Sri Lanka Sri Lanka at a Glance: 2001-02

COUNTRY REPORT

Sri Lanka Sri Lanka at a glance: 2001-02

OVERVIEW The People’s Alliance-led (PA) government will be forced to take tough economic decisions to ensure the continued disbursement of the IMF stand- by package and to ensure that a longer-term package is arranged to begin in 2002. However, the main focus of the government will continue to be on organising peace talks with the Liberation Tigers of Tamil Eelam (LTTE, or Tamil Tigers). GDP growth will slow in 2001, but increase in 2002 driven by stronger manufacturing and services growth. High interest rates and low levels of business confidence will lead to investment slowing in 2001. The textile-led export sector will perform relatively strongly in upper-end garments, but will face more competition in low-end production. Inflation will not fall below 8.5% in 2002 as administered price controls are reduced. Key changes from last month Political outlook • The UNP has so far failed to secure the necessary support to force the government to resign, but will continue in its attempts to woo coalition partners of the PA into its fold. Economic policy outlook • The release of an IMF package of SDRs200m (US$258m) is likely to speed the economic reform process and lead to increased disbursements from other funding agencies. Economic forecast • The EIU has raised its forecast for consumer price inflation in 2001 to 11%, as a result of continued administered price hikes and the continuing affect of the currency’s depreciation. • Owing to the increased inflow of funds stemming from the agreement with the IMF, we have lowered our year-end exchange rate forecasts to SLRs93:US$1 at the end of 2001 and SLRs97:US$1 at the end of 2002.

May 2001

The Economist Intelligence Unit 15 Regent St, London SW1Y 4LR United Kingdom The Economist Intelligence Unit The Economist Intelligence Unit is a specialist publisher serving companies establishing and managing operations across national borders. For over 50 years it has been a source of information on business developments, economic and political trends, government regulations and corporate practice worldwide. The EIU delivers its information in four ways: through our digital portfolio, where our latest analysis is updated daily; through printed subscription products ranging from newsletters to annual reference works; through research reports; and by organising seminars and presentations. The firm is a member of The Economist Group.

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Copyright © 2001 The Economist Intelligence Unit Limited. All rights reserved. Neither this publication nor any part of it may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of The Economist Intelligence Unit Limited. All information in this report is verified to the best of the author's and the publisher's ability. However, the EIU does not accept responsibility for any loss arising from reliance on it.

ISSN 0269-4174

Symbols for tables “n/a” means not available; “–” means not applicable

Printed and distributed by Redhouse Press Ltd, Unit 151, Dartford Trade Park, Dartford, Kent DA1 1QB, UK Sri Lanka 1

Contents

3 Summary

4 Political structure

5 Economic structure 5 Annual indicators 6 Quarterly indicators

7 Outlook for 2001-02 7 Political outlook 8 Economic policy outlook 10 Economic forecast

13 The political scene

16 Economic policy

19 The domestic economy 19 Economic trends 20 Industry 23 Agriculture 25 Infrastructure 27 Financial and other services

30 Foreign trade and payments

List of tables

10 International assumptions summary 11 Forecast summary 23 Tea production, Jan-Feb 28 Stockmarket indicators 30 Trade balance, Jan-Feb 31 Composition f exports, Jan-Feb 32 Composition of imports, Jan-Feb

List of figures

13 Gross domestic product 13 Sri Lanka rupee real exchange rate 19 Inflation, money supply and depreciation 23 Gross domestic product 27 Composite stockmarket index 33 Foreign-exchange reserves and import cover

EIU Country Report May 2001 © The Economist Intelligence Unit Limited 2001 2 Sri Lanka

EIU Country Report May 2001 © The Economist Intelligence Unit Limited 2001 Sri Lanka 3

Summary

May 2001

Outlook for 2001-02 The political climate will remain volatile as the opposition steps up efforts to engineer the fall of the government and the Janatha Vimukthi Peramuna (JVP) continues to exploit simmering civil discontent. Preliminary talks between the government and the Tamil Tigers are likely later this year. The granting of an IMF financing facility will compel the government to address the reform agenda. Progress will be made on privatisation, deregulation and labour reform. Monetary policy will gradually be relaxed. A shortfall in privatisation proceeds remains the biggest threat to the government’s borrowing targets. Inflation will rise in 2001 owing to administered price hikes, depreciation of the currency and higher duties and taxes.

Economic policy The 2001 budget was essentially short term, aimed at raising revenue and boosting foreign-exchange reserves. Corporate and indirect taxes were raised, but, apart from a curtailment in defence spending, no other meaningful cost cutting measures were announced. The fiscal deficit, which rose to 9.8% (excluding grants and privatisations) of GDP in 2000, is forecast to decline to 8.5% of GDP in 2001. The budget will continue to rely heavily on revenue and privatisation increases to deliver the reduction in the deficit/GDP ratio.

The domestic economy Inflation averaged 15.3% in the first quarter of 2001. Monetary policy has been relaxed slightly. The rupee has depreciated by around 5.7% since the end of 2000. Manufacturing output shrank in January. The government has embarked on a campaign to promote growth in the IT sector. Tourist arrivals surged in February and a campaign to boost tourism has been launched. Tea production climbed to record levels in January-February, but was harmed by industrial action in March. The stockmarket has continued to fall. A new index to track sovereign debt has been launched. The government plans to establish a development bank. Sri Lanka’s telephone density has improved and the telecoms sector is to be further deregulated in 2002. The government is to purchase 150 mw of power from private thermal power operators.

Foreign trade and A contraction in imports and surge in exports in February helped narrow the payments merchandise trade balance in January-February. Healthy growth in tea earnings propped up agricultural export growth. Imports of food and consumer goods contracted sharply in February. Intermediate goods imports also declined but imports of investment goods rose. Private remittances recorded healthy growth in 2000. Foreign reserves provided just one-and-a-half months of import cover by the end of January, but are expected to improve to three months of import cover following the receipt of IMF balance-of-payments support.

Editors: Gareth Price (editor); Kilbinder Dosanjh (consulting editor) Editorial closing date: May 7th 2001 All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

EIU Country Report May 2001 © The Economist Intelligence Unit Limited 2001 4 Sri Lanka

Political structure

Official name Democratic Socialist Republic of Sri Lanka

Form of state Executive presidency based on French model

The executive President is head of state and exercises all executive powers; elected for a period of six years by universal adult suffrage; may dissolve parliament at will

National legislature Unicameral legislature; 225 members directly elected for six years by a system of modified proportional representation

Local government Under the 13th amendment to the constitution, passed in November 1987, extensive powers devolved to nine directly elected provincial councils, primarily with a view to meeting Tamil demands for greater autonomy. Elections scheduled for 1998 were postponed, but were held in seven provinces between January and June 1999. Because of the continued conflict, elections in the remaining two provinces remain unscheduled

National elections Elections held every six years; next elections due by October 2006 (parliamentary) and December 2005 (presidential)

National government Chandrika Kumaratunga won a second term in office in December 1999. The People’s Alliance (PA) won the highest number of seats (107) but had to seek the support of a Tamil and a Muslim minority party to form a fragile coalition government with a combined total of 116 seats

Main political organisations Governing coalition—(PA), of which the main components are the Sri Lanka Freedom Party (SLFP), Sri Lanka Muslim Congress (SLMC), National Unity Alliance (NUA), Eelam People’s Democratic Party (EPDP), Mahajana Eksath Perumena (MEP) and the Ceylon Workers’ Congress (CWC); main opposition parties—United National Party (UNP), Janatha Vimukthi Peramuna (JVP), Tamil United Liberation Front (TULF); armed opposition—Liberation Tigers of Tamil Eelam (LTTE)

Main members of the President; finance, defence Chandrika Bandaranaike government Kumaratunga

Prime minister, Buddhist and religious Ratnasiri Wickramanayake affairs, plantations Agriculture D M Jayaratne Key ministers Constitutional affairs, industrial development G L Peiris Development, rehabilitation & reconstruction Douglas Devananda of the north, Tamil affairs Foreign affairs Lakshman Kadirgamar Highways A H M Fowzie Internal and international trade & commerce, Muslim religious affairs, shipping development Rauff Hakeem Labour Alavi Mowlana Livestock development & estate infrastructure Arumugam Thondaman Ports development & development of the south Ronnie de Mel Posts & telecommunications Nimal Siripala de Silva Information & media Anura Priyadarshana Yapya Secretary to the Treasury P B Jayasundera Transport Dinesh Gunawardena

Central Bank governor Amarananda Jayewardena

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Economic structure

Annual indicators

1996a 1997a 1998a 1999a 2000b GDP at market prices (SLRs bn) 768.1 890.3 1,020.0 1,111.3 1,255.3 GDP (US$ bn) 13.9 15.1 15.8 15.7 16.3 Real GDP growth (%) 3.8 6.4 4.7 4.3 6.0 Consumer price inflation (av; %) 15.9 9.6 9.4 4.7 6.2 Population (m) 18.3 18.6 18.8 18.6 18.9 Exports of goods fob (US$ m)c 4,095.2 4,638.7 4,808.0 4,585.8 5,230.6 Imports of goods fob (US$ m)c 4,895.0 5,278.3 5,313.4 5,293.1 6,372.6 Current-account balance (US$ m) –682.8 –394.7 –227.5 –493.0 –814.7 Foreign-exchange reserves excl gold (US$ m) 1,962.0 2,024.0 1,980.0 1,636.0 1,039.0a Total external debt (US$ bn) 8.0 7.7 8.5 9.5 8.9 Debt-service ratio, paid (%) 7.1 6.4 6.4 7.9 9.4 Exchange rate (av) SLRs:US$ 55.27 58.99 64.45 70.64 77.01a

May 7th 2001 SLRs90.45:US$1

Origins of gross national product 1999 % of total Components of gross domestic product 1999 % of total Agriculture, forestry & fishing 20.7 Private consumption 71.2 Mining 1.8 Government consumption 9.0 Construction 7.6 Investment incl stockbuilding 27.1 Utilities 1.5 Exports of goods & services 35.3 Manufacturing 16.4 Imports of goods & services –42.6 Services 52.0 GDP at market prices 100.0 GDP at factor cost 100.0

Principal exports 1999d US$ m Principal imports 1999d US$ m Textiles & garments 2,425 Cotton & textiles 1,320 Tea 621 Machinery & transport equipment 678 Leather & footwear 201 Food & drink 655 Diamonds & jewellery 163 Consumer durables 581 Rubber products 161 Petroleum 426 Total incl others 4,600 Total incl others 5,899

Main destinations of exports 1999d % of total Main origins of imports 1999de % of total US 38.9 Japan 9.5 UK 13.1 India 8.7 Middle East 7.9 Hong Kong 7.8 Germany 4.7 Singapore 7.6 Japan 3.5 South Korea 6.5 a Actual. b EIU estimates c IMF/World Bank definition. d Customs basis. e Imports cif.

