PARADISE POSTPONED
After two years of peace and progress in war-torn Sri Lanka, political troubles are once again clouding the economy. Are the bad old days back? And what are companies doing to manage the risk?
By Justin Wood

In the corner of Ronnie Peiris's office at John Keells Holdings (JKH) in Colombo stands a whiteboard that makes for unnerving reading. Written on it are the thoughts of senior managers on what risks lie ahead for the US$172 million-a-year conglomerate, one of Sri Lanka's biggest.

Top of the list with a score of 5 out of 5 for likelihood - signifying "almost certain" - comes political instability. Next up, with a score of 4 - or "likely" - sits "infrastructure development disruption".

Each risk is also assessed for its potential impact, although Peiris asks that these scores remain confidential. Safe to say, the results of the exercise would be enough to make many managers balk - but not Peiris. Indeed, after 24 years working abroad, Peiris joined JKH as its new finance director last year specifically to help the company navigate those risks. His reason? A turnaround in the fortunes of his native Sri Lanka.

After 20 years of bloody civil war, a cease-fire signed in 2002 promised to bring stability to the island nation and bless its economy with a much-needed "peace dividend". Peiris and many others like him rushed back to help rebuild their country. Foreign investors were equally eager to get involved and the future of the 19 million people of Sri Lanka never looked brighter. "The whole economy blossomed," recalls Peiris, "and people felt liberated. Suddenly Sri Lanka was no longer isolated by war. It became a world citizen and everyone's horizons were broadened."

But after two years of progress and excitement, could the good times be about to end? Some commentators certainly think so, for just as Peiris and his colleagues at JKH feared, political instability has raised its ugly head in recent months and cast a shadow over the country's peace process. Investors and businessmen alike are holding their breath, praying that politicians do the right thing. But as ever in Sri Lanka the potential for disaster is never far away.

Sri Lanka rancor

The ethnic conflict has a complex past. Under colonial rule, the majority Sinhalese population, who are largely Buddhist, complained bitterly of British favoritism towards the minority Tamils, who tend to be Hindus. Following independence in 1948, however, a Sinhalese-controlled government came into power and then it was the turn of the Tamil community to feel oppressed. Their grievances centered on many issues, from university admission policies to hand-outs of government land.

As time went by, demonstrations broke out which grew into riots and then full-blown war in 1983 as the Liberation Tigers of Tamil Eelam (LTTE) fought to set up a separate homeland in the northeast of the island. Twenty years of bitter strife followed, depriving the country of two decades of development and leaving 65,000 dead and almost a million more people displaced.

By December 2001, however, both sides were tired of war and a new government under the leadership of Ranil Wickremesinghe swept to power on a pro-peace platform. By February 2002 a cease-fire was signed that has stuck to this day. The benefits of two years of peace are plain to see. Whereas Sri Lanka's economy contracted by 1.5 percent in 2001, it grew by 4 percent in 2002. It then expanded by 5.7 percent in 2003 and the Central Bank expects GDP growth of 6 percent this year.

Tourists visiting Sri Lanka's beaches and wildlife reserves have risen by a staggering 70 percent, from 300,000 in 2001 to more than half a million in 2003. Military roadblocks have been lifted and highways to the north and east opened, boosting demand for goods. Naval restrictions have been removed, allowing fishermen to stay on the water for longer, while land closed off to agriculture is now available, yielding the country's biggest-ever rice crop in the first half of 2003.

Ports have grown busier too, now that insurance premiums for visiting ships have fallen, and the capital markets have been revitalized - since the cease-fire was signed, the Colombo All-Share Index has risen by 100 percent. Property prices have risen by a similar margin in many parts of the country, boosting the construction sector and helping banks sell repossessed assets and reduce non-performing loans.

Flying out of turbulence

No one has felt the benefit of the cease-fire more than Senaka Chandrasekera, finance chief of SriLankan Airlines. On July 24, 2001, six months before Wickremesinghe came to power, the Tamil Tigers launched one of their most daring attacks. In a pre-dawn raid on Colombo airport, a band of 13 rebels - all of whom died - blew up eight military planes and six of SriLankan's aircraft, four of them beyond repair.

