Nov. 6 (Bloomberg) -- Sri Lanka's President Mahinda Rajapaksa plans to increase overseas borrowing next year even as the International Monetary Fund said reliance on foreign debt to finance expenditure could destabilize the nation's economy.

Rajapaksa unveiled a 1.19 trillion rupee ($10.8 billion) government budget in Colombo today, with a fifth of that outlay directed at defense to end the nation's 25-year civil war with the rebel Tamil Tigers. Foreign financing will rise 25 percent, to fund more than a tenth of total spending.

Central bank Governor Nivard Cabraal yesterday said he'd back record funds for the military because it is vital to end the conflict for the South Asian island economy to prosper. Still, the seizing up of global credit markets may make it harder for Sri Lanka to find loans while the rupee's plunge to a record low raises the cost of repaying existing debt.

``You have to weigh one risk against the other and then see what is best for short, medium and long term,'' Cabraal said in an interview in his office in Colombo. ``No country can progress with a war at your backyard all the time, take a tough stand and finish with it.''

Slowing economic growth may throw a spanner into the government's tax revenue projections, forcing Rajapaksa to borrow more than he planned. Growth may weaken to 6 percent this year, the slowest pace in four years, the central bank said in an annual review released today.

`Feeling the Pinch'

``They can't play around too much on the revenue front as companies are already feeling the pinch,'' said Dushni Weerakoon, deputy director of Sri Lanka's Institute of Policy Studies. ``If they can pull off a military victory, they can depend much more on reconstruction aid flowing in coming budgets.''

Rajapaksa's fund-raising options this year may be constrained by a global credit crunch that has forced countries including Japan, Sri Lanka's biggest donor, to pump billions of dollars into their banking systems to prevent the financial crisis from spinning into a worldwide recession.

The president estimates foreign financing will rise to 154 billion rupees in 2009.

Borrowing from the Sri Lankan economy may also strain budget projections as the nation has Asia's second-highest borrowing costs. Still, Rajapaksa aims to narrow the budget gap to 6.5 percent next year from 7 percent this year by imposing fresh taxes. He said his move to cut fuel prices and value-added tax will also boost the economy, increasing tax collections.

Global Slowdown

The president raised import duties on wheat, milk products and sugar and imposed a tax on imported furniture, paper and fruit. He cut the value-added tax to 12 percent from 15 percent from Jan. 1. He lowered diesel prices by 30 rupees a liter, gasoline by 15 rupees a liter and kerosene by 20 rupees a liter.

Still, analysts say growth may weaken as exports, which make up a third of the $32 billion economy, are feeling the effects of the global slowdown, especially as the U.K., the nation's former colonial power, heads for its first recession since 1991.

``Some of our clients are offering discounts to boost sales and that is forcing us to cut prices,'' said Hasitha Premaratne, head of corporate finance at Brandix Lanka Ltd., the nation's biggest exporter and which counts Marks & Spencer Group Plc and Gap Inc. among their clients. ``There is pricing pressure.''

Marks & Spencer, the U.K.'s largest clothes retailer, reported a 43 percent drop in first-half profit on Nov. 4 and said consumers are cutting spending.

Currency Reserves

Sri Lanka, the world's fourth-biggest tea grower, plans to curtail production as overseas demand for the commodity slumps, the state-run tea board said last month.

The slowdown comes as currency reserves have dropped by almost a quarter in the past two months and the rupee had its biggest decline in two years last week. Sri Lanka's external debt amounted to $12 billion at the end of 2007, almost 40 percent of gross domestic product, according to the central bank.

The IMF said last month increased reliance on dollar- denominated short-term commercial borrowing adds to Sri Lanka's public debt distress, calling on the government to cut its budget deficit to prevent economic instability.

Cabraal said the nation has maintained its ability to service loans, pointing out that debt as a percentage of GDP will drop to 80 percent this year from 102 percent in 2001.

``If you continue to spend 3.6 percent of GDP as defense and there is nothing to show at the end of the day, it is of no use,'' Cabraal said. ``If you show 3.8 percent of GDP on defense and if you have something to show at the end of it, then that certainly has value.''

Civil War

Rajapaksa has said ending the conflict with the Liberation Tigers of Tamil Eelam, who have been fighting for a separate homeland, will turn the war-ravaged east and north into productive parts of the economy, increasing output of rice.

The nation's defense outlays are forecast to rise to a record 177.1 billion rupees ($1.6 billion) in 2009, from 166.4 billion this year, according to preliminary estimates unveiled last month.

``The military appears to be at a stage in the war when they just have to finish off the job,'' said Agost Benard, an associate director at Standard & Poor's in Singapore. ``The international capital markets are virtually shut, so it will not be easy to borrow externally.''

-- With reporting by Asantha Sirimanne in Colombo. Editors: Stephen Foxwell, Michael Dwyer

To contact the reporters on this story: Cherian Thomas in New Delhi at Cthomas1@bloomberg.net; Anusha Ondaatjie in Colombo, Sri Lanka at anushao@bloomberg.net.

Last Updated: November 6, 2008 06:55 EST