EIU Country Report May 2001 © The Economist Intelligence Unit Limited 2001 6 Sri Lanka

Quarterly indicators

1999 2000 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr Government finance (SLRs m) Revenue 47,694 45,494 53,825 59,655 53,120 50,781 59,285 n/a Expenditure 71,762 67,165 69,794 82,882 81,281 76,994 92,574 n/a Government cash deficit (% of expenditure) 33.5 32..3 22.9 28.0 34.6 34.0 36.0 n/a Output (SLRs bn) GDP at constant 1996 prices 195.73 182.59 208.17 221.85 208.71 196.19 219.54 n/a Wages & prices Wages (Dec 1978=100) Agriculturala 1,116.0 1,116.0 1,115.9 1,116.0 1,116.0 1,116.0 1,169.4 1,169.4 Government employeesb 1,001.4 1,001.4 1,001.4 1,001.4 1,001.4 1,001.4 1,164.5 n/a Consumer prices, Colombo (1995=100) 144.8 147.4 143.3 146.4 148.0 153.7 156.9 n/a % change, year on year 4.6 5.9 3.9 4.4 2.2 4.3 9.5 n/a Financial indicators Exchange rate SLRs:US$ (av) 69.00 70.29 71.59 71.66 73.20 75.55 78.57 80.70 SLRs:US$ (end-period) 69.35 71.53 71.73 72.17 73.67 78.97 79.40 82.58 Interest rates (%) Bank (end-period) 17.00 17.00 16.00 16.00 16.00 16.00 16.00 n/a Lending (av) 6.00 6.00 8.00 8.00 6.67 6.00 6.00 n/a Money market (av) 17.83 20.08 14.50 14.33 13.75 15.96 15.71 n/a Treasury bill (av) 12.51 12.61 12.49 12.43 12.03 12.49 14.04 n/a M1 (end-period; SLRs bn) 102.62 99.89 102.07 108.55 109.78 108.76 111.69 n/a % change, year on year 11.3 10.8 9.2 12.8 7.0 8.9 9.4 n/a M2 (end-period; SLRs bn) 322.39 325.41 334.62 355.30 363.45 367.97 380.67 n/a % change, year on year 8.3 9.5 10.9 12.4 12.7 13.1 13.8 n/a CSE Milanka Index (end-period; Dec 31st 1998=1,000) 855.6 829.6 924.5 937.5 796.1 853.2 859.3 698.5 Sectoral trends Exports (‘000 tonnes) Tea 60.4 71.5 69.3 68.1 67.1 67.6 80.7 n/a Rubber 13.3 11.1 11.1 7.4 9.6 8.2 8.2 n/a Tourist arrivals (‘000) 126.9 85.8 106.3 117.4 126.7 78.9 98.7 n/a Foreign trade & payments (SLRs bn) Exports fob 69.02 73.83 90.84 90.76 91.21 90.23 122.03 n/a Tea 9.73 10.90 11.18 11.92 12.08 11.98 14.62 n/a Imports cif –86.45 –94.28 –101.96 –133.54 –123.15 –141.72 –127.52 n/a Trade balance –17.43 –20.45 –11.12 –42.78 –31.94 –51.49 –4.69 n/a Current-account balance –2.35 –8.94 1.59 –25.37 –15.20 –39.12 n/a n/a Foreign payments (US$ m) Merchandise trade balance –127.3 –156.8 –12.9 –410.3 n/a n/a n/a n/a Services balance –75.6 –102.4 –127.9 –135.6 n/a n/a n/a n/a Income balance –65.1 –67.4 –75.7 –44.1 n/a n/a n/a n/a Current account balance –34.0 –127.2 22.2 –354.0 n/a n/a n/a n/a Reserves excl gold (end-period) 1,834 1,751 1,666 1,636 1,560 1,382 1,187 1,039 a Minimum rates. b Nominal rates. Sources: Central Bank of Sri Lanka, Bulletin; IMF, International Financial Statistics; Standard & Poor’s, Emerging Stock Markets Review.

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Outlook for 2001-02

Political outlook

Domestic politics The political climate will remain unsettled as the opposition United National Party (UNP) seeks to increase its voting power in parliament in a bid to force the government to step down. Public disenchantment will mount as the cost of living continues to rise and political manoeuvring continues. Labour unrest could become a serious concern, and the bickering between the two mainstream political parties will provide the Marxist Janata Vimukthi Peramuna (JVP, Peoples Liberation Front) with an opportunity to exploit simmering discontent. A deterioration in the maintenance of law and order could also become an issue for businesses.

The reform process has remained static for several months. The government’s package of devolution proposals is still the only solution being submitted for discussion. There has been no visible progress on attempts by opposition groups and certain of the government’s coalition partners to establish independent commissions to oversee the conduct of elections, and of the police, public services and the judiciary. Constitutional reform is likely to remain on hold until peace talks between the government and the Liberation Tigers of Tamil Eelam (LTTE or Tamil Tigers) begin.

The LTTE will continue to pose a threat to stability. They are likely to have used their recent ceasefire to rearm, retrain and re-deploy their fighting cadres. Peace talks between the government and the LTTE remain a possibility, despite the confusing and often conflicting positions taken by the two sides. The rebels have ended their unilateral ceasefire, declared at the end of last year, in the face of the government’s continued refusal to reciprocate. The decision by the LTTE not to extend their ceasefire beyond April 24th, would, on the surface, appear to be a major setback for the ongoing Norwegian-brokered peace initiative, particularly in light of the government’s immediate launching of an attack on the LTTE in Jaffna. However, the special envoy of the Norwegian government, Erik Solheim, who met representatives of the Tamil Tigers just days before the ceasefire was called off, remains hopeful that he can still bring the two parties together.

International relations Sri Lanka has successfully presented its position on the ethnic conflict and the proposed peace talks to several foreign governments and secured pledges of support and goodwill. The British ban on the LTTE is seen as a major foreign policy success for the government. Sri Lanka has also signed an agreement with Russia for joint police action to combat terrorism and other transnational crime. Trading relations are not expected to undergo any significant changes during the forecast period.

EIU Country Report May 2001 © The Economist Intelligence Unit Limited 2001 8 Sri Lanka

Economic policy outlook

Policy trends The government will face increasing pressure from international lending agencies to speed up the pace of reforms. The prospects for the more rigorous implementation of economic reforms are encouraging, particularly given the recent announcement of IMF financing, under a one-year, SDRs200m (US$258m) stand-by credit agreement, which will force the government to adhere to a prescribed reform agenda. The principal focus of reforms will be the deregulation and restructuring or privatisation of key economic and social sectors such as utilities and financial services. Some reforms have already been initiated. The 2001 budget identified some 35 enterprises that would be restructured or liquidated in the short to medium term. The privatisation of state farms, the National Insurance Corporation and the sale of the government’s remaining shares in plantations and hotels is to be completed this year. The telecommunications sector is to be deregulated further in 2002, with Sri Lanka Telecom set to lose its international gateway and fixed line monopolies. The restructuring of two state-owned banks has also been initiated—their boards have been reconstituted to include private-sector management and agreements with unions on the initial restructuring have also been concluded. The World Bank and Asian Development Bank (ADB) have provided financial and technical assistance for the restructuring of the Ceylon Electricity Board. The government is also likely to make further progress on education reforms, including the dilution of the state’s monopoly on university education.

Although the government is in principle committed to administrative and labour reforms, the political and social sensitivity of such reforms has impeded their implementation. Although the budget made no reference to labour reforms, pressure from aid agencies is likely to compel the government to address the issue, in particular amending the Termination of Employment Act in the next two years.

Political influence in the economy and weak governance will, however, remain major drawbacks in the operating environment. Bureaucratic procedures, a lethargic civil service and the overlapping functions of an inordinately large number of ministries will impede and reduce the effective implementation of reforms. Unless there is a dramatic change in the political culture, the prospects for an improvement in governance are not good.

Fiscal policy The budget deficit in 2000 climbed to 9.8% of GDP (excluding grants and privatisations), owing to sharp increases in defence spending and debt services, and a shortfall in revenue. The immediate priority of the government is to restore some semblance of fiscal stability. The EIU believes that the government will meet its fiscal deficit target of 8.5% of GDP in 2001. However, its ability to succeed remains uncertain. The principal weakness in the budget is that it relies heavily on a 25% increase in revenue and a sharp increase in privatisation proceeds to deliver the decline in the deficit, rather than resorting to meaningful cuts in current expenditure. Given a slowing economy and reduced corporate profits (further squeezed by an increase in taxes), the prospects for a sharp increase in revenue are uncertain. Equally questionable is

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the amount of revenue that the government has targeted to achieve through privatisation. The task of adhering to the fiscal deficit target will therefore remain a daunting challenge, and any overruns in expenditure or a fall in revenue will lead to an enlarged deficit, leaving the government little option but to revert to its usual practice of cutting back on capital spending to curb the growth in the deficit. Implicit in the fiscal deficit target is the assumption that there will be no dramatic escalation in hostilities requiring supplementary expenditures on defence. Should this occur (and this is still a big risk in our forecast) the government’s fiscal projections will be derailed, with the deficit again climbing above 9%.

Further reductions in the fiscal deficit will necessitate meaningful restructuring and reduction in the key components of current expenditure—debt service payments, military expenditure and the civil-service wage and pension bill. Reductions in the deficit (assuming constant defence spending) will only be gradual, given the rather rigid structure of expenditure. Unless drastic civil- service and pension reforms are initiated, and debt is reduced using privatisation proceeds, it will be difficult to reduce the deficit below 8% in 2002.