"In just a few short hours, 50 percent of our fleet was wiped out," recalls Chandrasekera. In the aftermath, the airline re-ordered its route network, dropping six of its least profitable destinations, and laid off 1,100 staff, or 20 percent of its workforce. Passenger numbers dropped by 37 percent and the airline posted a US$26 million operating loss for the year.

To make matters worse, insurance companies raised their war-risk insurance premiums by 300 percent overnight and kept them there until July last year. Some airlines, such as Dubai-based Emirates - which owns 43 percent of SriLankan - chose to bypass Colombo altogether to avoid the insurance hikes.

Today, however, SriLankan is in better shape. Buoyed by the increase in tourists, the company has seen its revenues climb by 74 percent in the two years since the cease-fire was signed to reach US$430 million for the 12 months to March 31. In the year ahead, Chandrasekera says SriLankan is expecting growth of 23 percent, and to that end it agreed to lease two new aircraft in November last year, another in March, and is expecting delivery of three more in the coming months to increase its fleet size to 17 - five more than before the airport attack..

Land of opportunity

JKH has done equally well. Last year its revenue grew by nearly 43 percent, and it's up again by 26 percent for the first three quarters of this financial year. With interests ranging from cold meats, soft drinks, and port services, to hotels, banking, and tea plantations, it's little wonder that JKH has shone, says Eranjan Kulatunga, a research analyst at CT Smith Stockbrokers in Colombo. "John Keells is pretty much a proxy for the whole Sri Lankan economy," he explains.

Another benefit of the cease-fire has come from falling interest rates. Thanks in part to efforts by Wickremesinghe's government to rein back a bloated public sector, but equally thanks to a cut in defense spending, public sector borrowing in Sri Lanka has tumbled, allowing the Central Bank to slash interest rates. In the past two years, the bank's overnight repo rate almost halved from 12 percent to 7 percent.

At SriLankan, Chandrasekera says his cost of capital has fallen too. Although he leases rather than buys his planes, Chandrasekera is now paying 30 percent less than three years ago. He attributes half of those savings to improved perceptions of risk in Sri Lanka by aircraft leasing firms.

Foreign companies have been equally quick to cash in on the benefits of peace. For example, banking giant HSBC is investing 2.5 billion rupees (US$25 million) in a new back-office IT center in Colombo that will employ 3,000 people. The country's Board of Investment says five more multinationals are considering similar investments.

An ongoing program of privatization is drawing other foreign investors. Under the auspices of the Public Enterprises Reform Commission, the Sri Lankan government is selling off state-owned assets and promoting competition. In the past two years, Ceylon Petroleum Corporation's monopoly of 1,070 retail outlets has been split three ways, with Indian Oil Company and Sinopec of China each taking a slice.

Perhaps most significant of all, 55 countries and 22 organizations together have pledged US$4.5 billion in loans, grants, and other financial aid to help jump-start the redevelopment program. The money will go towards building new roads, power stations, and other projects, provided the cease-fire holds.

The power and the furor

The prospects for Sri Lanka and its economy look encouraging indeed, and yet, in recent months, dark clouds have started to swirl over the country. In spite of all the obvious benefits that the country's ceasefire has brought, a protracted period of political instability now looks probable, perhaps even leading to a return to war.

The change in fortunes began last November when Chandrika Kumaratunga, the country's president and a bitter rival of Prime Minister Wickremesinghe, suspended parliament, declaring a state of emergency and sacking the ministers for defense, interior, and information. Citing national security worries, Kumaratunga even deployed troops on the streets of the capital. Over the next two days, the Colombo stockmarket shed nearly 18 percent of its value.

Her concerns centered on Wickremesinghe's peace talks with the LTTE. While Kumaratunga is committed to peace, she favors a hard-line nationalist approach to dealing with the Tigers, refusing to consider devolution, for example. Wickremesinghe, on the other hand, prefers a more conciliatory stance as a way to boost the chances of reaching peace.

