Sri Lanka appears to be on the verge of crushing Tamil Tiger rebels after decades of fighting but its success has blown a hole in the nation’s finances and forced it to seek an IMF bailout.
Negotiations are underway with the International Monetary Fund for a 2.4 billion-dollar rescue package as the island’s economy reels from the twin effects of unprecedented war spending and the global financial crisis.
Sri Lanka has turned to the IMF after earmarking 1.6 billion dollars this year to financing the military drive against the Tiger rebels that the government says it is close to winning.
This comes on top of three billion dollars spent in the previous two years.
President Mahinda Rajapakse has vowed to get the IMF money on his terms and not "pawn or sell our motherland to obtain any monetary aid".
But a source close to the negotiations said Sri Lanka would have to make "painful adjustments".
"This means allowing the rupee to depreciate, cutting subsidies and a freeze on state sector jobs," the source said. Economists say the country may also be forced to raise interest rates after cutting them to spur a slowing economy.
Economists say the money worries caused by the high defence spending have been compounded by the worldwide slump, a halt to privatisation of state enterprises and the central bank’s battle to defend the rupee that has drained foreign exchange reserves.
An IMF team left Sri Lanka last Tuesday after spending more than a week in the island to discuss terms of an aid package.
The IMF "continues discussions with the authorities on the latest economic developments and the economic programme to be supported by the IMF to improve the country’s balance of payment conditions," an IMF spokesman said.
The financial body has made no comment on any conditions for bailout.
But the source said: "The IMF mission wants to see progress before they can recommend to their board on April 25 that Sri Lanka is ready to receive this facility."
A Western diplomat said there could be an initial drawdown of 480 million dollars from the IMF by the end of the month if negotiations go smoothly.
He said the country "desperately needs the money" to make payments for imports and loans.
Sri Lanka needs around 900 million dollars to repay loans in 2009, the central bank has said.
Last year, the government made close to half a billion dollars in debt payments, said Colombo University economist Sirimal Abeyratne.
"We’re now in sort of a debt trap, borrowing to pay off what we borrowed earlier," Abeyratne said.
Economists say the country lost much of its foreign exchange reserves defending its currency, paying for imports and servicing loans.
Foreign currency reserves fell from 3.5 billion dollars last August to 1.7 billion dollars by December as the central bank sought to prop up the rupee, official figures show. Reserves have fallen further since then, analysts say, but no official figures are available.
"Sri Lanka tried to hold the exchange rate without an institutional framework to support it and lost most of its reserves," said the "Fuss Budget" column on Lanka Business Online, Sri Lanka’s main business website.
The IMF talks come against a background of growth slowing to 6.0 percent in 2008 from 6.8 percent the previous year, hit by sliding exports of tea and clothing as Sri Lanka’s main world markets went into recession.
The central bank forecasts growth will slacken to 5.0 percent this year while the IMF expects it to fall to around two percent.
Sri Lanka’s defence spokesman Keheliya Rambukwella said the government believes defeat of the Tigers will prompt an economic revival.
"It’s better to finish off the war rather than drag it out," he said.
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