Monetary policy A relatively large fiscal deficit, and the resulting continued high level of government borrowing, will limit the ability of the Central Bank of Sri Lanka to significantly relax monetary policy. However, with the foreign-exchange market more stable and the government signalling that it intends to reduce bank financing of the deficit, the central bank has relaxed monetary policy slightly. The key indicative interest rate, the overnight repurchase rate (repo rate), has been cut, in two stages so far in 2001, albeit by a modest 150 basis points, to stand at 18.5% at the beginning of April. Further loosening of monetary policy will depend on how successful the government is in curtailing its borrowing. The biggest risk would be if the government failed to raise the requisite funding to finance the deficit, leading to higher than budgeted for borrowing from the banking system.

The 2001 budget relies heavily on privatisation proceeds as a means of financing the budgetary gap. An ambitious target of SLRs25bn (equivalent to one-fifth of the deficit, or 1.7% of GDP) has been set to be raised from privatisation. Of this, SLRs21.25bn alone is expected to come from the sale of telecoms shares. Should the sale be postponed owing to insufficient interest, or should it realise less than anticipated, the resultant shortfall in financing would have to be met from increased recourse to market borrowing, in turn exerting upward pressure on interest rates. Additionally, a shortfall in revenue would also increase the public-sector borrowing requirement. The IMF package, together with probable increased aid inflows from other donors, will help to improve liquidity, permitting a gradual relaxation in monetary policy. However, the central bank will continue to adopt a cautious stance with respect to monetary policy and market interest rates are unlikely to dip below 17-18% in 2001.

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Economic forecast

International assumptions The global economy has slowed more sharply than previously envisaged. We now estimate that world growth will decelerate to 2.1% (at market exchange rates) in 2001, from 4.2% in 2000. Growth in the US economy is decelerating more rapidly than previously expected, the Japanese economy is also set to weaken dramatically and growth in the EU will also soften during 2001. Following strong world trade growth in 2000 (a rebound from the slowdown induced by the 1998 Asian crisis), trade growth will slow sharply in 2001, to 4.8%. For Sri Lanka, whose main export markets are in the OECD, a slowdown will weaken export demand, curtailing the pace of export expansion in 2001. The continued strength in international oil prices, and rising non-oil commodity prices, will place pressure on the import bill.

International assumptions summary (% unless otherwise indicated) 1999 2000 2001 2002 Real GDP growth World 3.6 4.9 2.9 3.8 EU 2.5 3.3 2.5 2.6 US 4.2 5.0 1.3 2.8 Exchange rates (av) SLRs:US$ 70.64 77.01 88.97 95.67 SLRs:¤ 75.25 71.14 85.86 103.56 SDR:¥100 0.642 0.704 0.617 0.598 Financial indicators US$ 3-month commercial paper rate 5.18 6.32 4.40 5.20 ¥ 2-month private bill rate 0.27 0.24 0.18 0.10 Commodity prices Oil (Brent; US$/b) 17.9 28.4 24.1 24.0 Tea (£/kg) 1.8 1.9 1.9 1.9 Food, feedstuffs & beverages (% change in US$ terms) –18.6 –6.1 8.0 14.8 Industrial raw materials (% change in US$ terms) –4.6 13.4 2.6 5.1

Note. Regional aggregate GDP growth rates weighted using purchasing power parity (PPP) exchange rates.

Economic growth Real GDP growth will slow to 4.5% in 2001, pulled down by a worsening international environment, domestic political instability and a lacklustre policy environment. Foreign investment will continue to be deterred by weak macroeconomic fundamentals and high security risk, while high interest rates and taxes will stifle growth in domestic investment. Growth in private consumption will be depressed by lower rural incomes owing to the projected slump in the agricultural sector, combined with lower disposable incomes resulting from high indirect taxes and rising inflation. Efforts to reduce the fiscal deficit will limit the increase in government consumption. Exports, the driver of economic expansion, will be adversely affected by the deterioration in global demand. Industrial exports will also face increased competition. Although exports of high-grade garments will continue to grow (albeit at a slower pace) anchored by long-term contracts, lower-grade garment exports

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will suffer. Since import growth generally follows the trend in export and investment growth, some slowdown is likely, exacerbated by a weaker rupee.

Although the manufacturing sector will continue to power GDP expansion, the rate of growth in this sector of the economy is set to weaken. Slower expansion in industrial exports will curb growth in export-oriented industries (which form the bulk of manufacturing), while slack consumer demand will subdue growth in industries catering to the domestic market. Agricultural output will stagnate in 2001, pulling down GDP growth. Coconut and rice production, both principal agricultural crops, have slumped and rubber production has continued to fall. Growth in the combined services sector will also be affected by the deceleration in export and import trade, while rising inflation will curb domestic demand. Power shortages will result in a sharp slowdown in electricity growth, and growth in port services will continue to be weak, hampered by lack of capacity and increased competition. Telecoms and financial services will help to prop up growth in the services sector, with the rate of increase declining only slightly to an annual average of 5% in 2001 before accelerating in 2002. We expect real GDP growth to pick up to 5.8% in 2002, as world trade growth boosts exports. Infrastructure projects will help to raise the overall level of investment, while a revival in the economic reform programme and in exports will encourage higher growth in private investment.

Forecast summary (% unless otherwise indicated) 1999a 2000b 2001c 2002c Real GDP growth 4.3 6.0 4.5 5.8 Gross agricultural growth 4.5 1.9 1.0 2.9 Unemployment rate (av) 9.0 7.7 7.6 7.2 Consumer price inflation Average 4.7 6.2 11.0 8.5 Year-end 4.0 8.0 9.0 7.0 Short-term interbank rate 14.5 16.5 17.0 14.7 Government balance (% of GDP) –6.8 –6.7 –6.1 –5.1 Exports of goods fob (US$ bn) 4.6 5.2 5.7 6.6 Imports of goods fob (US$ bn) 5.3 6.4 6.7 7.5 Current-account balance (US$ bn) –0.5 –0.8 –0.6 –0.6 % of GDP –3.1 –5.0 –3.8 –3.5 External debt (year-end; US$ bn) 9.5 8.9 8.9 9.3 Exchange rates SLRs:US$ (av) 70.64 77.01a 90.06 94.09 SLRs:¥100 (av) 62.01 71.46 71.59 77.78 SLRs:¤ (av) 75.25 71.14 85.86 103.56 SLRs:SDR (av) 96.59 101.57 115.98 130.10

a Actual. b EIU estimates. c EIU forecasts.

Inflation Annual consumer price inflation in the year to March edged up to 9.5%, from 8.7% in February, despite a slight deceleration in the year-on-year increase in inflation in March. Inflation in the first quarter of 2001, however, remained high at an average rate of 15.3% year on year. With more price increases on the

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cards—diesel and kerosene prices were hiked again on April 16th, a 25% surcharge on electricity came into effect in March and a 15% telecoms tariff hike is expected in June—annual average inflation in 2001 is now expected to climb to 11%. Inflationary pressures will receive an additional twist from the strengthening in international prices for key foodstuffs and the depreciation of the rupee. The projected curb on government spending and in the deficit, combined with a fairly tight monetary policy, will keep demand-induced inflationary pressures in check. With the government under pressure to commercialise the operations of public utilities and other state services, we expect administered prices to continue to rise in 2002 as well. This, combined with a fall in the value of the rupee (albeit at a slower pace) and continued strength in oil and non-oil commodity prices, will prevent inflation from declining below 8.5% in 2002.

Exchange rates The rupee has stabilised considerably since its float at the end of January, and remained steady through February and March as a result of weak demand for US dollars, in turn owing to the conditions imposed on importers in booking foreign exchange and on slower import growth. However, a seasonal rise in demand for the dollar, led to a modest depreciation of the rupee, which fell to SLRs90:US$1 by May, from SLRs85.6:US$1 at the end of March. Although a persistent trade deficit will continue to exert downward pressure on the rupee, the prospect of higher foreign inflows in the form of foreign aid and grants, foreign borrowing by the government and privatisation proceeds should prop up the rupee, particularly in the second half of the year. With the primary focus being on reducing inflation, the central bank is likely to intervene to prevent a sharper depreciation of the rupee. Accordingly, we expect the depreciation in the rupee to be more modest than earlier forecast. Our revised forecast is for the rupee to fall to SLRs93:US$1 by the end of 2001 and to SLRs97:US$1 by 2002.

External sector Sri Lanka’s trade gap narrowed slightly in the first two months of the year, primarily as a result of a sharp dip in imports. The external trade position is likely to improve modestly in 2001-02. Although both the trade and current account will remain in deficit, the size of the gap is expected to narrow in dollar terms. Growth in dollar-denominated earnings will be less impressive than in 2000 which, to a large extent, was a bounce back from 1999’s export slump. Softer demand will curb exported volumes growth, but this will be partly compensated for by a strengthening in prices for some key exports such as manufactures. Import payment growth is likely to slow in 2001. The devaluation of the rupee, a surcharge on import duties and the restrictions imposed on importers on booking foreign exchange will combine to reduce the value of consumer durable imports. Expenditure on investment goods will also be less, given the rather subdued investment climate, and there is now a lower requirement for military equipment imports.

Growth in dollar earnings from exports of services—primarily tourism receipts—will remain stagnant unless there is a dramatic improvement in the political climate. The income deficit will continue to deteriorate as profits are repatriated and debt interest payments rise. Nevertheless, there will be

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sustained growth in private remittances, and this together with a smaller trade deficit will facilitate a decline in the current-account deficit. As a result of these factors the current-account deficit will fall from an estimated 5% of GDP in 2000 to 3.5% of GDP in 2002.

The political scene

Opposition attempt to The failure of the opposition United National Party (UNP) to defeat the defeat the budget fails government’s budget when the crucial vote was taken in April, is symbolic of the political stalemate that has dogged the country for several years. Despite the visible public disenchantment with the ruling Peoples Alliance (PA) coalition of the president, Chandrika Kumaratunga, the UNP, as widely expected, could not command the 113 votes required to force the government to abdicate. There are many reasons for this, but the key to the UNP’s failure was the party’s inability to convince the public that it could handle Sri Lanka’s pressing political and economic problems better than the incumbent regime. Added to this is mounting evidence that votes in the 225- seat legislature are increasingly being pledged in accordance with the highest bidder rather than the lawmakers’ consciences, a trend that the government in power is better able to exploit. It is also possible that some minority Tamil groups did not want to rock the boat at a time when the government appeared to be moving closer to peace talks with the separatist Liberation Tigers of Tamil Eelam (LTTE, or Tamil Tigers).

