"I think the main reason foreigners are staying away is concern about the exchange rate," said Geeth Balasuriya an equity analyst at Acuity Stockbrokers.

"With some clear direction on IMF funding and with other funding the government is seeking; foreign investors will be comfortable.”

"Now that the market is up significantly, we could see a slowdown in the rally and a consolidation at these levels," he said.

Stock price are up 14 percent since the Tiger leadership was wiped out on May 18 2009, while trading volumes are up 20 times to a billion rupees daily.

Balasuriya says stocks can't rise much further without foreign buying support.

Delayed

Sri Lanka’s request for a 1.9 billion dollar IMF bailout, to tide over a balance of payments crisis, has been delayed by the fund mainly on US pressure, while negotiations are ongoing with the Libyan government for a 500 million dollar loan.

"I’m not advocating for a stronger rupee, but a stable rupee. Foreign equity investors are comfortable when the currency is stable," says Dulindra Fernando who manages the Ceylon Index Fund, where over 80 percent of investments are foreign.

"When the currency is unstable foreign investors tend to wait and see."

Central Bank defended the Lankan rupee at 108.0 to the dollar depleting foreign reserves but floated the currency after it wrapped up a staff level deal with the lender.

The float is the key tool behind an IMF bailout and it has already succeeded in ending a peg defence cycle, and foreign reserves are rising. Even with an IMF bailout, the central bank has to buy dollars in the market and eventually repay the lender.

But an IMF program can help keep budgets in line and prevent another slide in the economy.

The rupee is now kept at 115.00 to the dollar levels, with the central bank buying dollars heavily to prevent an appreciation, though jitters remain.

Stocks in the six billion dollar Colombo bourse have erased two years of losses (losses of 40 percent in 2008 and 7 percent in 2007) with the 53 percent gain so far this year.

Despite the intensifying conflict last year the market received 14 billion rupees in net foreign buying.

That trend continued to mid May this year when net foreign inflows topped 1.4 billion rupees.

However the trend has eased following the end of the military campaign. The net foreign outflow has topped 258 million rupees by June 12, led by foreign selling in conglomerate John Keells Holdings (JKH) and National Development Bank.

Analysts say most of the outflow is due to US based hedge fund manager Raj Rajaratnam selling out of JKH.

Attractive option

Shares are cheap compared to their profit multiples. Early this year shares were selling at five times their past profits.

The ratio climbed to eight and a half times, after the April and May rally.

"With foreign interest we have seen this market trading at 15 mines or even higher," says Balasuriya.

"Although earnings don’t support such a re-rating the market can sustain something - lets say between 10 to 11 times with the current economic and corporate earnings outlook."

Balasuriya forecasts earnings will rise eight percent this year as lower interest rates ease the shackles on private companies.

Business profit growth was stymied for 25 years due to large budget deficits, high inflation and high interest rates hurting economic stability and corporate profits. The last phase of fighting took particularly heavy toll.

C T Smith, a stock brokerage, says profits at 195 listed companies that reported December quarter earnings are down a massive 66 percent, to 6.8 billion rupees in the quarter.

"Earnings will continue to suffer in the next quarter because of the impact of high interest rates inflation and all that but it will recover later this year," he says, said Balasuriya.

"But definitely we are expecting better corporate earnings in 2010."

The Colombo Stock Exchange rise mirrors gains in other regional markets including India where share prices are up 57 percent this year from their April low.

"We are viewed as part of India. With India’s boom some of the good news will overflow in to Sri Lanka," says Fernando.

His ten stock Ceylon Index Fund (including JKH, Sri Lanka Telecom, Dialog, Hatton National Bank, Commercial Bank, Distilleries, Nestle, Aitken Spence, Lanka Indian Oil Company and Chevron) is mirroring market performance.

"They (India) are probably one of the rare good news storeis out there right now," he adds.

But Indian markets are liquid and investors can easily get in and out.

Fernando says the slew of good news including the new markets in the North and Eastern areas of the island will increase listed company profits, especially those of banks, consumer goods firms and construction companies this year.

He reckons global investment funds, which have so far kept away, are eyeing developments before they step in.