2012 Investment Climate Statement — Sri Lanka

OPENNESS TO, AND RESTRICTIONS UPON, FOREIGN INVESTMENT

The end of Sri Lankas long-running civil war in May 2009 has opened a new era of economic opportunities and rebounding economic growth. The Government of Sri Lanka (GSL) has set very ambitious goals for economic development, aspiring to GDP growth rates over 8%, and developing economic hubs in ports, aviation, commercial, knowledge and energy. Sri Lanka also provides very strong prospects in tourism and infrastructure. Sri Lankas strong prospects for economic growth have attracted the interest of foreign investors. Sri Lanka can still be a difficult place to do business, however, with an unpredictable policy environment, cumbersome bureaucracy, and a recent asset seizure bill that has created business uncertainty. Further, the government has increased control of the economy recently and is a concern for private investors. Nonetheless, compared to other South Asian countries, Sri Lanka is relatively open to foreign investment. It offers a relatively open financial system, moderately good infrastructure, and generally capable workers. Some U.S. and other foreign investors have realized worthwhile returns on investment in Sri Lanka while others have tried and departed frustrated.

The Government of Sri Lanka (GSL) has created concerns with several economic policies. In November 2011 the GSL rushed through parliament, under an urgent mechanism, a law to seize 37 underperforming companies and assets. Although most of these companies were defunct enterprises, several were operating. The GSL stated that these companies had violated the terms of their land leases with the government. The GSL has promised that this was an one off measure, but the GSL subsequently announced plans to seize 37,000 hectares of allegedly unused tea plantation land. Although the assets seized were not American businesses, the new law, and its passage after one day of debate in Parliament, have created business uncertainty. In another area, stockbrokers criticized laws promulgated by the Securities and Exchange Commission (SEC) to impose price bands and limit credit offered by stockbrokers to their clients. The chairwoman of the Securities and Exchange Commission resigned on principle, and a month earlier the SEC Director General had been transferred to a new position outside the SEC. Although a new SEC chairman has been appointed, there are concerns on the regulation of the stock market.

Strong Economic Growth

Sri Lanka is poised for strong economic growth. Despite the 1983-2009 civil war, GDP growth averaged around 5% from 2000-2008. Due to the global recession and escalation of fighting during the final stages of the war, GDP growth slowed to 3.5% in 2009 and foreign reserves fell sharply. Economic activity rebounded strongly with the end of the war and an IMF agreement resulting in two straight years of 8% growth in 2010 and 2011. Sri Lanka is now a lower-middle income developing nation with a gross domestic product of about $59 billion. This translates into a per capita income of about $2,800, among the highest in the region. There are significant regional disparities with the western province contributing to about 45% of GDP. The contribution of former conflict affected northern and eastern provinces is 3.4% and 5.9% respectively.

There are many bright spots for the Sri Lankan economy, although there are concerns with a large trade deficit and the exchange rate. The economic re-integration of northern and eastern provinces, where the war was fought, has boosted agriculture and fisheries. Reconstruction in the north and east, and infrastructure development throughout the country including new ports and roads, are also fuelling growth. Tourism rebounded strongly and arrivals reached record levels. Inflation, which had reached double digit levels in the war years, was around 6% in 2011. External trade remained strong, but a widening current account deficit is a concern. Sri Lankas exports grew by about 23% in 2011. Imports grew even more strongly by about 50% resulting in a massive trade deficit of $9 billion, up from $5.2 billion in 2010. Contrary to expectations, the loss of GSP Plus trade benefit to EU did not dent export demand. Remittances from migrant workers, at around $5 billion, are Sri Lankas largest source of foreign exchange and helped to partially offset the trade deficit. Sri Lanka also receives multilateral and bilateral financial support. While China has emerged as the largest lender, traditional donors such as the IMF, World Bank, ADB, and Japan as well as neighboring India continue to provide significant funds to Sri Lanka. In 2009, Sri Lanka received IMF assistance to overcome a balance of payments crisis. The fund has so far disbursed $1.7 billion to Sri Lanka under its $2.6 billion loan program, but the IMF program is under indefinite review. Increased foreign commercial borrowings including a $1 billion Eurobond have also helped external reserves, which reached $6 billion (4 months of imports) in 2011. The IMF has cautioned Sri Lanka about the declining non borrowed reserves. Despite the widening current account deficit, the Central Bank of Sri Lanka intervened in the foreign exchange markets throughout 2011 to keep the rupee stable until it was depreciated 3% in November. Some analysts believe that the rupee is still overvalued.