Opposition plans For the UNP, the prospect of overthrowing the government has seemed no-confidence motion tantalisingly close for some time now (the party mobilised 107 votes against the PA budget in April, just six short of a simple majority) and the party will continue to try its luck. Senior UNP leaders insist that the only reason the party did not go all-out to defeat the budget on the last occasion was the reluctance of some of the would-be defectors from the PA ranks to contest another election in the event the president dissolved parliament, rather than offer the government to the UNP. The UNP is now reportedly planning to move a vote

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of no confidence against the government in May, in the hope that, should it be carried, the president would ask it to form the government. Given the UNP’s now notoriously poor skills at organising, however, this may well not occur. Some elements within the UNP are blaming the leader, Ranil Wickremasinghe, for the party’s failure and have forced him to commit to greater power-sharing within the UNP. The president has the option of proroguing parliament to forestall PA politicians from supporting the UNP and buy herself time to win back likely dissenters in the government ranks. She has also mooted the possibility of a cabinet reshuffle in a carrot-and-stick-like strategy to keep members of her party in line.

Corruption and lawlessness Ironically, Mrs Kumaratunga’s control of the situation does not reflect her are on the rise government’s standing in the domestic arena. The credibility and popularity of the PA is at an all-time low, with widespread allegations of rampant corruption and lawlessness being levelled at several ministers and parliamentarians. In March, the government was rocked by the resignation of the high-profile head of its Board of Investment (BOI) following an allegation that he had solicited a bribe to approve an investment project. Bodyguards and loyalists of senior members of the government have been linked with a spate of armed robberies and other acts of violence. A reportedly zealous customs department investigator was shot dead in March for probing certain deals of powerful politicians, and investigations into the killing have uncovered links between other customs officials, politicians and underworld figures. The cost of living continues to rise and a serious shortfall in hydro-electric power generation (an important source of the country’s electricity) owing to the failure of monsoon rains, has increased public discontent.

The Marxist JVP fans The deteriorating political and economic situation has provided the ideal labour unrest climate for the Marxist party, the Janata Vimukthi Peramuna (JVP or Peoples Liberation Front), to fan simmering discontent within the ranks of labour unions in the private sector. The JVP, which was responsible for two failed insurrections in 1971 and 1987-89, is now the third-largest political force in the country, with ten seats in parliament. The party claims to have eschewed violence as a means to its political ends, but is using the country’s archaic and disproportionately worker-friendly labour laws, and the ineffectiveness of the two mainstream political parties, to build its power base. In April, two major business groups (Unilever and Ceylon Biscuits) felt compelled to make uncharacteristic public denouncements of the JVP’s tactics and warned that they would have to curtail local manufacturing operations if the labour crisis engineered by the party worsens. The JVP-led unions have made what the companies say are unreasonable wage demands and are resisting efforts to increase productivity and adopt strategies needed to increase competitiveness.

Peace talks are the The PA is pinning its hopes of survival on peace talks with the Tamil rebels. government’s only hope The LTTE has called off its unilateral ceasefire (first called on December 24th, 2000), because of the government’s refusal to reciprocate and its continued attacks on the LTTE. The government did announce a three-day cessation of offensive operations during the National New Year/Easter weekend, which has been a practice in past years. However, the Tamil Tigers have stated that they

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remain committed to peace talks. The LTTE has repeatedly expressed its willingness to begin a dialogue with the government, facilitated by the Norwegian special envoy, Erik Solheim, but has also sent out confusing messages about its conditions for participating in such talks. Mr Solheim has held several rounds of talks with rebel representatives in London and northern Sri Lanka, as well as with the government in Colombo. Following his last visit to a rebel base in the remote Wanni region in early April, the LTTE announced it had stipulated that the authorities in Colombo should lift the ban on the group and end hostilities if talks were to take place. The government has on previous occasions refused to accept this position, arguing that fighting could end after the talks had made some progress. Both sides will ultimately talk, but this posturing buys them time to prepare for a return to war if and when the talks founder. Current indications are that preliminary negotiations will take place in Oslo in the near future.

The Tamil rebels remain a The fact that the Tigers retain the capacity to pose a serious challenge to the serious threat security forces was underscored in March, when three fast-attack craft of the Sri Lankan navy intercepted three heavily laden rebel boats on a logistical run, just off the eastern coast. The rebels deployed a flotilla of gunboats to defend their supplies boats and in the ensuing firefight forced the crew of one of the navy craft to abandon ship. The rebels boarded the craft, removed some of its weapons and sank it, inflicting a loss of SLRs500m (US$5.8m) on the government. This was the first major confrontation between the two sides in three months and provided an ominous warning to hardliners in the Buddhist community who had almost written off the LTTE after it announced its ceasefire.

UK ratifies a ban on the The LTTE suffered a setback internationally just a week after the incident LTTE when in the UK the House of Lords approved an amendment to the Terrorism Act ratifying the proscription of the group in the country. The LTTE is believed to have relocated many of the functions of the group’s international secretariat in London to its jungle base in the Wanni in Sri Lanka ahead of the ban taking effect.

The latest offensive against The government launched operation Agni Kela (“ray of fire”) on April 25th in the LTTE fails what appeared to be a pre-emptive strike against the LTTE in case the rebels had used the ceasefire as an opportunity to rearm and regroup. The government is extremely cautious about peace talks and the operation may have been aimed at weakening the Tigers in order to compel them to enter talks without setting further conditions. However, the government seems to have under-estimated the Tamil Tigers’ strength, and ended the operation on April 28th after suffering a high number of casualties. The fighting should not affect the likelihood of peace talks taking place.

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Economic policy

The principal aim of the The 2001 budget was presented to parliament by the deputy finance minister, budget was to raise revenue Professor GL Peiris, on March 8th. The budget lacked a medium-term focus and was essentially stop-gap in nature, aimed primarily at correcting the large fiscal imbalance and boosting foreign-exchange reserves. The principal theme of the budget was revenue generation, and several proposals designed to raise government revenue in 2001 were announced. Unlike previous budgets, the government was restrained in granting new fiscal concessions, which were limited to only a handful of activities deemed to be priority areas. Overall, the budget was lacklustre and did little to boost flagging business confidence—the ad hoc revisions to corporate taxes and indirect taxes only served to further undermine the predictability of the policy regime and perpetuate the government’s image, as poor economic managers, prone to crisis management rather than adhering to a long-term policy plan.

The 2000 fiscal deficit Provisional estimates for the 2000 fiscal outturn are now available. The fiscal climbed to 9.8% of GDP deficit (excluding grants and privatisations) is estimated to have reached 9.8% of GDP. The principal reasons cited for the deviation of the deficit from the original target of 7.5% of GDP were the massive increase in defence spending and slower than anticipated growth in government revenue. Government revenue rose by a mere 8% in nominal terms to SLRs211.3bn (US$2.35bn), but as a percentage of GDP declined to 16.7%, from 17.6% in 1999 and an original target of 18.7%. The drop in revenue resulted from lower tax and dividend collections from government enterprises, as well as several ad hoc duty concessions granted on the import of key products including food, pharmaceutical products, petroleum and motor vehicles.

Current expenditure rises Government expenditure on the other hand rose sharply, by 22% in nominal dramatically terms to SLRs253.7bn. Over 80% of the overrun in expenditure was on account of current expenditure, which rose by 22.4% in nominal terms to SLRs253.7bn from SLRs207.3bn in 1999, and as a percentage of GDP to 20% from 18.7% in 1999. The overrun in current expenditure was the combined result of a 45% increase in military expenditure; a 15% rise in interest payments; a 19% expansion in the civil service wage and pension bill; and a 24% rise in welfare spending. The deficit in current expenditure increased almost fourfold to SLRs42.4bn, from SLRs11.4bn in 1999. This was equivalent to 3.4% of GDP and significantly higher than the 1% deficit recorded in 1999 and the original target of a surplus of 0.6% of GDP. As has been the trend in recent years, capital expenditure was cut to accommodate the increase in recurrent spending. Actual capital spending in 2000 fell to 6.4% of GDP—nearly 2% below the original target of 8.2% of GDP.

The 2001 fiscal deficit The 2001 budget envisages a reduction in the fiscal deficit to 8.5% of GDP. target is set at 8.5% of GDP Government revenue is forecast to increase by a rather ambitious 25% in nominal terms to SLRs264.5bn, and as a percentage of GDP to an equally ambitious 18.3%. Total government expenditure on the other hand is forecast to rise by 15.4% to SLRs387.7bn, or 26.9% of GDP. This forecast assumes a slower

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rate of increase in current expenditure and a faster growth in capital spending relative to 2000. On the external accounts side, the government expects the current-account deficit to be restricted to SLRs16.9bn, equivalent to 1.2% of GDP.

Defence spending is to be The nominal growth in recurrent expenditure is expected to halve to 10.9% curbed to 4.4% of GDP from 22% in 2001. Recurrent expenditure is to be restricted to SLRs281.4bn so that it falls as a percentage of GDP to 19.5%. The curtailment in current expenditure in 2001 is primarily owing to a lower estimate for defence spending, which is expected to decline to SLRs75bn (this includes a SLRs12bn component for deferred payment on purchases made in 2000) from an estimated SLRs84bn spent in 2000. As a percentage of GDP military expenditure will fall in 2001, to 4.4% compared with 5.6% in 2000.

No meaningful cost-cutting Cost-cutting proposals incorporated in the budget were a rationalisation of measures are initiated operating expenditures of government ministries and departments, including a curb on the expenses and perks afforded to the country’s large cabinet of ministers. However, apart from these, which tend to be cosmetic in nature and rarely occur in practice, no meaningful reforms to cut expenditure were announced. Because of the sharp increase in government borrowing in 2000 at high interest rates, debt-service payments are expected to increase to 6.3% of GDP in 2001, from 5.6% in 2000. The wage and pension bill as a percentage of GDP is also expected to rise (given the increases in wages announced in the run-up to the election), albeit more modestly, to 3% from 2.8% in the preceding year. Expenditure on other components of current expenditure has been retained at last year’s level.

