Sri Lankan markets jittery as bullets fly ahead of next week’s budget

November 10, 2006 (LBO) – Sri Lankan share prices are breaking records amidst flying bullets, but financial markets are uneasy that the government may use next Thursday’s budget to tax capital gains, analysts said. One of Asia’s best performing indexes, the island’s tiny stockmarket is up over 30 percent since January, largely on deal making on few blue chips and mid sized stocks.

Share prices climbed down from its highs on Friday as the Sri Lankan navy and Tamil Tiger rebels fight a fierce sea battle and a pro-rebel lawmaker Nadarajah Raviraj was gunned down in the capital, spooked investors, traders said.

“I strongly fear a capital gains tax may be brought in to pay for some of the heavy expenses,” says Murtaza Jafferjee, Managing Director of JB Stockbrokers. “Stockmarket was hitting all time highs for the past few days with people making a lot of money as well.”

Sri Lanka’s president Mahinda Rajapakse, who is also the country’s finance minister, presents the November 16 budget amidst a surge in violence and mounting international condemnation over heavy civilian casualties in the conflict.

Financial markets are hoping Rajapakse’s budget box will contain measures to retain investor confidence and not raise taxes to pay for expensive military purchases.

Government spending is due to go up 42 percent to 804.6 billion rupees next year, according to the 2007 budget appropriation bill before legislators in October.

Military spending is due to rise 45 percent to 139.55 billion rupees next year from an estimate of 96.21 billion rupees in 2006.

The military's capital spending, which reflects purchases of weapons and other equipment, jumped almost three-fold with the army, navy and the air force budgets leaping while police capital spending showed a decline.

Traders said uncertainty could drive stocks down further next week, while bond markets would depend more on next year’s replacement budget.

Sri Lanka's 24-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. Ultimately, the pressure will come from the war front and international crude prices, which leaves very little room for the government to maneuver next year,” says Dushyanth Wijayasinghe, head of research at Asia Securities.

“I feel the government may raise taxes on non-essential goods to reduce the country’s import bill a bit,” Wijayasinghe said.

The economy has expanded every quarter since a ceasefire was signed with the rebels in February 2002, with third quarter growth for 2006 due to hit 8.0 percent, according to treasury secretary P B Jayasundara.

"Investors dislike uncertainty, they may sit out and wait till things get a bit clearer," said Channa Amaratunga, chief investment officer at Boston Asset Management.

However, a permanent peace deal with the Tamil Tigers is seen as vital to achieving double-digit growth in the eyes of international lenders.

“I still maintain that making progress towards sustainable peace, achieve and maintain economic stability, and deepen economic reform, particularly in areas which would invite investment and enhance efficiency and productivity, are all keys to move Sri Lanka to a path of higher and sustained growth,” says Luis M Valdivieso, IMFs Senior Representative for Sri Lanka.

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 and add pressure on the exchange rate.

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Deputy Finance Minister Rankith Siyambalapitiya said the government was looking at shrinking the budget deficit to 5 percent of gross domestic product next year, from an estimated 9.0 percent in 2006 based on higher tax collections.

He said the government does not plan to introduce new taxes but will bring in measures to improve revenue collection through streamlining the existing tax system.

Valdivieso says it is important the budget be ‘consistent with the government's commitment to reduce the deficit’.

“It is not news that there are pressures on the public finances related to the uncertain security situation, hence it will be key that the government will be as explicit as possible about the trade-offs they have encountered and what decisions they had to make to offset whatever unexpected expenses while trying to keep the overall deficit target,” Valdivieso adds.

Three decades of ethnic bloodshed has claimed over 60,000 lives in Sri Lanka. .