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InterviewsMarch 30 2010

Ajith Nivard Cabraal

Central bank governor of Sri Lanka, Ajith Nivard CabraalHaving emerged from years of civil war, Sri Lanka is in a position to address its long-term economic development and infrastructural regeneration. The country's central bank governor discusses his monetary policy for 2010 and explains how it will work alongside the government's reform plans. Writer Michelle Price
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Ajith Nivard Cabraal

The central bank governor of Sri Lanka, Ajith Nivard Cabraal, recently visited London at a seminal moment in his country's modern history: following last year's defeat of Sri Lanka's ethnic minority separatist group the Liberation Tigers of Tamil Eelam (LTTE), the country is enjoying peace after some 26 years of civil war.

But the crushing of the LTTE under the popular president Mahinda Rajapaksa, elected to power in 2004 on a mandate to defeat the LTTE, has strained Sri Lanka's relations with Western governments, who have accused Mr Rajapaksa's administration of wartime human rights violations. In January, Mr Rajapaksa won a second term, defeating former army commander general Sarath Fonseka in what proved a tumultuous and brutish election.

Riding a post double-victory high, the Rajapaksa administration hopes to repair fractured relations with Western governments and reap the long-awaited economic dividend promised by peace. And according to Mr Cabraal, who visited London in February to promote the new, post-conflict Sri Lanka to Western investors, the country has a strong economic story to tell: in recognition of Sri Lanka's long-term speedy economic development, the International Monetary Fund (IMF) recently upgraded the country to middle-income emerging market status and has forecast gross domestic product (GDP) growth of 5% for 2010.

The Sri Lankan government, meanwhile, is targeting an exuberant 8% growth on the basis of what Mr Cabraal claims are solid macro-economic fundamentals. "Inflation, interest rates, unemployment: all those are now at benign levels. This means Sri Lanka can now have a fresh start."

Profit in Peace

Peace, that most fundamental of fundamentals, is also expected to endure. "I am able to very confidently say that we have put the chapter with regard to terrorism behind us," says Mr Cabraal. Economic development and infrastructural regeneration are central to the government's plan to build a long-standing, sustainable peace, with $1bn a year allocated to regenerating the northern Tamil-dominated regions. Bank lending in the country is slowly beginning to recover and the banking sector, through the distribution of credit, also has a "crucial role to play" in sustaining peace, says Mr Cabraal.

In a much-celebrated development, HSBC Sri Lanka opened a branch in the country's former war zone in February, making it the first foreign bank to venture into the troubled northern region since the conflict began. "It is a very important signal that not only are the local banks opening in the previously conflicted areas, but even foreign banks have the confidence to go and invest too," says Mr Cabraal. The signs are positive: the central bank has already approved some 70 licence applications to establish branches in the north of the country.

Enfranchising the minority ethnic Tamils into the formal financial system will not only play a role in promoting much-needed economic development, but it will also help ensure that the resulting prosperity is more evenly distributed. This issue is critical. Historically, investment and economic development in Sri Lanka has largely centred on the western province in the vicinity of Colombo, creating divisive economic disparities. Mr Cabraal says that the post-war regeneration plans are more evenly distributed and locally focused, and the government plans to fund a project in every village: "All of these [measures] on a national, provincial and village level will [ensure] the evenness of the economic growth is maintained. [This] will have a major impact on the stability of the nation."

Multilateral funding

Many of the major infrastructure projects are being funded through multilateral agencies such as the Asian Development Bank and the World Bank, and the country has taken on bilateral loans from the likes of India, Malaysia, China and Iran. The government plans to fund further reconstruction through the sale of $500m-worth of 10-year dollar-denominated bonds after the budget is unveiled in April, following the parliamentary elections. Previous debt sales have garnered major interest, with the country's October 2009 sale of $500m-worth of five-year bonds some 13 times oversubscribed. But the government may be forced to pay a higher coupon on its next bond sale as it has become increasingly apparent that the war and reconstruction efforts, combined with the global economic slump, have taken their toll on the government's coffers.