Capital spending intended Capital spending is forecast to increase by an ambitious 30% in nominal terms, to rise dramatically to SLRs106.1bn (or 7.4% of GDP) in 2001 from an estimated SLRs81.9bn (6.4% of GDP) in 2000. However, given the historical trend, the ability and commitment of the government to adhere to its public-investment targets in the face of high, and possibly rising, current spending remains uncertain.

Corporate and indirect The key revenue-raising proposals announced in the budget were a 20% taxes set to rise surcharge on corporate income tax and a hike in the national security levy (NSL) from 6.5% to 7.5%. With the surcharge on corporate taxes, the effective rate of tax for private companies has increased from 35% to 42%, and for priority sectors (such as exports and agricultural activities) from 15% to 18%. The surcharge is expected to net SLRs2.6bn in additional revenue; the increase in the NSL is expected to raise 6.1bn. The NSL is a relatively elastic tax and is the third-largest source of tax revenue after the goods and services tax and excise duties. Revenues from the NSL climbed to SLRs33.5bn in 2000—rising to 2.7% of GDP, from 2.5% in 1999.

Government fees and levies Other revenue-generating proposals announced were an increase in the were increased gambling and betting levy; an increase in the airport embarkation tax; a hike in resident visa fees; and an increase in administrative fees and charges. The government also announced proposals to computerise all areas of tax administration and simplify procedural formalities in order to increase tax compliance.

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A surcharge on import In addition the government imposed a 40% surcharge on import duties with duties was imposed the twin aims of curbing growth in high-value consumer goods imports as well as raising import duty collections. The surcharge on import duties was announced on February 21st, prior to the budget, and will remain in effect until the end of the year. The sharpest increase was on consumer durables, the rate of duty for which was raised from 35% to 49%. The 25% tariff band has been hiked to 35%, the 10% band to 14% and the 5% rate (applicable to only a few select items) has been raised to 7%. Capital goods, intermediate goods such as crude oil and goods subject to zero tariffs have been exempted from the surcharge. Essential foodstuffs have also been excluded from the surcharge.

Privatisation is vital to In financing the fiscal deficit (SLRs123.1bn) the government has placed heavy finance the fiscal deficit reliance on privatisation proceeds, which are targeted to raise SLRs25m— equivalent to 1.7% of GDP. Of this, some SLRs21.3bn is to be raised from the sale of Sri Lanka Telecom. Should the sale be postponed, as a result of insufficient investor interest, or the price fall below target (a strong possibility given the downturn in technology stocks globally), the government will be hard pressed to raise funds to meet the shortfall. The major part of the deficit (SLRs69.1bn or 4.8% of GDP) is to be financed by domestic borrowing. The government also expects to raise SLRs21.5bn in international capital markets for its deficit financing.

A few new fiscal The number of fiscal concessions announced in the budget were relatively concessions are announced limited when compared with the generous and innumerable concessions granted in previous budgets. The need to stem the erosion in the country’s tax base was probably responsible for the government’s uncharacteristic rectitude in announcing new concessions. New fiscal incentives were announced only for information technology industries and services, and those currently available for infrastructure development were expanded.

Privatisation programme is The government has indicated that the privatisation programme will be stepped to be stepped up up and that state-owned enterprises which cannot be privatised or commercialised will be liquidated. Professor Peiris announced that 35 enterprises have been identified for liquidation in the short to medium term. Privatisations that will be completed in 2001 are the sale of the National Insurance Corporation; the divestiture of government’s remaining shares in plantation companies and hotels; the sale of government-owned farms; and the divestiture of an additional 35-40% of the government’s shareholding in Sri Lanka Telecom.

Labour reforms not The budget made no reference to labour reforms, which was one of the key addressed proposals put forward by the private sector, and for which there is pressure from international lending agencies for the government to implement as a priority. Given growing public disenchantment with the rising cost of living, and simmering labour unrest, the government probably thought it prudent to temporarily postpone such reforms. However, it did announce that the number of public holidays (Sri Lanka has the distinction of having the largest number of such holidays in the world) would be rationalised.

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The domestic economy

Economic trends

Inflation continues to Consumer price inflation edged up to 9.5% in the 12 months to March, from strengthen 8.7% in the year to February. However, the year-on-year increase, according to the Colombo Consumers Price Index (CCPI), slowed to 13.5% in March from an average of 16% in January-February. Improved supplies of key food items such as rice and vegetables helped to dampen growth in the food-price component of the index. The average rate of growth in consumer prices for the first quarter was nevertheless still high at 15.3%, compared with an average of 2.3% in the same quarter of 2000.

The rupee depreciated Weak demand for US dollars led to a modest strengthening of the rupee from slightly in April the middle of February. The rupee appreciated slightly from SLRs87.1:US$1 on February 9th to SLRs85.5:US$1 by mid-March. However, from March 23rd the rupee began to slide gradually, as seasonal demand for the dollar pushed up the rupee-dollar exchange rate. Imports of foodstuffs ahead of the Sinhalese and Tamil New Year, saw import bills come into the market. By April 7th, the rupee had edged down to SLRs87.5:US$1, and it weakened sharply in later in April to stand at SLRs90.45:US$1 on May 7th, owing primarily to heavy import demand and an unwillingness by exporters to exchange dollars at the lower rate.

Foreign-exchange market As a consequence of the relative stability in foreign-exchange market, the regulations are eased Central Bank of Sri Lanka in mid-March moved to ease the regulations it had imposed on the market in January. The time limit for exporters to remit their export proceeds was extended from 90 to 120 days; the deposit margin imposed on forward sales of foreign exchange was reduced from 50% to 25%; and the limits on the daily working balances of commercial banks were reduced.

Monetary policy is relaxed The stability in the foreign-exchange market also prompted the central bank to slightly gradually ease its restrictive monetary stance. On March 2nd the overnight repurchase rate (repo rate, the indicative rate at which commercial banks and

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primary dealers can invest their surplus funds in sovereign bonds held by the central bank) was cut by 100 basis points to 19%, while the reverse repo rate was also reduced by the same amount, from 23% to 22%. This was followed by a further relaxation in April, with the repo rate being reduced to 18.5% and the reverse repo rate to 21.5%. The central bank commented that as markets continued to be stable and inflation had showed signs of decelerating in March the cut was warranted. The Treasury has hinted that a further relaxation is likely towards the second half of the year, when the government’s fiscal position stabilises and assistance from the IMF and other aid agencies improve liquidity in the foreign-exchange market.

Interest rates remain high Despite the easing in monetary policy interest rates continue to remain high. The average prime-lending rate, which stood at around 22.7% in early March, has barely fallen. It fell slightly to 22.2% on April 12th. The interest rates on 12-month sovereign bonds have also hardly moved, remaining in the 19-20% range, while the rates for three- and six-month Treasury bill rates have also remained fairly static at 19-20%. One possible reason is that lack of liquidity— there is a SLRs35bn (US$389m) shortfall in the inter-bank market—and low foreign-exchange reserves have also contributed towards maintaining the upward pressure on rates.

Sharp rise in banking Total government debt for 2000 stood at SLRs1.2bn, up by 16% from the sector debt SLRs1.1bn of a year earlier. Domestic debt, which climbed to SLRs676.7bn in 2000 from the year earlier figure of SLRs543.5bn, accounted for 55% of total debt, compared with 52% in 1999. Medium- and long-term debt amounted to SLRs468.7m, equivalent to 69% of total domestic debt. This reflects the government’s policy of developing the medium- and long-term market for debt securities. Bank borrowings increased sharply by 42% to SLRs199bn, from SLRs139.7bn a year earlier. The widening in the fiscal deficit and the shortfall in privatisation proceeds necessitated increased recourse to bank financing. Borrowing from the non-bank sector (the National Savings Bank and Employees Provident Fund) rose by 18% to SLRs477.7bn. Total foreign debt at the end of 2000 stood at SLRs541.9bn, up from SLRs507.9bn at the end of 1999.

Industry

Manufacturing output fell According to provisional estimates, both private- and public-sector output in January contracted in January. Public-sector output fell sharply by 72.6% year on year. This was primarily owing to the closure of the Ceylon Petroleum Corporation (which accounts for over 90% of public-sector production) for biennial maintenance. Private-sector industrial production fell by 3.7% in the same period. The decline was led by a contraction in the textiles, garments and footwear industries, which accounts for 40% of industrial production. Output declined by 14.7%, almost entirely resulting from a contraction in export volumes in January. The output of non-metallic mineral products also fell, by 4.6%, owing to a contraction in the production of two key export activities—diamond processing, which fell by 10.3%, and ceramics which dropped 21%. Anchored by domestic demand, the food beverage and tobacco

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industry (21% of total industrial output) fared reasonably well, with output rising by 7.1% year on year in January. The output of other industrial categories, which also have fairly substantial domestic markets, also increased. Output of chemicals, rubber, plastic and petroleum products rose by 16.4%, wood and wood products by 13.2% and metallic products by 24.4%.

More incentives for textiles The 2001 budget announced several proposals aimed at encouraged growth in and garments companies Sri Lanka’s garments industry. The playing field between the Board of Investment (BOI) and non-BOI garment manufacturing companies has been levelled, with the government declaring that the latter would also be eligible for BOI incentives provided they had an annual turnover of US$1m and employed over 150 workers. The establishment of a fund financed by the cess (levy) on garment quotas was also announced. The aim of the fund is to provide financial support to companies to upgrade and modernise their technology. The cess on garment quotas was thus raised from SLRs1 to SLRs3 for each quota garment, and a special levy of SLRs1 was imposed on non-quota garments. However, following protests from the industry that the increase would siphon off some SLRs1bn from the industry, the cess on quota garments was subsequently reduced to SLRs2 per garment, while that on non-quota garments was lifted altogether.

