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Sri Lanka’s rising risks whet investor appetite

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Sri Lanka’s asset prices, if politics and economics had any bearing on them, should have been hugging the bottom of the Asian heap.

As it turns out, the island off India’s southeastern coast is the only Asian country whose equity index is among the world’s 10 best-performing this year.

The Sri Lanka All Share Index has risen 1 percent since Foreign Minister Lakshman Kadirgamar was assassinated Aug. 12, taking the gain this year to 49 percent in U.S. dollar terms.

The next best-performing Asian benchmark is South Korea’s Kospi index, which is up only 19 percent. The Sri Lankan rupee has strengthened 3.7 percent against the U.S. dollar so far this year, more than the 2.2 percent rise in the Chinese yuan.

Investors’ perception of what’s good for Sri Lanka need not be shared by the country’s voters.

The outlook for a gradual revival in tourism following the Dec. 26 tsunami has worsened since the minister’s assassination. The government this month imposed a state of national emergency, a move that may spook Western tourists.

Along with exports of garments and tea, tourism is an important source of hard currency for the country of 19 million people.

The Liberation Tigers of Tamil Eelam (LTTE), who seek economic and political autonomy in the island’s northern and eastern parts, have denied the government’s charge that they carried out the killing. The assignation cast doubt on the future of the February 2002 cease-fire that ended two decades of debilitating civil war between the Tigers and the armed forces.

Sri Lanka’s fragile politics complicates matters. The current government lost its majority in parliament in June after its biggest coalition partner quit over President Chandrika Kumaratunga’s decision to distribute tsunami aid jointly with the Tigers.

Meanwhile, consumer prices are rising at an annual 13 percent pace. Inflation would have accelerated further had the government not forced gasoline retailers to absorb a large part of the rise in energy import costs.

It isn’t that investors in Sri Lanka are oblivious to the risks. They’re placing a complicated - and dangerous - bet that the current climate of disquiet would hasten a political resolution of the conflict between the two major linguistic communities: the dominant Sinhalese and the minority Tamils.

A presidential election is round the corner and money managers such as Singapore-based Arisaig Partners (Asia) Pvt. expect that Ranil Wickremesinghe, a former prime minister and currently the leader of the opposition, will win the top job and then call for parliamentary elections to wrest power from President Kumaratunga’s People’s Alliance party.

Wickremesinghe, who signed the truce with the Tigers three years ago and brought them to the negotiating table, was ousted last year by Kumaratunga on grounds that he was making too may concessions in his haste to secure a peace accord.

During his brief tenure, Wickremesinghe also tried to prune the bureaucracy, trim expensive state subsidies, sell state assets and make it easier for employers to fire surplus workers.

Should Wickremesinghe gain control of both the presidency and parliament, it would improve prospects for economic reform as well as peace, Arisaig Partners wrote in its latest investment commentary. The firm is one of the biggest overseas investors in Sri Lanka.

However, investors’ bet on Wickremesinghe’s party being in absolute control of the island’s politics some time in 2006 is a risky gamble to take now, especially in an illiquid market like Sri Lanka where one can’t sell stocks in a hurry.

The outlook for a gradual revival in tourism has worsened since the foreign minister’s assassination.

As for investors’ faith in the Sri Lankan private sector’s ability to withstand shocks and deliver profits, much of that resilience is illusory. A simpler explanation is that the island’s central bank has been very hesitant to raise interest rates. Unless oil prices ease in 2006, more aggressive monetary tightening may become inevitable, and profit growth will slow.

Recent history shows that investors’ perception of what’s good for Sri Lanka need not be shared by the country’s voters.

Many investors wanted Wickremesinghe to come back as prime minister in parliamentary elections in April 2004. Voters denied him the chance because, in their view, his programs to promote peace and reduce government control of the economy had fared poorly in controlling the cost of living.

While inflation is a much bigger challenge now than it was last year, the present government of Prime Minister Mahinda Rajapakse has done the politically astute thing by scrapping taxes on milk powder and cooking gas. Milk powder prices were a sore point with voters in April 2004 elections as well.

Rajapakse is Kumaratunga’s candidate for the presidency. Kumaratunga, who’s finishing a second term this year, is legally barred from seeking an extension.

Investors betting on absolute political control for Wickremesinghe must also consider the Rajapakse government’s generosity in handing out a 33 percent pay rise for non-managerial central government employees between June 2004 and June 2005, according to the central bank’s wage index.

Along with subsidies on food, fertilizer and fuels, a wage increase for civil servants is a powerful election plank in a country with a bloated bureaucracy.

Besides, the Rajapakse government can also claim credit for creating new jobs. Government employment in Sri Lanka rose 7 percent last year after a 0.6 percent decline in 2003.

Investors in Sri Lanka who expect their preferred political outcome to be a done deal may be underestimating the power of unabashed populism.

Andy Mukherjee is a columnist for Bloomberg News. The opinions expressed are his own.

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