By Shihar Aneez and Bryson Hull

Currencies

COLOMBO, March 1 (Reuters) – Sri Lanka holds parliamentary elections on April 8 amid economic worries, not least the IMF’s decision to delay the third tranche of a $2.6 billion loan after the government missed its 2009 deficit reduction targets.

Following is a summary of key political risks to watch:

* PARLIAMENTARY ELECTIONS

Newly re-elected President Mahinda Rajapaksa is proceeding full speed ahead towards the April polls, aiming for a two-thirds majority in parliament that would give him a free hand to change the constitution. He won the presidential election by a margin of 18 percent over former army commander General Sarath Fonseka, and the opposition is yet to recover from the defeat. The fractured and demoralised opposition’s claims of poll rigging are expected to go nowhere, and political protests are now prohibited up to April 15 by law because parliamentary elections have been called.

What to watch:

- Whether Rajapaksa can secure two-thirds majority. This would be broadly positive for markets as it would allow decisive policymaking, including reforms, to attract foreign investment. He is likely to make overtures to opposition parties to secure this.

- The parties Rajapaksa keeps in his rejigged coalition. That will indicate the kind of policies he will follow.

- How the government deals with a coup plot it says Fonseka and his supporters tried to hatch, or any large protests after the polls. If it acts with too heavy a hand, it risks some backlash at home, plus further damage to international ties.

* IMF LOAN AND FISCAL REFORM

The IMF’s delay in paying a loan tranche was a negative factor for investor sentiment. [ID:nSGE61O0GP] The $40 billion economy will face more pressure as the government says the 6 percent IMF deficit goal for 2010 is also challenging due to spending to promote reconciliation after the end of the war with the Tamil Tigers. [ID:nSGE61M0DB] The IMF says it will reconsider paying the third tranche after going through the budget numbers following the parliamentary polls. The delay comes ahead of Sri Lanka selling a 10-year, $500 million sovereign bond this year. What to watch:

– Whether the IMF delays the loan tranche again after review in May, or comes up with additional conditions for continuing.

– The reaction of ratings agencies to any further delay.

– The impact of any further delay on the price Sri Lanka is able to get for its sovereign issue. It will have to pay a higher interest rate if the IMF withdraws support. However, the yield on Sri Lanka’s Eurobonds LK045930114= LK032736246= has come down in recent weeks, despite the IMF’s concerns.

– Progress in efforts to raise revenue collection or rein in public-sector spending. Rajapaksa pledged pay raises to public employees during the election. How he pays for this will be a good indicator of what tack his government will take.

* ECONOMIC REFORM AND POST-WAR FOREIGN INVESTMENT

Despite post-war economic optimism, foreigners remain interested mostly in the safest heaven, government treasury bills and bonds CENSL10, in which there is a foreign investment cap of 10 percent. Offshore investors in Sri Lanka’s bourse .CSE, one of the world’s best-performing last year with a return of 125 percent, have been net sellers so far this year to the tune of over $42 million.

Foreign direct investment fell a third in 2009 compared to a year earlier. An uptick in FDI is expected now the war is over, but many potential direct and portfolio investors say they want to see reforms first — in particular reducing the corporate tax rate and the bureaucratic hurdles for starting a business.

What to watch:

- How much corporate tax rates are cut through a tax reform committee after the post-poll budget by end-April.

- Timing of the central bank issue of its planned $500 million sovereign bond and whether it increases the foreign investment limit in government securities

* THE RUPEE AND INFLATION

Inflation has been rising for five months and hit 6.5 percent in January. The central bank has kept rates at multi-year lows to spur growth. Central Bank Governor Ajith Nivard Cabraal has said the central bank will allow flexibility in the rupee LKR= exchange rate, with currency controls set to be relaxed to spur investment and allow the rupee to float more freely.

What to watch:

– Any monetary tightening, and the impact on inflation and the rate of credit growth.

– 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 $136 million a year. [ID:nLDE61E1W0]

Rajpaksa’s behaviour towards beaten presidential candidate Fonseka has added to misgivings among Western countries. However, Sri Lanka’s willingness to turn to China, Russia, 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 Sri Lanka avoid a serious rift with Western countries.

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 export earner.

– The extent of Western redevelopment aid, versus that from India and China, largest donors since the end of the war so far.

– Any concrete steps Rajapaksa takes to address Tamil political demands, something he said he would do after elections.

(Editing by Andrew Marshall)