Malaysian companies set up A Malaysian company, Merbok Hilier Berhad, is to invest US$20m in a in Sri Lanka to sell in India factory manufacturing furniture, which is expected to be the largest in the wood products sector in Sri Lanka. The factory is to begin production by the end of 2001 and, apart from supplying the domestic market, is also intended to export its products to India, taking advantage of the Indo-Lanka Free-Trade Agreement (FTA). Most of the company’s supplies of raw materials will be sourced from Sri Lanka—at a later stage the company also plans to grow its own rubber trees. Another Malaysian company, SMS Metals, also has plans to tap the Indian market using the concessions provided in the FTA. The SLRs20m project—a Malaysian-Sri Lankan joint venture—is to set up a plant to manufacture stainless-steel water tanks.

Enhanced fiscal concessions The government has identified the information technology (IT) sector as an to encourage IT investment area with enormous growth and employment potential, and has accordingly doubled its efforts to encourage investment in the industry. Although Sri Lanka was a relatively late entrant to IT, exports from this sector have grown from virtually nothing to US$55m in the past four years. Employment creation has also been substantial and an estimated 4,000 workers are directly employed in IT companies. As part of its ongoing promotion of IT services, the government singled out the sector for preferential treatment in its 2001 budget by announcing new incentives. The concessions accorded to export-oriented software industries in 1996 were expanded to include non-export oriented software companies as well—these companies are also now eligible for a five- year tax holiday (extendable to eight years if 70% of the output is exported) provided that they record a minimum turnover of SLRs40m per annum. New concessions—including a five-year tax holiday and exemption from the goods and services tax and national security levy (NSL)—were also announced for other export-oriented IT services, including services such as transcription,

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logistic management, web farming, data warehousing, insurance-claim processing and IT-enabling services.

Government invests heavily The government is supporting the development of the IT industry by investing in IT infrastructure in the necessary infrastructure and human capital to ensure an adequate supply of IT-proficient workers. Dedicated IT parks are being constructed in three locations in close proximity to Colombo. A substantial sum has been earmarked to equip schools with computers and to launch the teaching of computer science as a subject at both secondary school and university level. Regional IT centres dedicated to training are also in the process of being established. A training institute capable of training 2,000 IT professionals is under construction in Malabe and some 50 IT centres are also being developed under private-public partnerships.

The number of projects contracted by the Board of Investment in January- February 2001 totalled 52. The total investment component of these projects was SLRs11.9bn, of which the foreign investment component was SLRs6bn. Service projects accounted for over one-half of the number of approved projects and one-third of the value of investment approved.

February increase in tourist An upsurge in the number of visitors in February boosted overall growth in arrivals tourist arrivals in the two months to February, to 4.5%, up from a 2% increase in January. February arrivals, at 46,300, were 7% higher year on year and were the highest ever recorded in that month. An influx of visitors from the UK to attend the England-Sri Lanka cricket test series boosted growth in UK arrivals by 19.5% in February, and city hotels boasted a 100% occupancy rate during the series.

A campaign to reinvent The Ceylon Tourist Board has embarked on a major promotional campaign to tourism is launched breath new life into the country’s flagging tourist industry. The main thrust of the campaign is to harness the private sector’s input in a co-ordinated marketing strategy. The theme of the campaign is to re-invent Sri Lanka’s tourist product and enlarge its image from being primarily a beach destination to one that offers nature, culture and adventure tourism.

Tourist sector in need of Although the conflict between the Sri Lankan army and the Liberation Tigers revamping of Tamil Eelam (LTTE or Tamil Tigers) is the biggest deterrent to the growth in the tourist industry, analysts have also pointed out that the country’s tourism policy needs to be revamped to attract more operators into the country. Sri Lanka does not have an open skies policy, with restrictions imposed on the number of flights and passengers carried by foreign airlines, partly to protect the national carrier SriLankan Airlines. This, combined with high landing charges, has made it uneconomic for airlines to operate in the country. As a consequence some airlines have discontinued or cut down their operations. Aeroflot announced in March that it was pulling out of the country and a Dutch airline, MartinAir, is likely to follow suit. Two other airlines, Saudia and Kuwait Airways, have reduced the frequency of their flights in and out of Colombo.

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Port services growth The performance of port services—affected in the past two years by increased remains lacklustre competition from other ports in the region, capacity constraints and reduced efficiency—has remained lacklustre. Total container handling by the Colombo port contracted year on year by 0.1% to 280,019 twenty foot equivalent units (TEU’s), from 280,395 TEU’s in the same month of 2000. The number of domestic containers handled fell by 3.5%, from 90,467 TEU’s in January 2000 to 86,935 TEU’s in January 2001, reflecting the slowdown in export volumes. Transhipment cargo also remained depressed, with the number of containers handled increasing by a negligible 1.3% to 186,126TEU’s, from 183,711TEU’s shipped out in January 2000.

Agriculture

Tea production hits record Tea production in the two months to end-February rose year on year by a levels healthy 21% to 53.6m kg, from 44.2m kg in the same period of 2000. Production climbed to record levels in both January and February, with production in January peaking at 27m kg (the highest ever recorded in this month) a 20% increase on the 22m kg recorded in the same month of 2000. In February, production increased year on year by 23% to 26.3m kg—also the highest output ever recorded in this month. The previous monthly high, of 23m kg, was recorded in February 1999. Although both high- and medium-grown teas rose significantly, the sharpest increase was recorded in low-grown teas, which retained their pre-eminence as the most dynamic and productive category.

Tea production, Jan-Feb (m kg) 2000 2001 % changea High-grown 12.33 12.56 1.9 Medium-grown 8.11 8.29 2.2 Low-grown 23.80 32.75 37.6 Total 44.24 53.60 21.2

a Percentage increases may differ owing to rounding. Source: Sri Lanka Tea Board.

Estate workers launch a Tea production in March was affected by a go-slow campaign on estates go-slow campaign in March managed by plantation companies. The campaign was orchestrated by the Ceylon Workers Congress (CWC, a powerful political party representing estate workers) which demanded a SLRs400 (US$4.4) devaluation allowance to be paid to workers each month. The plantation companies resisted the demand on the grounds that their cost of production was the highest among tea- exporting countries, accounting for 60-70% of their expenditure. They also pointed out that the wage hike demand contravened the collective agreement signed between the companies and workers in June 2000, which was supposed to be effective until June 2002. However, following an increase in the incidence of violence against estate mangers and a threat by the CWC to withdraw its support from the ruling coalition, the government was compelled to intervene in the crisis.

Companies agree a new On March 16th the 25-day campaign ended with the companies offering a new wage formula wage formula to appease the unions. Under the new wage package workers will receive SLRs121 per day. This includes a basic wage of SLRs101 and a price- share supplement which has been increased to SLRs15 from SLRs6. Workers will also receive an incentive payment for attendance of 75% or more working days a month. The revised wage package will cost the companies an additional SLRs500m per year. This is, however, considerably less than companies estimate it would have cost had they been forced to pay according to the original demand.

Export earnings record Export earnings for tea in the first two months of 2001 were up by a massive healthy growth 32% to SLRs9.8bn from SLRs7.5bn for the year-earlier period. The sharp increase in earnings was primarily price induced as export volumes rose only by a modest 8% year on year to 44.9m kg, from 41.7m kg exported in the same period of 2000. The Commonwealth of Independent States (CIS) countries remained the leading market for Sri Lanka’s teas, although the quantities bought declined to 9.5m kg compared with 10.2m kg in January-February 2000. However, the drop in purchases by the CIS was more than compensated for by the surge in exports to the second largest buyer, the United Arab Emirates, where the quantities exported rose by more than 50% to 7.9m kg, from 5.1m kg in the corresponding period of 2000.

Although bulk teas continued to be the leading export category, export volumes in this category in January-February dropped to 26.4m kg from 28m kg a year earlier. However, this was more than offset by an increase in exports of packaged teas, where export volumes rose to 12.8m kg from 8.48m kg. Value-added exports—primarily tea bags—continued their downward trend, with quantities exported falling to 1.99m kg from 2.21m kg.

Tea prices continued to Tea prices have continued to strengthen in rupee terms. The total average price strengthen for all teas moved up to SLRs155.5/kg in February, from SLRs154.9/kg in January. For the 12 months to February the average price was SLRs155.2/kg, 17% higher than the SLRs132.5/kg fetched in the year-earlier period. The prices of all three categories of tea improved substantially. The average price for high- grown varieties rose by 12.5% to SLRs148.5/kg in the year to February, from

SLRs131.9/kg for the year-earlier period. The price for medium-grown teas rose to SLRs136.3/kg from SLRs121.6/kg, while low-grown tea prices rose sharpest, rising year on year by 20% to SLRs164.4/kg from SLRs136.8/kg.

Coconut and rubber output The other two plantation crops—rubber and coconut—are on a declining exhibit a declining trend trend. In the first two months of the year, rubber production contracted by 2.6% to 15.2m kg. The diversion of land used for rubber production to more profitable uses (primarily tea and buildings), and the low prices paid for rubber wood, have combined to reduce the re-planting and new planting of rubber trees. Coconut production has also declined, decreasing in January by 2.7% year on year to 231.2m, from 237.4m in January 2000. The decline in international prices in 2000 has reduced fertiliser application, while falling demand for coconut oil (partly owing to lower prices for alternative oils) has also acted as a disincentive to raising production.

Infrastructure

Sri Lanka’s telephone Sri Lanka’s telephone density improved in 2000, to 4 telephones per 100 density improves people from 3.5 in 1999. There was also a 14.2% increase in the number of telephone connections, reaching 767,411 at the end of 2000 from a year- earlier figure of 671,916. The highest number of connections (72,945 new connections) were installed by Sri Lanka Telecom (SLT), whose subscriber base grew to 653,144 by the end of the year. The customer base of the wireless phones operated by the private sector increased from 91,717 to 114,267. However, the growth in the cellular phone industry continued to outstrip the rate of expansion of the other operators. The number of mobile phone users rose by over 30% to 256,655. Internet facilities have also become more accessible, with the number of Internet users growing by over 50% to 40,495, from 25,535 in 1999 and just 18,984 at the end of 1998. Nevertheless, by international standards Sri Lanka’s Internet and communications penetration is still low.