The Central Bank expects the economy to continue to grow by 8% in 2012 aided by growth in all sectors of the economy. Sri Lankas growth prospects could be affected due to economic problems in the U.S. and EU, the key export markets. The Central Bank forecasts inflation to remain at single digit levels. Government fiscal control has improved, but the losses of state controlled companies are a major concern. The budget deficit reached 8% in 2010, and is forecast to fall to around 7% in 2011 and 6.2% in 2012. The public debt has at times reached close to 100% of GDP, but due to declining budget deficits and strong economic growth it has declined to 78% of GDP in 2011.

FDI has increased since the end of the war but remains relatively low. Sri Lanka continues to struggle to attract FDI as the government sends mixed signals to the investor community. One exception is the tourism sector. For the first time, several regional and international hotel chains have expressed a strong interest in developing properties in Sri Lanka. Investor interest in other sectors has been limited. Sri Lanka expects FDI to reach $1 billion in 2011, its highest level ever.

Stable Political Situation

Sri Lanka is a stable parliamentary democracy. In 1978, it shifted away from a socialist orientation and opened to foreign investment, although changes in government have often been accompanied by reversals in economic policy. Of the two major parties, the more pro-business United National Party has been in opposition in recent years. When it last held power, from 2002 to 2004, it pursued privatization and regulatory reform welcomed by domestic and foreign investors.

In January 2010, President Rajapaksa was re-elected for a second six year term, which commenced in November 2010. President Rajapaksas Sri Lanka Freedom Party-led government also won Parliamentary elections in May 2010, and holds a two-third majority, giving President Rajapaksa control of the legislative branch.

Statist Economic Policy

The GSL follows a rather statist economic policy, guided by Mahinda Chintana (Mahindas Thoughts). Mahinda Chintana seeks to reduce poverty by steering investment to disadvantaged areas; developing small and medium enterprises; promoting agriculture; and expanding the already enormous civil service. The Rajapaksa government has halted privatization reversing several previous privatizations and advocates state control of what it deems strategic enterprises such as state-owned banks, airports, and electrical utilities. The government has increased its control of the banking sector utilizing government controlled funds and companies to take majority control of leading private banks. The Sri Lankan military is also slowly becoming engaged in activities traditionally reserved for the private sector including air and sea transport and tourism. The government has adopted import substitution strategies. Taxes on imports remain high although the government removed taxes on certain intermediate imports to make the country a trading hub. The Mahinda Chintana plan aims to double Sri Lankas per capita income to $4,000 within six years. To do so, Sri Lanka requires GDP growth well over 8%, and the investment rate needs to rise from 27% of GDP to 35% of GDP. The majority of investment is expected from private investment as public investment is expected to remain around 6.5%. Mahinda Chintana seeks to develop Sri Lanka as a regional hub for air and sea transportation, trading, energy, and knowledge based services.

While the state is a major player in many economic sectors, there is a strong private sector that plays a key role across the economy including in finance, exports, tea, apparel, IT and tourism. However, both local and multinational companies complain that increasing government role in business is harming the investment climate. Though many multinational companies perform better than the local private sector, international MNCs and SMEs feel the government is blatantly biased towards local companies. Some investors are concerned, that Sri Lanka is becoming a highly nationalistic environment where the government is prone to blame foreigners for its economic and social ills.

Sri Lanka has established strong economic ties with Asian countries such as China and India. China has increased its political influence and is a major player in infrastructure development, building ports, power stations and roads. Several GSL leaders believe that Asia is their future, although Sri Lankas exports still are primarily destined for Western markets.

