Sri Lanka: Risk Assessment

Country Rating¹

Rating: C

Business Climate Rating¹

Rating: B

Risk Assessment²

Strong growth thanks to the end of the civil war
Strong growth resumed in 2010 thanks to improvement in international economic conditions and in the security situation. The end of the civil war boosted investment, especially in property and infrastructure, driven by reconstruction projects in northern and eastern Sri Lanka. And private consumption, the main growth engine, rebounded due to the increase in remittances from expatriate workers and farm income. Textile exports and tourism moreover performed well.
In 2011, the economy will remain buoyant. Agriculture will be dynamic driven by yield of land put into cultivation in northern and eastern Sri Lanka. Improvement in household and corporate confidence will moreover underpin the economy. The dynamism of household consumption will spur the retail sector. Manufacturing and construction will benefit from vast reconstruction projects and infrastructure investments. And conditions in the services sector will be booming as a result of the growth of tourism and travel between the regions formerly affected by the civil war and the rest of the country.

Weak financial position despite IMF support
As regards external accounts, the current account deficit widened in 2010 as a result of the sharp rise of imports in a context of recovery of domestic demand, a trend likely to continue in 2011. FDI will only cover a limited proportion of the resulting financing needs. Taking on additional debt, still mostly concessional, will again prove necessary. However, an impending reduction of foreign aid could undermine Sri Lanka's efforts to cover its financing needs.
In 2008-2009, the crisis triggered the flight of volatile capital, which weakened the rupee and prompted authorities to drop the currency's dollar peg. Central Bank interventions in support of the currency drew heavily on foreign exchange reserves. To avoid a foreign-exchange liquidity crisis associated with massive capital flight, the IMF granted a $2.6 billion loan in July 2009. In this context, renewed investor confidence prompted a large influx of capital and enabled the replenishment of reserves (five months of imports in 2010).
The state of public-sector finances remains nonetheless a source of concern. Although the fiscal deficit has narrowed as a result of the decline in security spending and subsidies, fiscal revenues have remained structurally limited due to the narrowness of the fiscal base. This deficit was partly financed by a ten-year billion-dollar sovereign issue at a 6.25% rate in September 2010. The deficit is expected to decline further in 2011 as a result of fiscal reforms initiated in June 2010: limitation of tax exemptions, adjustments in VAT, customs duties, and income tax. In this context, the public-sector debt will likely decline but nonetheless remain at difficult to sustain levels (80% of GDP).

Despite the end of the Civil War, political tensions will likely persist
The armed conflict that opposed the Colombo government and the separatist Tamil Tiger rebellion for 26 years came to an end in May 2009 with the victory of the Sri Lankan army. The end of the hostilities enabled gradual improvement in the climate of security. Sporadic attacks will remain possible, however, and the national reconciliation will be difficult. This military success increased the popularity of President Rajapakse who won re-election by a wide margin in January 2010 and whose party won a resounding victory in the April 2010 parliamentary elections. In the resulting context structural reforms could accelerate.

Strengths

• Move up market by textiles
• Diversified agricultural production (tea, rice, cocoanut, rubber)
• Poverty reduction
• Revival of investment with end of the civil war
• Proximity to the rapidly developing Indian market
• Very high tourist potential albeit under-exploited thus far
• Human development and governance effectiveness surpassing the levels achieved in neighbouring South Asian countries

Weaknesses

• Marked dependence on the textiles sector
• Lack of infrastructure
• Low public capital spending as a result of the heavy debt service on the public debt
• Vulnerability to financial crises because of the dependence on short-term foreign financing and the overvaluation of the exchange rate