Traders said uncertainty could drive stocks down further this week, while bond markets would depend more on a replacement 2006 budget from Sri Lanka's new President Mahinda Rajapakse.
Sri Lanka's tiny stock market has lost 600 million dollars in value since Friday as investors feared the country would return to war. The amount wiped out was slightly higher than the country's annual defence budget.
"Factors in the north (the outbreaks of violence) are giving the market the creeps at the moment," said Namal Kamalgoda, Chief Investment Officer at Eagle NDB Fund Management.
The Colombo bourse crashed 5.7 percent on Tuesday, after falling three percent on Monday, as investors dumped tourism and property related stocks, two of the most vulnerable sectors at this time of unrest.
Sri Lanka's tourist arrivals fell 25.
8 percent year-on-year to 44,095 in October, the sharpest monthly percentage decline since January, the tourist board said Tuesday.
Visitors have stayed away from the traditional resorts following last year's tsunami and the hospitality industry heads for the busy winter season with half of its rooms empty.
Sri Lanka's 20-billion-dollar economy is heavily dependent on foreign remittances, clothing and tea exports, and tourism. which is sensitive to the country's deteriorating security situation.
"It will be interesting to see how the government manages the present situation. If not handled properly things could escalate," says Alastair Corera, Country Head of Fitch Ratings Lanka Limited.
The economy has expanded every quarter since a ceasefire was signed with the rebels in February 2002. A permanent peace deal with the Tamil Tigers is seen as vital to achieving double-digit growth in the eyes of international lenders.
"Investors dislike uncertainty.
Two days of incidents have already spooked investors and they may sit out and wait till things get a bit clearer," said Channa Amaratunga, chief investment officer at Boston Asset Management.
"Investors are likely to be cautious as they await President Mahinda Rajapakse's next move in handling the peace process and the budget," he said.
Rajapakse, in his capacity as finance minister, is expected to present the revised budget on Thursday to include welfare measures promised in his election manifesto.
The budget is expected to focus on wage hikes for state employees and subsidies to farmers, two things analysts say could widen the deficit and lead to more inflation.
The 'extras' come with a 50 million dollar price tag, which is likely to widen the budget deficit marginally by about 0.
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2 percent of gross domestic product, analysts said.
The 2006 budget presented on November 8, which was later scrapped, set a nine percent deficit target, higher than this year's estimate of 8.5 percent.
The defunct document forecast total spending for 2006 of 721 billion rupees (7.21 billion dollars), compared with 586 billion rupees this year.
The government was hoping to raise 4.77 billion dollars in revenue in 2006, up from 3.86 billion dollars this year, by slapping higher taxes on banks, companies, tobacco and alcohol sales.
However, if violence in the troubled northeast intensifies, the government may be forced to tap international capital markets to fund its spending plans.
Analysts say the government is unlikely to borrow from the domestic market as it would not want to widen the deficit too much ahead of plans to secure a sovereign rating.
Three decades of ethnic bloodshed has claimed over 60,000 lives in Sri Lanka. - AFP
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