Despite the generally bright prospects, there are still significant impediments to investment in Sri Lanka, such as inconsistent economic policies, bias towards state control of the economy, the workers declining English language skills, inflexible labor laws, overburdened infrastructure (although the GSL is moving to improve roads and ports), and an unreliable court system. Sri Lanka boasts a 90% literacy rate in the local Sinhala and Tamil languages, but English, which was once widely spoken, is now less prevalent. The government has launched a drive to increase English proficiency. Sri Lankas labor laws include many model protections, but can make it nearly impossible for companies to lay off workers even when market conditions fully warrant doing so. The cost of dismissing an employee in Sri Lanka is, percentage-wise, one of the highest in the world. Until recently Sri Lanka has not invested in infrastructure to keep pace with its growth. Its roads are narrow and congested. With the conclusion of the war, Sri Lanka is renovating and constructing roads in the North and East. Multi-year projects to expand the ports in Colombo and Hambantota are underway.

Sri Lankas electricity supply is generally reliable but can fail to meet peak demand in years of low rainfall. Electricity costs are priced higher than in other Asian countries. Businesses in Sri Lanka also face high interest rates, although rates have come down in the past few years. Sri Lankas courts cannot be relied upon to uphold the sanctity of contracts. The courts are not practical for resolving disputes or obtaining remediation, because their procedures make it possible for one side in a dispute to prolong cases indefinitely. Aggrieved investors (especially those dealing with the government on projects) have frequently pursued out-of-court settlements, in hopes of speedier resolution. In late 2008, the Supreme Court, in an interim order, halted payments to five international and local banks involved in oil hedge contracts with the government. One of the involved banks is American. The record on international arbitration is mixed, as one bank won its case, the government won one case (against the American bank), and there has not been a decision in the third case.

Trade

According to preliminary data for 2011, Sri Lankas exports (mainly apparel, tea, rubber, gems and jewelry) were $10.5 billion and imports (mainly oil, textiles, food, and machinery) were $20.0 billion. Although Sri Lanka has a $9 billion trade deficit with the world (primarily India and China), the United States has a large trade deficit with Sri Lanka. Exports to the United States, Sri Lankas second largest market, are projected to be $2 billion in 2011, or 19% of total exports. The United States is Sri Lankas second biggest market for garments, taking about 40% of total garment exports. The United States exports to Sri Lanka are projected at $250 million in 2011. U.S. exports consist primarily of wheat as well as industrial machinery, medical instruments, aircraft parts, lentils, paper, specialized fabrics and textiles for use in the garment industry, fruits and pharmaceuticals. United States investors have invested approximately $200 million in foreign direct investment. U.S. investors are much more significant in portfolio investment; for example, U.S. investors purchased a little over 40% of a $1 billion sovereign bond fund in 2011.

Board of Investment

The Board of Investment (BOI) (www.investsrilanka.com ), an autonomous statutory agency, is the primary government authority responsible for investment, with a focus on foreign investment. The BOI recently underwent a major restructuring process in order to improve its ability to capture foreign direct investment. BOI promotes the following sectors as priority sectors for FDI: Tourism and leisure, infrastructure, knowledge services, utilities, apparel, export manufacturing, export services, agriculture and education. Specialized divisions representing these sectors strive to provide services to foreign investors through the entire investment process.

Large investment projects, both local and foreign, identified as strategic development projects are handled by the Treasury and a special Cabinet Review Committee, outside of the BOI. These projects require approval from the full cabinet, a process which is not transparent and which can politicize even the most urgently needed investments. Parliamentary approval is also needed for these projects.

The BOI manages a number of export processing zones which feature business-friendly regulations and improved infrastructure for foreign investors. The BOI is intended to provide one-stop service for foreign investors, with duties including approving projects, granting incentives, and arranging services such as water, power, waste treatment, and telecommunications. It also assists in obtaining resident visas for expatriate personnel, and facilitates import and export clearances.

BOI incentives are attractive and real, but the BOI is not the one stop shop it aspires to be. Although it is relatively effective in assisting investors who want to establish operations within its industrial processing zones, it is less effective in facilitating and servicing large investments outside these zones. Sri Lankas large, inefficient, and dated bureaucracy often works at cross-purposes with BOI authorities and commitments. Registration of foreign company branch offices in Sri Lanka can be cumbersome as well.