Fall in profits and credit The government has indicated that it will press ahead with its proposed risk undermine SLT sell off divestiture of 40% of the shares in SLT, with an initial public offering possibly taking place in September. The issue, originally scheduled for 1999, was postponed twice owing to the downturn in the stockmarket and the escalation of the conflict between the Sri Lankan army and the LTTE. Apart from the pressing need to raise revenues from privatisation, the government also probably feels the longer they postpone the issue, the less their ability to get an attractive price. SLT’s profits have weakened considerably over the past two years. Huge investments to expand and modernise the network (leading to a sharp rise in debt servicing) and substantial losses in revenue of around SLRs2bn (US$22.2m) owing to the diversion of international calls to companies offering voice-over-Internet facilities, have combined to reduce SLT’s profitability. In 2000 profits tumbled by an estimated 93% to SLRs89m, compared with SLRs1.2bn in 1999. This led to the company being put on a ratings watch by the credit ratings agency, Fitch Ratings Lanka. In 1999 SLT received an “SL AA+” rating from the credit rating agency on its SLRs1bn five-year

debenture issue. Consequently, there is considerable uncertainty as to whether the government will be able to raise the US$250m (down from the original estimate of US$400m) that it has targeted from the sale. The prospect of Nippon Telephone & Telegraph’s (NTT’s) management contract ending in August 2002 has also added an element of uncertainty. NTT, which has a 35% equity in SLT, has hinted that they are undecided about renewing their management contract.

Further deregulation of The telecommunications industry is to be deregulated further in 2002. The telecoms sector in 2002 government announced in its 2001 budget that it would auction a second international gateway licence when SLT’s monopoly on the network expires in August 2002. The government also said that it would issue a licence to another fixed line operator in 2002. At present SLT is the only fixed-land-line operator. Two other private operators—Suntel and Lanka Bell—operate under wireless- line technology.

Emergency purchases of The government has decided to seek an additional 150 mw of thermal power 150 mw of thermal power to meet the growing demand for power. Five existing private power operators— Colombo Power, Asia Power Ltd, AES Kelanitissa, ACE Power and Lakdhanavi—have responded to the government’s request for tenders. The additional generating capacity will be divided amongst the operators as an extension to their existing supplies. Four thermal power projects with a combined capacity of 350 mw are due to come on stream in 2001-04. Sri Lanka is currently facing a shortage in power supplies owing to the depletion in the country’s hydropower reservoirs. The Central Electricity Board has warned that failure to implement the coal-power project, even with hydro power generation levels returning to normal, would mean the country facing a power shortage in 2002. In its 2001 budget the government announced that it was considering proposals to develop large-scale power plants fired by liquid natural gas.

Progress has been made on The project to develop the south harbour of the Colombo port has moved a the south harbour project step forward. In early April, the government and the Asian Development Bank (ADB) signed a memorandum of understanding, under which the ADB will provide a technical assistance loan of US$10m for the detailed design and engineering plan for the harbour. The study is scheduled to start in the second half of this year.

World Bank assistance for a The government is also attempting to revive a US$45m loan, provided by the port improvement project World Bank in 1998 (but not utilised), to improve the efficiency of the Colombo port. The total cost of the project is estimated to be US$60m, with the balance of US$15m being provided by the government. Under the project, the operations of the Colombo port will be computerised and work methods reorganised to promote greater efficiency.

Donors are pressing for Both the ADB and the World Bank have prescribed essential reforms to the port reform Colombo port, necessary if the government is to secure additional assistance for port projects. Amongst the reforms that the agencies are pressing for are a rationalisation of the labour force, the privatisation of the Jaye Container

Terminal (by converting it into an independent commercial entity) and the creation of a regulatory authority for port services. The efficiency of Colombo port has deteriorated significantly in recent years owing to political involve- ment in the ports operations, in particular the recruitment of workers. The World Bank has pointed out that since 1999 the Sri Lanka Ports Authority has been recruiting workers at the rate of 100 per month. As a consequence, excessive labour has undermined efficiency and raised costs at a time when the port is facing growing international competition. The port has an estimated 19,000 workers handling some 1.7m TEU’s, compared with Singapore’s workforce of just 5,000 which handles 15m TEU’s. The agencies have recommended a freeze on recruitment initially, followed by a voluntary retirement scheme.

Financial and other services

The Colombo stockmarket The downward spiral in the Colombo Stock Exchange has continued unabated. continues to slide The Colombo stockmarket All Share Price Index (ASPI) plunged to 428.9 on March 23rd, its lowest level in 11 years. By April 26th, the ASPI was down to 417 points, a decline of just over 6.1% since the beginning of the year, though it had only fallen to 416 by May 1st. The slide in the market has been aggravated by continuous heavy selling by foreign investors. On April 2nd stockmarket turnover dipped to SLRs2.1m (US$23.5m), the lowest in four years. The previous low of SLRs1.7m was recorded in July 1996. No let-up in the bearish sentiment, which continues to dominate the market, is envisaged. The budget has further added to wariness. The surcharge on corporate taxes has reduced prospects for improved profits and investors perceive the budget numbers as unrealistic and unachievable. Political uncertainty is another factor that has prevented an improvement in investor sentiment.

Stockmarket indicators (end-period unless otherwise indicated) 2001 Feb Mar April 26th CSE all-share price index (1985=100) 442 422 417 Milanka price index(1998=100) 688 639 632 Market capitalisation (SLRs bn) 87.5 83.5 82.6 Source: Central Bank of Sri Lanka: Selected Weekly Economic Indicators.

The NDB is to set up a The National Development Bank (NDB), one of the two leading development separate commercial bank banks in Sri Lanka, has continued to press ahead with its diversification programme. In March the bank announced that it had finalised arrangements for its take-over of the Colombo operations of Dutch-based ABN-Amro. The NDB said that it intended floating a new company, licensed to carry out commercial banking, to purchase ABN-Amro’s Sri Lankan subsidiary. The purchase is to be funded partly by the equity of the company (through a rights issue) and partly by borrowing. The NDB will have at least a 25% stake in the new bank and the ADB and International Finance Corporation (IFC) are also expected to be shareholders.

Specialised housing-finance The NDB is also to establish a specialised Housing Bank, focussing entirely on institution planned housing finance. The ADB has committed an equity investment of US$360,000 to the new venture, which will also receive technical assistance from one of India’s leading housing-finance specialists, the Housing and Development Finance (HDFC) company. The NDB is also seeking the financial support of the IFC for this venture. The Employees Provident Fund and Eagle Insurance are also expected to take a stake in the new institution.

DFCC teams up with The Development Finance Corporation of Ceylon (DFCC), the other leading German banking giant development bank in Sri Lanka, has entered into a partnership with German banking giant Hypo Vereinsbank Group (HVG) for the US-dollar financing of capital goods imports by Sri Lankan companies engaged in export trade or infrastructure development. HVG has allocated 50m euros towards this venture. However, since DFCC is classified or categorised as a specialised lending institution and under current central bank regulations is not permitted to provide dollar-denominated loans through its foreign-currency borrowing window, it has sought, and is awaiting, approval from the central bank for the joint venture.

A low-cost credit scheme is The NDB in partnership with ten other financial institutions has launched a launched new low-cost credit scheme for small and micro industries (SMIs). The Small and Micro Industries Leader and Entrepreneur Promotion Project (SMILE 2) project has received a partial funding of SLRs3.3bn from the Japan Bank for International Co-operation. Under SMILE 2, micro enterprises will be eligible to receive loans up to a ceiling of SLRs7m (with an interest rate of 14% and repayable over ten years) from any of the ten participating financial institutions, which include DFCC, two state-owned banks and several domestic private banks. In addition, the SMIs can also access concessionary finance to upgrade managerial and technical skills under the technical assistance

component of the scheme. The first SMILE programme was launched in 1997, under which a credit of SLRs3.5bn was utilised to approve a total of 6,117 loans.

A development bank for The 2001 budget mooted a proposal for the establishment of a separate small industries is mooted enterprise development bank for small and medium-sized enterprises (SMEs). The new bank is to be set up by the government with a capital contribution from the central bank as well as from other government-owned financial institutions. The government’s aim is to channel the wide range of special loan schemes implemented by the two state-owned banks to the new bank, so that the two state banks can focus entirely on commercial banking. The provision of loans to government-sponsored projects has been one of the principal factors that has undermined the commercial viability of the state banks. The banking sector, however, has questioned the logic and timing of such a move, on the grounds that it would only lead to a duplication of functions given that most banks (in particular development banks) already operate dedicated schemes for SMEs. They point out that the government’s thrust should instead be directed towards raising more concessionary funds to be channelled to existing banks, which, with a combined branch network of 1,500, have the existing infrastructure and expertise.

More financial institutions More financial institutions are seeking a credit-risk rating ahead of raising are seeking credit ratings funds in capital markets. Commercial Bank of Ceylon became the first domestic commercial bank to receive an “SL AA+” credit rating from Fitch Ratings Lanka Ltd. The rating denotes a very low expectation of credit risk. The bank now plans to raise SLRs1bn through a redeemable preference share issue. Lanka Orix Leasing Company (LOLC), one of the largest leasing finance institutions in the country, was also assigned a rating of “SL F-1” from Fitch for its short-term debt. The rating, which denotes high credit quality, is just one place below the highest rating of “SL F-1+”. LOLC now plans to go ahead with its SLRs100m short-term paper issue.

Seylan Bank has plans for a Seylan Bank, a domestic commercial bank, plans to increase its capital- SLRs300m debenture issue adequacy ratio through a SLRs300m debenture issue due to be floated at end- April. The five-year unsubordinated, redeemable debentures, which carry a face value of SLRs100 each, will be listed on the second board of the Colombo Stock Exchange. Investors can choose from two fixed-interest-rate options—monthly interest of 15% per year or annual interest of 16% per year—or a floating-rate option which offers a 1% premium over the prevailing treasury-bill rate, subject to a floor of 12% and a ceiling of 22%.