In late February, the IMF delayed the third tranche of a $2.6bn loan approved in July 2009 after the Sri Lankan government announced that it had missed its 2009 deficit reduction target by a wide margin hitting an eight-year high of 9.7% of GDP. The IMF agrees, however, that economic conditions overall are improving. But the fund will wait until the budget is unveiled in April before it considers releasing the third tranche. Mr Cabraal downplays the situation: "The IMF is satisfied with the programmes we have launched and the programmes we will launch in future," he says. "We are in a dynamic process: certain situations need different approaches at different times. The IMF recognises that."

Inflation concern

Inflation is another area of concern for some onlookers. Headline inflation has risen consecutively for the five months leading up to January 2010, accelerating to a 12-month high of 6.9% in February of this year, although this is a far cry from the double-digit inflation seen in 2008. Onlookers believe, however, that the central bank governor, who has kept rates at a five-year low of 9.75% for reverse repurchase and 7.5% for repurchase since November, will be forced to raise rates in due course. According to Mr Cabraal, however, the central bank has kept rates relatively high compared with other Asian economies.

"We did expect this shift in the inflation rate in this period and that there would be a base effect taking place, and to provide for that we deliberately kept interest rates higher," he says, adding that the central bank expects inflation to accelerate until April and then moderate. Nor has it "ruled out" raising the country's reserve deposit ratio, which is currently 7%, suggesting that Mr Cabraal may seek to tighten monetary policy without raising rates. Moreover, political analysts believe that Mr Rajapaksa will seek to suppress the cost of living and borrowing to preserve his party's popularity in the lead up to the April elections, making a rate rise even less likely.

Although political analysts say that the president does not take an active day-to-day interest in running the economy, the central bank has been accused of allowing such political pressures to influence monetary policy decisions in the past. What does Mr Cabraal say to critics who claim that the central bank lacks independence? "I would tell them to look at our track record," he says. "During the past few months we kept interest rates at very high levels, giving a huge burden to the government. No central bank, unless it is independent or strong enough, would have been able to do that," he adds. "At the same time, we have a good relationship with the government and I think you do need to have a good relationship."

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Best of enemies: Mahinda Rajapaksa (left), Sri Lanka's president, and former army general Sarath Fonseka (right) had worked side by side during the country's civil war but fought a tumultuous election this year

Investor interest

Foreign investors have certainly been encouraged by the end of the civil war, but inflows have largely been channelled into Treasury bills: in 2009, foreign investors bought $1.7bn-worth of Treasury bonds and bills in the months from May to November, according to the central bank. Portfolio investors have been put off, however, by the government's widening budget deficit. According to Reuters, offshore investors in the Colombo Stock Exchange, which was one of the best-performing bourses globally in 2009, proved net sellers throughout the first quarter of 2010.

As peace ensues, a general surge in foreign investment is anticipated. But both portfolio investors and potential foreign direct investors complain of ongoing hurdles, in particular a burdensome corporate tax rate and an obstructive level of bureaucracy: the country ranks 105 in the World Bank's 'Doing Business 2010' report, although this still puts it some 28 places ahead of neighbouring India. Mr Cabraal recognises these complaints and points to a tax commission which was recently established to make recommendations regarding tax reforms. "That will be an important piece of advice. Sri Lanka's tax irregularities or weaknesses will be addressed and we are taking steps to ensure that the different areas where we have been weak, and the ease of doing business, will improve," he says.

During the presidential election, Mr Cabraal also announced plans to relax currency controls as part of his monetary policy programme for 2010. Under the sweeping reform programme, foreign investors will be allowed to purchase Sri Lankan corporate debt, while Sri Lankan companies will be able to invest in foreign equity and debt instruments and list on foreign bourses. But the government was forced to backpedal on this pledge amid bitter accusations voiced by Mr Fonseka's opposition supporters that key members of the administration would exploit a relaxation of currency controls to siphon their personal assets out of the country.

With political victory safely established, the row has subsided and Mr Cabraal says that the central bank remains firmly set on this path. "This year's road map clearly states that there will be certain relaxations in terms of investment out as well as investment into Sri Lanka: that is on target and that will happen," he says. "Sri Lanka is now considered to be a middle-income emerging market nation and we have to change our policies to suit that status," he adds.

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