Just days before Kumaratunga's power grab, the LTTE had submitted its latest ideas for peace and how the central government should cede some of its powers to the Tamil north-east. While the LTTE said it was no longer interested in a separate homeland, it demanded responsibility over areas such as tax collection, spending, and security. Kumaratunga regarded these powers as the first step towards establishing a separate state. She also accused the Tigers of using the cease-fire as a chance to smuggle in weapons and rearm - a charge widely acknowledged as being true, says Jehan Perera, director of Sri Lanka's National Peace Council.

Political risk

On February 7 this year, Kumaratunga dissolved parliament completely and called for fresh elections on April 2 - almost three years early. Once again the markets fell, this time by 11 percent.

The president's party teamed up with the JVP, a hard-line Marxist nationalist group to form the United People's Freedom Alliance (UPFA). Accusing Wickremesinghe and his United National Party of being an LTTE lapdog, the alliance targeted the rural masses who had yet to feel the benefits of peace. The alliance also promised to reverse Wickremesinghe's fiscal austerity - much praised by the International Monetary Fund - by offering wage increases for the public sector of as much as 70 percent, and providing subsidies for fertilizer and essential foodstuff.

The UPFA came out on top and Mahinda Rajapakse replaced Wickremesinghe as prime minister. Yet again the markets fell, by another 10 percent. "As far as the peace process is concerned the election result was negative," observes Perera of the National Peace Council. "It resulted in the coming into power of an alliance of parties that both want to take a much harder line with the LTTE."

To complicate matters further, adds Perera, the UPFA didn't win an outright majority and looks unable to build a majority coalition in parliament. What's more, the two parties that make up the UPFA don't agree themselves on how to approach negotiations with the Tamil Tigers, with some parts of the JVP favoring a return to war. "It's a recipe for political uncertainty," notes Perera.

Uncertain outlook

Many businessmen agree. Jayantha Perera, manager of the capital markets division of the Merchant Bank of Sri Lanka, is one. "With the new government in power, the cease-fire and the peace process look a lot shakier than before," he says grimly. "The risks of the country falling back into conflict are certainly stronger now."

Kapila Jayawardena, country head for Citibank in Sri Lanka, concedes that "at the moment there's a lot of uncertainty." As he puts it: "We'll need to see a prolonged period of political stability before confidence returns. Most companies are adopting a wait-and-see attitude when it comes to investing. They want to give the new government a chance to bed down." That said, Jayawardena does not foresee a return to war. "The president has said she's committed to peace and I expect we'll see progress in time."

Kulatunga at CT Smith Stockbrokers shares his confidence. "Even if the peace talks don't achieve anything over the next year or two, I expect the cease-fire to hold," he says. "Nobody wants to be seen as firing the first shot; they would lose too much credibility with the international community."

There is also the US$4.5 billion in promised aid that will disappear if war returns. Donor organizations have made the grants and loans conditional on the cease-fire holding and peace talks progressing.

Still, companies doing business in Sri Lanka can't afford to ignore the risks. JKH, for example, is betting on peace but still runs its strategy through a war-time scenario. Take JKH's US$40 million acquisition in September 2003 of Asian Hotels Corporation (AHC). "The deal was prompted by the improved prospects for peace and rising visitor levels," says Peiris. But, he stresses, JKH was careful to consider what impact a return to war would have. "Previously we only owned resort hotels but in AHC we were buying city hotels. We discovered that city hotels are less sensitive to war than resort ones," he explains.

At SriLankan Airlines it's a similar story. The firm's current fleet expansion is a bet on peace and stability. But all the aircraft have been taken on short operating leases of between three to five years. "It wouldn't be difficult for us to cut the fleet back if we had to," says Chandrasekera.

Still, it's cold comfort to a company that flourished during two years of peace.

Justin Wood is managing editor of CFO Asia, based in Singapore.