FACTBOX-Key political risks to watch in Sri Lanka

By C. Bryson Hull

COLOMBO, April 5 (Reuters) - Sri Lankans vote on April 8 to elect their first parliament since the end of a quarter-century war with the Tamil Tiger separatists last May.

Following is a summary of key risks to watch in Sri Lanka:



* GOVERNMENT EFFECTIVENESS

The Colombo Stock Exchange and the government securities markets have been relatively inured to the noisy political scene in Sri Lanka since the war's end in May. That's simply because the political to-and-fro causes nowhere near the volatility the war did. Investors shrugged off the arrest of General Sarath Fonseka, who unsuccessfully challenged President Mahinda Rajapaksa in a Jan. 26 presidential vote.

Market players expect the conclusion of the April 8 parliamentary elections to give a boost to confidence, as the polls will probably put Rajapaksa firmly in control and remove uncertainty about the island's policy regime. It remains to be seen whether his political alliance will make history by winning a two-thirds majority at the polls, giving him the votes he needs to change the constitution.

What to watch:

- Whether Rajpaksa can secure two-thirds majority in the election, or by striking deals with opposition legislators afterwards. This would be broadly positive for markets because it would allow decisive policymaking, but there is always the risk Rajapaksa could put his own interests first.

- Whether Rajapaksa shrinks a bloated cabinet and pays less heed to the influence of the more strident nationalists in his new-look government. That will to a large degree signal the types of policies he will follow.



* FISCAL REFORM AND MANAGEMENT

Sri Lanka is in the middle of a 20-month, $2.6 billion International Monetary Fund (IMF) loan. The lender delayed releasing the third tranche of it after the country's 2009 budget deficit hit 9.7 percent instead of the 7 percent target.

Although foreign investment into Sri Lanka has picked up since the end of the war in May, market players say the IMF delay is holding back some demand, in particular for government securities. The benchmark 91-day t-bill was yielding 8.52 percent at auction on Tuesday, and dealers say there is demand for anything of up to an 18-month tenure. If the IMF question is settled, they expect that to strengthen.

The government has said it plans to make tax and investment reforms, seen as key to attracting more investment and improving perennially low tax collection and high public spending.

What to watch:

-- The budget, expected to be presented in May. The IMF says that if the budget is 'consistent with the spirit of financial consolidation', it will move forward with the programme. Tax and public-sector reforms are supposed to be part of this budget.

-- Any sign of an erosion in fiscal discipline, in particular how the government pays for an election promise of a public sector pay hike equal to about 1 percent of GDP. Credit rating agencies say adherence to the IMF plan is crucial for international investor confidence. Any problem could cause a credit rating downgrade and a withdrawal of foreign money.



* THE RUPEE CURRENCY AND INFLATION

Under Central Bank Governor Ajith Nivard Cabraal, inflation has fallen from more than 28 percent in 2008 to single digits. But it has been rising again, and the governor says he is willing to tighten monetary policy to keep it in check, after loosening policy last year to spur private-sector credit growth. Still, credit growth is negative year-on-year. The rupee currency has been stable with the central bank saying it will let the currency move but step in to prevent sharp volatility.

What to watch:

-- Any monetary tightening, and the corresponding reaction of both the inflation rate and the rate of credit growth. The IMF has cautioned against tweaking the policy rates.

-- Any move to relax currency controls, and the subsequent reaction of the exchange rate.



* INTERNATIONAL RELATIONS

Western countries, and groups in the Tamil diaspora, are pressing for some kind of accountability for thousands of civilian deaths at the end of the war. Sri Lanka is adamant its soldiers did not violate international law, and that for now has cost it enhanced European Union trade preferences known as GSP+ worth $100 million a year. However, Sri Lanka's willingness to turn to countries like China and Iran appears to have prompted the West to take a softer line. India remains a steadfast ally, and its influence is likely to help that trend continue.

What to watch:

-- Whether Sri Lanka can reach a deal with EU to get GSP+ back. The reinstatement of the trade concession would help Sri Lanka's garment industry, its top foreign exchange earner.



(Editing by Andrew Marshall)

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