(AFP) - `A0`A0 The International Monetary Fund Wednesday warned Sri Lanka to revive a peace process with Tamil rebels and step up its tsunami reconstruction or risk compounding already serious economic woes.

Large fiscal deficits and a high level of public debt are sources of macro-economic instability while inflation is galloping away and reforms lagging, the international lender said.

"The longer-term challenges facing Sri Lanka include moving toward fiscal consolidation, implementing structural reforms that enhance the investment climate and reviving the peace process," the IMF said in a statement.

The statement, issued after a review of the country's performance in the first half of the year, noted that the budget deficit was ballooning, privatisation revenues had fallen way short of targets and inflation was on the rise.

Annual inflation hit 16.8 percent by the end of December, reflecting higher food and oil prices, it said adding that economic growth this year was forecast at 5.3 percent, down from 5.4 percent in 2004 and 6.0 percent in 2003.

The budget deficit reached 8.25 percent of Gross Domestic Produt (GDP) in 2004, or 1.5 percentage points higher than originally estimated. Revenues fell short of the budget target while expenditure overruns were due to higher subsidies.

The IMF urged Sri Lanka to ensure that oil prices reflected the actual cost of production and to do away with subsidies the economy could not afford.

It also noted that although Sri Lanka had a "fiscal responsibility" law to ensure prudent economic management by the state it had yet to deliver results and also called for the independence of the Central Bank.

However, the IMF did commend Sri Lanka for its "prompt and effective" relief following the December 26 tsunami that claimed 31,000 lives and left a million people homeless.

"A key ongoing challenge will be to manage the reconstruction activity in an efficient and transparent manner by mobilising donor assistance effectively and maintaining macro-economic stability," the IMF statement said.

 It noted that the troubled peace process must be revived for the economy to recover.

The tsunami was initially seen as uniting the government and Tamil Tiger rebels to work together to deliver aid to people affected by the worst natural disaster to hit the island but it has in fact deepened the divisions.

Sri Lanka's Supreme Court last month virtually shot down a proposed joint mechanism by the two former warring parties to share part of the three billion dollars in aid promised by international donors.

Sri Lanka's peace broker Norway, meanwhile, is sending Deputy Foreign Minister Vidar Helgesen here Thursday to try to jumpstart the stalled peace process between Colombo and the Tamil Tigers.

Diplomatic sources said that Helgesen would try to salvage the tsunami joint mechanism to ensure that international donors could support the island's reconstruction effort fully.

The Colombo government needs the cooperation of the Tigers to carry out reconstruction work in the island's north-east, parts of which are held by the guerrillas.