Sri Lanka Rejoining the World

The government of Mahinda Rajapaksa in Sri Lanka has probably botched its dealings with the United States, the European Union and the United Nations. Still, the disenchantment with Colombo may be overblown three years after the end of the 26-year civil war, which ended in 2009.

While major countries and agencies continue to wag their fingers in irritation, they are privately moving ahead with interacting with the government.

During a recent macro research visit to the country, we found that there are lingering domestic tensions that risk renewed flare-ups of uncoordinated incidents of violent conflict, but domestically the civil war is now a non-issue with zero risk of a sustained violence derailing a structural peace.

That doesn’t mean there has been much reconciliation. The New York-based Human Rights Watch NGO said in July that since the war ended the government “has not launched a single credible investigation into alleged abuses.” More than 100,000 Sri Lankans remain in India’s Tamil Nadu state, saying they would rather not return, citing economic hardship and concern over human rights abuses, according to the United Nations Office for the Coordination of Humanitarian Affairs.

“My relatives who have returned say `Don’t come. ‘There aren’t any jobs and the cost of living is too high’,” 46-year-old Sivabalan Palaniyandi from Gummidipoondi, an industrial town 40km north of Chennai, the capital city of Tamil Nadu, told the UN agency’s news service, IRIN.

Journalists have been beaten and some have been murdered, allegedly by individuals acting in behalf of the Rajapaksa government. Although longstanding emergency regulations have lapsed, other legislation granting police and other security forces overbroad detention powers remains in place. The president, human rights watch said, continues to issue monthly decrees granting the armed forces search and detention powers.

Last year the European Union removed GSP Plus trade preference in protest over the unresolved post-war human rights issues. And more recently, the United Nations issued a non-binding resolution -- led by the United States and signed by India -- criticizing the government's record of post-civil war reconciliation efforts.

However, so far, the US has indicated it is uninterested in turning this into a major diplomatic issue and the same goes for India. For example, the day after the UN issued its resolution earlier this year, the US State Department announced it was removing export restrictions on military-use optical equipment.

India has also reached out with a positive diplomatic missive shortly thereafter. Such timing was not coincidental. The US also recently gave Sri Lanka a six-month waiver on Iran oil sanctions, based on continued progress that Sri Lanka has made in diversifying some of the 90 percent of the oil imports it typically sources from Iran.

International blowback: still a risk

However, if Sri Lanka puts its head in the sand on this issue, the country risks sowing the seeds of a festering problem that could result in more serious diplomatic sanctions, and turn what currently is a tempest in a teacup into a diplomatic nightmare. A potentially disruptive foreign policy scenario, for example, could play out for Sri Lanka if the extremely well-funded and organized Tamil diaspora finds common purpose with human rights groups in lobbying G20 governments to pursue active sanctions related to continuing reconciliation problems.

Debilitated by years of conflict, Sri Lanka can count on a period of economic “catching up” in the years to come, which will help insulate domestic growth from global headwinds – assuming the government doesn’t drop the ball. Two thirds of a coastline featuring world class beaches and half of the country’s highly productive arable land were effectively frozen during the civil war. The economy has responded positively as these two pillar industries have finally been unshackled by war and boosted by government sponsored infrastructure development over the past several years, including new and desperately needed highway projects connecting the east and west already (and soon the north and south).

So far this year industrial growth has held up pretty well despite slowing manufacturing output, agricultural output looks good in annual terms although the sector is coming off a low base because of last year’s rains. Annual GDP growth should best 6 percent growth and can be expected to go above 7 percent for 2013, according to consensus projections, well above continuing global stagnation.

This is despite slowing global growth and the lingering hangover effects from an “emergency” policy adjustment program the government implemented in February 2012 aimed at addressing a nascent balance of payment crisis fueled by the central bank’s ill- advised ultra-loose monetary policy in the second half of last year. The policy adjustment program included rate hikes, currency depreciation and a large and widely unpopular reduction in fuel subsidies, all of which successfully killed two big birds with one stone. First and foremost, the policy adjustment package helped restore macroeconomic stability, but just as importantly it paved the way for a resumption of the IMF program suspended in September 2011 when IMF officials rightly warned the central bank against deploying foreign exchange reserves to defend the currency.

We are extremely encouraged by Sri Lankan policymakers’ deep new commitment to negotiating a follow up IMF program (after the successful conclusion of the previous one in July 2012). We expect officials to sign a new agreement, including a line of credit in the US$1 - 2 billion range, by November of this year – and we expect this will help anchor foreign portfolio-investor confidence going forward. Policymakers learned a painful lesson last year when snubbing the IMF resulted in near economic calamity.

Wild Card: Ports, Gas, Hydro

Sri Lanka is potentially sitting on vast deposits of natural gas in nine off-shore fields. Two of three fields tested so far have given positive signatures for gas and phase two development of these fields has begun with roughly US$125 million being spent this year on the projects -- not a lot by international standards, but a start. Production on active wells could come into play as soon as three years from now.

Hydro represents 70 percent of Sri Lanka's power generation. This is a blessing when the rains are normal. When they aren’t, it’s a problem. The balance of payments stresses in 2H11 were exacerbated by seasonally high oil imports required to offset lost hydro power resulting from a historic drought. This year’s rains are also showing early signs of weakness. The monsoon rains in India were down 24 percent in June, although they have recovered somewhat since, and rain levels are off in Sri Lanka as well -- suggesting another big year of oil imports in 2012. Oil accounted for 30 percent of imports last year, roughly 42 million barrels.

Two thirds of global sea traffic passes by Sri Lanka, representing opportunity. The government has big plans to inject the country into the pan-Asian supply chain by developing the Hambantota port, which has been open for 18 months, yet only received its first ship more than a year later in June 2012.

Government critics we met with called the port project an unmitigated disaster. We believe it is too soon to conclude disaster, but there is no doubt that private sector expertise and capital are urgently needed in this and other Sri Lankan projects to improve the efficient deployment of scarce public capital resources.

Sri Lanka has been written off as an irrelevancy for decades. Investors now are sniffing around. To keep them interested, the country obviously has to move forward on lots of different fronts, and not just on human rights, as the Hambantota port fiasco shows. Still, there are encouraging signs after so many years of disaster, including what we expect will be a new IMF program announced in the next month or two. The government must capitalize on this and other opportunities to re-build foreign and domestic investor confidence if it wants to continue reaping the peace dividend. The ball is in their court.

(Sam Baker is an Asia specialist for Trans National Research, based in New Jersey, USA. He made a recent fact-finding trip to Sri Lanka.)

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