Sri Lanka has just celebrated the first anniversary of victory over the Tamil Tiger separatists, which ended a three-decade war and ushered the Indian Ocean nation into the ranks of Asia's emerging frontier markets. Recently re-elected President Mahinda Rajapakse has a powerful parliamentary majority and is now turning his attention to long-awaited economic and political change. Following is a summary of key risks to watch in Sri Lanka: Uncertainty over IMF loan The International Monetary Fund said it was encouraged by Sri Lanka's proposals to bring deficit reduction back on track, chiefly through measures to be included in the 2010 budget due in parliament on June 29. The IMF delayed disbursement of the third tranche of Sri Lanka's $2.6 billion loan in March, saying it wanted to see the fiscal reforms in the budget first. A pair of elections which ended in April prompted Rajapakse to delay the budget. Sri Lanka missed by a wide margin the 2009 IMF budget deficit targets, and has said it wants to negotiate less demanding goals. The IMF, after a mission to the island, has said it would not rule that out. What to watch • The IMF executive board's decision, which is expected to come after the budget is presented. It is possible the IMF could release both the third and fourth tranches together. • The influence of allies of the president who say the loan is no longer necessary, since it was intended to solve a balance-of-payments crisis when foreign reserves dipped to just $1.27 billion. They have now climbed to over $5 billion. • The reaction of credit ratings agencies if the IMF or government cancels the loan. It was a key factor in getting Sri Lanka's credit rating raised after the war, and this gave foreign investors the confidence to come in. If the loan is cancelled, capital flight could be a risk. The Rajapakse factor The president, like many in Sri Lanka and south Asia before, has made politics a family affair. His elder brother is the parliament speaker, and his youngest brother is in charge of the new economic development ministry responsible for tourism, nation building and investment promotion. Another brother, the defense secretary, is now in charge of the agency responsible for developing prime government real estate in Colombo, by moving buildings to the administrative capital of Sri Jayawardenapura. The president is also the finance minister, so in short, any big investment decision needs the blessing of the Rajapakses. What to watch • Whether Rajapakse and his family show evenhandedness in the development of public-private investment partnerships. • Whether Rajapakse can shake off concerns that investments can be interfered with by the government. Privately, some wealthy local investors say they are afraid to commit because they worry the government could meddle with their investments or use them as pawns in the political arena. Constitutional change The president's ruling alliance has 144 seats in the 225-member parliament, just six shy of the two-thirds majority he needs to change the constitution. He has been vague about proposed changes, aside from saying he might create a second house of parliament, do away with the problem-plagued preferential voting system and abolish the powerful executive presidency he now enjoys. Some of his allies say they want to remove the presidency's two-term limit as their first priority. Sri Lanka has had a relatively disastrous history of changes wrought by constitution and many Sri Lankans are watching to see whether Rajapakse follows a more virtuous path. What to watch • The crossovers Rajapakse engineers to give himself the two-thirds majority. Already, there is talk he will not do this until he takes his oath for his second term in November. • The concrete reforms the president proposes, and whether they tend to favor him or the polity as a whole. The rupee and inflation Under Central Bank Governor Ajith Nivard Cabraal, inflation has fallen from more than 28 percent in 2008 to single digits. But it has been rising again, and the governor says he is willing to tighten monetary policy to keep it in check, after loosening it last year to spur private-sector credit growth. Still, credit growth is negative year-on-year. The rupee currency is being pushed upwards by economic fundamentals and the central bank policy is not to allow any swift movement. What to watch • Any monetary tightening and the corresponding reaction of the inflation and credit growth rates. • A change in regulations to boost banks' statutory reserve requirements, which Cabraal has said is an option. • Any move to relax currency controls, and the reaction of the exchange rate. Most currency traders expect the rupee would rise, which would not please exporters who contribute 17 percent of Sri Lanka's $42 billion GDP. International relations Western countries, and groups in the Tamil diaspora, are pressing for some kind of accountability for thousands of civilian deaths at the end of the war. Sri Lanka is adamant its soldiers did not violate human rights or commit war crimes, but international disquiet has cost it enhanced European Union trade preferences, known as GSP+, worth $100 million a year. However, Sri Lanka's willingness to turn to countries like China and Iran appears to have prompted the West to take a softer line, and India remains a close ally. What to watch • Whether Sri Lanka can reach a deal with the EU to get GSP+ back. Talks are on now and the reinstatement of the trade concession would help Sri Lanka's garment industry, its top foreign exchange earner.
