Sri Lanka Business Forecast Report Q4 2008

An Island Facing Mounting Challenges Sri Lanka's economy has proved highly resilient to the ongoing civil war, having expanded by 6.8% in 007, but we are forecasting a slowdown to 6.0% in 008, as the island nation suffers from record high oil prices and inflation, and weaker growth in the EU and US - its principal export markets. Meanwhile, the civil war will continue, with the Liberation Tigers of Tamil Eelam (LTTE, Tamil Tigers) stepping up suicide attacks in government-controlled areas.

President Mahinda Rajapaksa will continue to pursue his strategy of defeating the Tamil Tigers militarily, while seeking to re-integrate former rebel-controlled areas through elections and infrastructure spending. As an executive president with a six-year term that does not expire until 011, Rajapaksa remains secure in office, although frequent cross-party voting tends to make the passage of key legislation unpredictable and leaves open the possibility of early legislative elections.

Over the long term, we have concerns that the longer the civil war drags on, the more likely it is that civil liberties and media freedom are likely to be eroded.

Although Sri Lanka's economy has been resilient in the face of civil war, we forecast a deceleration of expansion from 6.8% in 2007 to 6.0% in 2008 owing to record-high oil prices and inflation, and weaker growth in the island's main export markets (the EU and US). Provincial disparities will remain one of the most salient features of the economy, which is overwhelmingly dominated by the Western province (centred on Colombo) and the adjacent provinces. We do not see scope for much progress, because chronically high budget deficits and external debt levels preclude significant extra infrastructure spending needed to reduce these disparities. Meanwhile, we believe that the Sri Lankan rupee's de facto peg with the US dollar will ultimately prove unsustainable, given the country's rising oil import bill and widening current account deficit. Beyond 2008, we believe real GDP growth can remain within the 6.0-7.0% range, but that acceleration to the 7.0-8.0% range will be unlikely unless the civil war is brought to an end, or at least reduced to a minimal level of violence.

Sri Lanka's business environment will continue to suffer from the civil war, which remained intense in 2008. More broadly, while Sri Lanka stands to benefit from a favourable geographic location and a well-educated workforce, corruption in the judiciary, and particularly in the contract-bidding process, remains a concern. Meanwhile, the physical infrastructure is inadequate to cope with the economy's needs. However, the government is slowly pressing ahead with its infrastructure programme, and is increasingly relying on foreign borrowing for funding. The business environment is unlikely to see a significant improvement under President Mahinda Rajapaksa, who has been pursuing a more nationalistic and less business-friendly economic policy than his predecessor.