By Cherian Thomas and Stephen Foxwell
Nov. 6 (Bloomberg) -- Sri Lanka's central bank Governor Nivard Cabraal said he'd back an increase in defense spending because it is vital to end the nation's 25-year civil war for the economy to prosper.
``The urgency of it is certainly greater now,'' Cabraal said in an interview yesterday in his office in Colombo. ``No country can progress with a war at your backyard all the time; take a tough stand and finish with it.''
President Mahinda Rajapaksa will present his budget in parliament today to spell out how he'll fund record military outlays without relying on overseas funds. Currency reserves have dropped by almost a quarter in the past two months and the rupee slid to a record low as concern of a global recession sparked an exodus from emerging markets.
``The military will be top priority in the budget, that is especially the case now when the military appears to be at a stage in the war when they just have to `finish off the job','' said Agost Benard, an associate director at Standard & Poor's in Singapore. ``The international capital markets are virtually shut, so it will not be easy to borrow externally.''
Rajapaksa's fund-raising options at home are constrained by interest rates at a six-year high and an economy projected to expand at the slowest pace in four years. He needs funds as defense outlays are forecast to rise to 177.1 billion rupees ($1.6 billion) in 2009, from 166.4 billion this year, as the government pushes to defeat the separatist Tamil rebels.
`Feeling Pinch'
``They can't play around too much on the revenue front as companies are already feeling the pinch,'' said Dushni Weerakoon, deputy director of Sri Lanka's Institute of Policy Studies in Colombo. ``If they can pull off a military victory, they can depend much more on reconstruction aid flowing in coming budgets.''
Foreign currency reserves slumped to $2.6 billion last month from $3.3 billion in August, Cabraal said. The rupee had its biggest drop in two years last week after the central bank said it would allow a limited depreciation to shield exporters from slowing global demand for tea and textiles.
Economic growth is likely to slow to 6 percent to 6.5 percent this year, the Central Bank of Sri Lanka said in an annual review released today. That's slower than the 6.5 percent to 7 percent estimated by Cabraal on Oct. 2.
Switched Tools
Cabraal said the central bank has switched from using its benchmark interest rate as its main monetary tool and instead relied on reducing the amount of money in circulation in the economy to slow bank lending and check inflation.
Rates at which consumers and companies borrow from commercial lenders have increased by an average 7 percentage points in the past year because of this, the central bank said. The monetary authority is scheduled to release its November policy review next week.
``We have seen overall reserve money target working and if it works we do not see a reason to fix it,'' Cabraal said. ``We found that the policy rate increasing did not have the impact on inflation that we wanted it to have.''
Inflation will be ``appreciably less than 20 percent this year,'' Cabraal said, and it will touch a single digit by the end of 2009, unless something untoward happens. Economic growth will accelerate to between 6.5 percent and 7 percent next year driven by increased agricultural output, the central bank said.
``Our job is to ensure inflation is brought down, that we respond to this crisis in the world, but at the same time ensuring the growth momentum is not killed,'' the governor said. ``We have been maintaining that and we are on track.''
Slowing Growth
Sri Lanka, the world's fourth-biggest tea grower, plans to curtail production and buy tea at auctions to support prices as overseas demand for the commodity slumps because of the credit crisis, the state-run tea board said last month.
Slowing growth, a dependence on foreign borrowings and an overvalued currency pose a ``serious risk'' to economic stability, the International Monetary Fund said last month.
Cabraal, 53, said the nation has maintained its ability to service debt, pointing out that debt as a percentage of gross domestic product will drop to 80 percent this year from 102 percent in 2001.
The $32 billion Sri Lankan economy had total outstanding debt of $12 billion at the end of 2007, the governor said.
Ending Conflict
Rajapaksa has said ending the conflict with the Tamil separatists will turn the war-ravaged east and north into productive parts of the economy, increasing output of rice and freeing up access to the nation's only natural deep-water port.
The Liberation Tigers of Tamil Eelam, who have been fighting for a separate homeland, have been pushed into one stronghold in the north by the Sri Lankan military in the past two months. Sri Lanka spends a fifth of its budget on the army, navy and air force, almost double neighboring India's defense outlays by percentage.
``If you continue to spend 3.6 percent of GDP as defense and there is nothing to show at the end of the day, it is of no use,'' Cabraal said. ``If you spend 3.8 percent of GDP on defense and if you have something to show at the end of it, then that certainly has value.''
To contact the reporters on this story: Cherian Thomas in New Delhi at Cthomas1@bloomberg.net; Stephen Foxwell at sfoxwell@bloomberg.net.
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