of food rose by 40% yearon year, owing largely to increased imported volumes of sugar, wheat and milkpowder, while imports of consumer durables rose by 46.4%, boosted by a 50%increase in imports of motorcycles and cars and a 56% increase in the value ofhome appliances. Imports of intermediate goods rose year on year by 19.2% inDecember, and those of investment goods grew by 24.1%. Overall in 2003,consumer goods imports accounted for over one-fifth of total imports.Consumer durables accounted for a little over one-half of all consumer importsand for over 10% of all imports.

The US-dollar value of intermediate goods imports rose by 0.9% year on year in2003. In line with export performance, the leading import subcategory wasimports of textiles and garments, which increased by 3.9% to US$1.4bn. Crudeoil imports rose year on year by 7.7% in the same period, while the value ofother petroleum products rose by 9.3%. All principal intermediate goodsimports recorded increases in line with improved industrial activity. Imports of

Tea exports have beenrebounding

Imports increased sharply inDecember

Intermediate imports rose inline with economic growth

Sri Lanka 31


chemical products rose by 9.5% year on year, while those of paper productsincreased by 10.9% and those of dyeing products rose by 15.2%.

Composition of imports(US$ m)

2002 2003 % changeConsumer goods 1,319 1,481 12.3

Intermediate goods 3,492 3,811 9.1Investment goods 1,170 1,320 12.8

Total incl others 6,105 6,672 9.3

Source: Central Bank of Sri Lanka, Annual report 2003.

Investment goods imports grew by 12.8% in 2003. In line with the pick-up in theconstruction sector, imports of building materials rose year on year by 21%.Imports of transport equipment, comprising mainly accessories for trains andbuses, rose by 37%, while imports of machinery and equipment grew by amodest 9%. Machinery imports consisted primarily of sewing machines andrelated equipment for the garment industry, electric generators and computerequipment. The share of investment imports in total imports rose from 19.1% in2002 to 19.8% in 2003, in line with the increase in domestic investment.

The current-account deficit fell to US$101m (0.6% of GDP) in 2003, fromUS$237m (1.4 % of GDP) in 2002. The contraction in the deficit was primarilyowing to higher service inflows, private remittances and a narrowing in the netincome deficit, which helped to offset the widening of the merchandise tradedeficit. Higher tourism and port receipts lifted the net surplus in the servicesaccount to US$396m in 2003 from US$295m in 2002. Net private remittancesgrew by a healthy 9% to US$1.2bn, anchored by increased remittances frommigrant workers. The net incomes deficit narrowed by 24% to US$192m, thanksto higher income generated from the build-up in international reserves.

Higher inflows from privatisation, increased utilisation of foreign aid by thegovernment and continued foreign direct and portfolio investment led to animprovement in the capital and financial account, which expanded toUS$702m in 2003 from US$444m in 2002. Total direct investment grew by 8.6%to US$201m in 2003. Although foreign direct investment fell in absolute termsto US$171m in 2003 from US$181m a year-previous, this was offset by a 500%increase in inflows from privatisation which rose from US$5m in 2002 toUS$30m in 2003. The net outcome of these developments was an expansion inthe overall surplus in 2003 to US$502m from US$338m in 2002. This was thethird consecutive year of an overall surplus in the balance of payments.

The improved balance-of-payments position boosted the country!s externalreserves to comfortable levels in 2003. Gross official reserves (those held by thegovernment and the Central Bank of Sri Lanka) grew by a spectacular 37% toUS$2.3bn, equivalent to 4.2 months of imports. Purchases by the central bank(net purchases were US$375m) were partly responsible for the increase inofficial reserves. The country!s total external assets (consisting of gross officialreserves plus reserves held by commercial banks) grew by an equally

Investment goods importsgrew fastest last year

The current-account deficitnarrows

The balance of paymentsrecorded an overall surplus

International reservesincreased sharply last year

32 Sri Lanka


impressive 28.9% to US$3.2bn, sufficient to finance 5.8 months of merchandiseimports.

The upward trend in both exports and imports continued in January this year.Exports rose by 20% year on year to US$459m, whereas the pace of importgrowth was slighter slower at 15%. The trade deficit in January 2004 widenedby 2.8% to US$151.7m, from US$147.5m in the same month a year earlier.Industrial exports, which rose year on year by 19% in January, contributed 74%of the incremental increase in export earnings. Earnings from textiles andapparel grew by 18%. Exports of other industrial goods also recorded double-digit growth, although this was partly attributable to a low base in January2003. Exports of rubber-based products grew by 51%, diamond and jewelleryexports rose by 62%, those of chemicals increased by 38%, and petroleumproduct exports expanded by 15%. Earnings from machinery and electricalequipment, however, declined by 4%. Earnings from agricultural exports rose byan impressive 24% in January, boosted by a 19% increase in earnings from tea, adoubling in the earnings from rubber and a hefty 61% increase in coconutexport earnings. Reversing a declining trend earnings from minor agriculturalexports rose by 10%.

Expenditure on imports expanded by 15% year on year from US$531m inJanuary 2003 to US$611m in January 2004. Investment goods imports, whichgrew by 58% year on year in January 2004, generated over 70% of theincremental increase in imports. This was primarily attributable to the importof a generator, which on its own boosted the value of machinery andequipment imports by 74%. Excluding this, the pace of increase in investmentgoods imports was still a healthy 22%, underpinned by a 58% increase intransport equipment imports and a 30% rise in imports of building materials.Intermediate goods imports rose by 6% in January, while consumer goodsimports increased by 3% year on year. Food imports declined by 5%, owing tothe build-up in stocks following the exceptionally high level of imports inDecember 2003.

The upward trend in exportscontinues

Imports grow strongly

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