An index of sovereign debt The country’s first bond index to track the performance of the sovereign bond is introduced market was introduced in early April by the First Capital Group, a primary dealer in sovereign debt. The First Capital Bond Index (FBI) has two separate indices—the Total Return Index (TRI) and the Principal Return Index (PRI). The TRI is the absolute return that a bond offers (and includes both coupon interest and capital gains/losses), while the PRI tracks the change in the net price of the bond. The index represents around SLRs83bn or 37% of the total outstanding bond stock of SLRs220bn. Treasury bonds are the most capitalised asset category amongst the economy’s tradable financial instruments and account

for a much larger share of the market compared with other instruments such as treasury bills, equity, quoted debt and commercial paper.

Foreign trade and payments

The trade deficit narrowed Sri Lanka’s external trade performance improved in the first two months of the in early 2001 year, as a surge in exports and a sharp contraction in imports in February facilitated a decline in the trade balance. A 12.3% year-on-year decline in exports in January was more than offset by a 19.5% increase in earnings in February, allowing dollar-denominated exports to rise by 3.6% to US$788.7m in the two months to February. On the other hand, a 6.2% year-on-year increase in imports in January was followed by a sharp 15% contraction in February. Total import expenditure (excluding aircraft) in the first two months thus fell by 4.3% to US$1,004.6m. As a consequence, the merchandise trade balance (which widened by a massive 52.7% in January) shrank by 25% to US$215.9m in January-February, from US$287.9m for the year-earlier period. (In February a small trade surplus of US$15.2m was recorded.)

Trade balance, Jan-Feb (SLRs m; US$m in brackets) 2000 2001 % change Exports fob 55,281.4 67,487 22.1 (761.5) (788.7) (3.6) Imports –76,181.1 –85,498.8 –12.2 (–1049.4) (–1004.6) (–4.3) Trade deficit –20,899.7 –18,011 –13.8 (–287.9) (–215.9) (–25.0) Source: Central Bank of Sri Lanka: Selected Weekly Economic Indicators.

Industrial exports recover Industrial exports, which contracted by 21.4% in January, recovered in February impressively to grow year on year by 24% in February, enabling earnings from these exports to rise by 0.9% in the first two months of 2001. Earnings from textile and garment exports recorded a small decline of 0.5% in the January- February period. This was entirely a result of a sharp 24.6% year-on-year contraction in earnings in January. In February garment exports recovered to grow by 24.4% year on year. The decrease in January was attributable to a seasonal drop in exported volumes, which shrank by 25%. Exports peaked in December owing to an end-of-the-year rush in shipments to meet the quota deadline of December 31st. According to the Central Bank of Sri Lanka, the decline reflected the timing of shipments rather than an underlying trend in export expansion. Since new quotas are also issued in January this results in shipment delays normally making January a lean month for apparel exports.

Other key industrial exports, the performance of which deteriorated in January, also made an impressive recovery in February. Overall, in the first two months of the year, exports of food, beverages and tobacco rose by a healthy 15.2% (helped by a 89% year-on-year increase in exports of fresh and frozen fish in February), after declining year on year by 7.4% in January. Exports of leather

and rubber goods increased by 17.6% in the January-February, boosted by a 63% year-on-year increase in exports of rubber products and a doubling in the earnings from travel accessories in February. Earnings from exports of machinery and electrical equipment, which grew by just 0.6% in January, rebounded to grow by 41% in February, thus raising overall growth in earnings in the first two months of the year by an impressive 20.8%. Other exports, which recovered in February from a subdued performance in January, were plastic products earnings from which grew by 56% in February, and tableware which increased year on year by an impressive 126% in February, after having contracted by 44.4% in January. Earnings from mineral exports rose by 28.4% in the first two months of the year, underpinned by healthy growth in earnings from gem exports. Exports of jewellery and diamonds, however, contracted by 21.3% and 24.4% in January and February respectively, as a result of a drop in international demand.

Tea exports prop up Agricultural exports rose year on year in January-February by a modest 3.2% in agricultural export receipts dollar terms. In rupee terms the increase was more pronounced at 21.3%. The increase in export earnings was almost entirely owing to buoyant growth in tea exports, earnings from which rose year on year by 12.2% in dollar terms and by an impressive 31.8% in rupee terms. Reversing the decline in earnings experienced in 2000, earnings from minor agricultural crops grew by 5.2% to US$21.8m. Coconut exports continued to fall sharply—dollar earnings plummeted by nearly 31.8% in the first two months of the year as a result of the downturn in international prices for all coconut products. The declining trend in rubber exports continued with dollar-denominated earnings decreasing by 20.8%, although in rupee terms the drop was less pronounced at 7%.

Composition of exports, Jan-Feb (US$ m) 2000 2001 % change Agricultural exports 153.5 158.4 3.2 of which: tea 103.3 115.9 12.2 coconut 23.6 16.1 –31.8 rubber 5.7 4.5 –20.8 Industrial exports 583.4 588.6 0.9 of which: textiles & garments 412.9 411 –0.5 leather & rubber 62.5 73.5 17.6 food, beverages & tobacco 19.8 22.8 15.2 minerals 15.5 19.9 28.4 petroleum products 14.5 9.3 –35.9 other industrial products 73.7 72.0 –2.3 Total incl others 761.5 788.7 3.6 Source: Central Bank of Sri Lanka: Selected Weekly Economic Indicators.

Imports decline sharply in Imports (net of aircraft) dipped by 4.3% year on year in the two months to February January 2001. If the value of aircraft purchased in January 2000 is included, the drop is sharper at 12.5%. The fall in import expenditure was owing to a sharp contraction in imports in February. The February 2001 import bill of

US$439.3m was 15% lower than the February 2000 import value, and was the lowest recorded import bill since April 1999.

Consumer durable imports The 8.2% rise in consumer goods imports in the first two months of the year contract sharply was entirely owing to the sharp increase in imports of consumer durables (in particular pharmaceuticals, radios and television sets) in January. In anticipation of a sharp depreciation of the currency, importers of consumer durables stocked up and expenditure on these imports thus rose year on year by 84.3% in January. The uncertainty following the free float of the rupee on January 24th, the conditions imposed by the central bank on importers for the booking of foreign exchange and the imposition of the surcharge on imports (effective from February 21st) combined to sharply dampen growth in imports of consumer durables in February—expenditure on these products fell by 8.8% year on year in February. This trend is likely to continue given that higher import duties and taxes on these goods will continue to curb demand in the coming months. The value of food imports, which rose year on year by 27% in January, contracted sharply by 59.4% in February. Thus, the value of food imports for the first two months of 2001 was 20% lower in dollar terms from the year-earlier level. This was a result of lower imported volumes of key foodstuffs such as such as rice, flour and milk products.

Intermediate goods Expenditure on intermediate goods imports decreased by 10.8% in the same imports decline two-month period. This was owing to lower demand for textiles, fertiliser, diamonds and other industrial inputs. There were no crude oil imports in January and February because of the closure of the Ceylon Petroleum Corporation for routine maintenance.

Investment goods imports Investment goods imports excluding aircraft rose year on year in January- rise February by 14.5%. Imports of building materials rose year on year by 13.1%, while machinery and equipment imports rose by 15.8%. Imports of transport equipment contracted by 84.5%—this is primarily statistical as it reflects the imports of aircraft in January 2000.

Composition of imports, Jan-Feb (US$ m) 2000 2001 % change Consumer goods 185.9 201.1 8.2 Intermediate goods 591.8 528.0 –10.8 Investment goods 205.9 235.7 14.5 Other (incl military ) 65.8 39.7 –39.7 Total 1,049.4 1,004.6 –4.3 Source: Central Bank of Sri Lanka: Selected Weekly Economic Indicators.

Healthy growth in private Net private remittances grew by a healthy 8% to US$974m in 2000, from remittances US$887m a year earlier. Earnings from migrant workers have become an increasingly important balancing element in the current account and have emerged as Sri Lanka’s largest net foreign-exchange earner after garments. Recognising the importance of such earnings, the 2001 budget incorporated several incentives to encourage increased repatriation of foreign-exchange

earnings from Sri Lankan workers employed overseas. These included concessionary housing loans up to twice the amount maintained in a foreign- currency account, insurance compensation for dependants and monthly pension benefits for workers aged over 55 who return after employment overseas.

Foreign reserves fall Total foreign reserves at the end of January stood at US$2,016m—5.2% lower further than the US$2,126m at the end of 2000. Gross official reserves fell below the US$1bn mark to US$950m in January, equivalent to an 8.9% decrease from the US$1,043m at the end of December 2000. At this level, reserves were sufficient to finance just one-and-a-half months of imports.

IMF package should boost The purchase (in stages) of US dollars by the central bank from the interbank forex reserves market has led to a slight improvement in reserves in March. Reserves are expected to be boosted to an acceptable level of three months import equivalent by the middle of the year, following the receipt of a balance-of- payments support facility by the IMF.

In late April, the IMF formally announced that it had approved a 14-month, SDRs200m (US$253m) stand-by credit facility for Sri Lanka. The facility is aimed at shoring up the country’s dwindling reserves, and Sri Lanka can immediately avail itself of SDRs103m (US$131m). The IMF facility augurs well for an acceleration in the pace of economic reforms and has also paved the way for the release of an estimated US$270m from other donors, including the World Bank, Asian Development Bank (ADB), US and Japan. According to the central bank, the IMF decision is seen as an endorsement of the country’s economic programme and policies. It is likely, therefore, to help in improving business confidence and encouraging investment. The balance of the facility will be released after the IMF evaluates progress made on the economic front.

The stand-by facility is a precursor to a longer-term funding programme under the poverty reduction and growth facility (PRGF), which the government is also negotiating with the IMF. The PRGF would be a three- to five-year programme, under which funds of approximately US$500-700m could be obtained. Sri Lanka hopes to receive the facility by May 2002.

With the government now engaged in an IMF funding programme, the prospects are positive for an acceleration and more rigorous implementation of reforms. The government is now tied to a commitment to reduce the fiscal deficit from 8.5% of GDP in 2001 to 6.75% of GDP in 2002. The reduction in the deficit is expected to come from a widening in the tax base, better tax administration and a cut in defence spending. The government will also have to adhere to a programme of structural reforms which include extended privatisation and deregulation of state sectors; rationalisation of the civil service and pension scheme; a further relaxation on limits in foreign direct investment on remaining areas such as financial services; rationalisation and commercialisation of state banks; improvements in the functioning of labour markets; and possibly a further broadening of the goods and services .