Even with incentives and BOI facilitation, foreign investors face difficulties operating in Sri Lanka. Problems range from difficulty clearing equipment and supplies through customs speedily to difficulty obtaining a factory site. Legal challenges to environmentally sensitive projects have been burdensome, even when objections are unfounded. Slow and indecisive application of bureaucratic requirements has also obstructed investment. In part to avoid these delays, and to overcome land allocation problems, the BOI encourages investors to locate their operations in BOI-established industrial processing zones. Investors locating in industrial zones also get access to relatively better infrastructure facilities such as reliable power, telecommunications and water supplies.

Laws Affecting Investment

The principal law governing foreign investment is Law No. 4, created in 1978 (known as the BOI Act), as amended in 1980, 1983 and 1992, along with implementation regulations established under the Act. The BOI Act provides for two types of investment approvals. Under Section 17 of the Act, the BOI is empowered to recommend concessions to companies satisfying certain eligibility criteria on minimum investment. Such companies are eligible for generous investment concessions granted under the Inland Revenue Act Section 17(A). Investment approval under Section 16 of the BOI Act permits companies to operate under the normal laws of the country and applies to investments that do not satisfy eligibility criteria for BOI incentives. Strategic Development Project Act of 2008 (SDPA) provides generous tax incentives for large projects identified by the Cabinet of Ministers as Strategic Development Projects. The government has recently granted incentives to Shangri-La hotels for hotel projects and to Cairn Lanka Ltd for oil exploration under the SDPA. Other laws affecting foreign investment are the Securities and Exchange Commission Act of 1987 as amended in 1991 and 2003, and the Takeovers and Mergers Code of 1995 revised in 2003. A new Companies Act came into effect in 2007, replacing the Companies Act of 1982. The new law aims to improve trade and commerce as well as corporate governance in the business sector. It features simplified regulations concerning company formation; provisions specifying the duties of company directors; provisions to prevent the abuse of powers by directors; provisions to protect creditors; and a dispute board to settle disputes among directors. Various labor laws and regulations also affect investors. See sections below.

Foreign Equity Shares by Sector

The government allows 100% foreign investment in any commercial, trading, or industrial activity other than a few specified sectors mentioned below.

The following sectors are regulated and subject to approval by various government agencies or the BOI: Air transportation, coastal shipping, large scale mechanized mining of gems, lotteries and manufacture of military hardware, military vehicles and aircraft, dangerous drugs, alcohol, toxic, hazardous or carcinogenic materials, currency and security documents.

Foreign investments in the areas listed below will be limited to 40% of foreign equity. Foreign ownership in excess of 40% will be approved on a case by case basis by the BOI: The production for export of goods subject to international quotas, growing and primary processing of tea, rubber, coconut, timber based industries using local timber, deep sea fishing, mass communications, education, freight forwarding, travel agency and shipping agency business. The GSL is considering opening higher education to foreign investment.

Foreign investment is not permitted in the following businesses: non-bank money lending; pawn-brokering; retail trade with a capital investment of less than $1 million and coastal fishing.

Privatization Halted

The GSL has halted privatizations, preferring to maintain state-owned enterprises, and has even reversed several privatizations. In 2008, the Supreme Court cancelled a privatization of a government-owned bunkering company, done in 2002, stating that it was illegal. In 2009, the Supreme Court cancelled a 2003 sale of a government-owned large insurance company. In 2010, the government bought back shares of two privatized companies when their owners sought to exit the companies. In one instance, the government bought shares of Sri Lankan Airlines, the national carrier, from Emirates Airlines of UAE. The government also bought shares of Shell Gas Lanka held by Royal Dutch Shell Company.

Labor unions in state-owned enterprises are often opposed to privatization and restructuring and seem particularly averse to foreign ownership. In the past, this made the privatization of government entities problematic for new foreign owners.

Sri Lanka ranks 89th out of 183 countries in the World Banks Doing Business 2012 Index, ahead of its South Asian neighbors except Maldives (87). Within the index, Sri Lanka ranked at 38th in terms of starting a business, 42nd in resolving insolvency and 46th in protecting investors. The country ranked lower at 173rd in paying taxes, 161st in registering property, 136th in enforcing contracts, 111th in dealing with construction permits, 95th in getting electricity and 78th in getting credit. The GSL is trying to improve Sri Lankas ranking in the index.

INTERNATIONAL BUSINESS RANKINGS