The document summarizes Sri Lanka's economic prospects after the end of its civil war in 2009. It finds that:
1) Sri Lanka is well positioned for steady GDP growth of around 7% annually over the next few years, driven by increased activity in formerly conflict-affected areas, improved investor confidence, and large-scale infrastructure investment.
2) Exports and remittances have picked up in 2010 alongside growth in agriculture, industry and services, though imports have also risen sharply.
3) Government investment and spending played a key role in keeping the economy afloat during the crisis and conflict, though fiscal consolidation will now be a priority to ensure stable growth.
The document summarizes Sri Lanka's economic prospects after the end of its civil war in 2009. It finds that:
1) Sri Lanka is well positioned for steady GDP growth of around 7% annually over the next few years, driven by increased activity in formerly conflict-affected areas, improved investor confidence, and large-scale infrastructure investment.
2) Exports and remittances have picked up in 2010 alongside growth in agriculture, industry and services, though imports have also risen sharply.
3) Government investment and spending played a key role in keeping the economy afloat during the crisis and conflict, though fiscal consolidation will now be a priority to ensure stable growth.
The document summarizes Sri Lanka's economic prospects after the end of its civil war in 2009. It finds that:
1) Sri Lanka is well positioned for steady GDP growth of around 7% annually over the next few years, driven by increased activity in formerly conflict-affected areas, improved investor confidence, and large-scale infrastructure investment.
2) Exports and remittances have picked up in 2010 alongside growth in agriculture, industry and services, though imports have also risen sharply.
3) Government investment and spending played a key role in keeping the economy afloat during the crisis and conflict, though fiscal consolidation will now be a priority to ensure stable growth.
Sri Lanka: State of the Economy 2010 Prospects free download / e-version 17. Prospects Post-conflict Sri Lanka appears comfortably placed to experience a steady improvement in its economic outlook. A targeted GDP growth rate in the range of 7 per cent per annum over the next 2-3 years seems well within reach on the back of increased eco- nomic activity of the previously conflict-af- fected areas, improved investor confidence and the multiplier effects of a large scale in- frastructure investment drive. GDP growth in the first half 2010 in excess of 7.5 per cent has already signaled that a strong post- conflict economic recovery is underway. However, the figures have to be interpreted with some care. For the most part, first half GDP estimates for 2010 reflect the 'bounce- back' effect of economic activity from a low base in 2009 (Table 17.1). Nonetheless, the strong rebound is promis- ing. As the global economic recovery strengthens - with global GDP growth firmed up to 4.6 per cent in 2010 and 4.3 per cent in 2011 - Sri Lanka's main export sectors stand to benefit from stronger demand. Export earn- ings have already picked up, recording a growth of 13.7 per cent in earnings during January-June 2010 compared to a contrac- tion in earnings of 18 per cent in the same period of 2009. Workers' remittance inflows too have picked up sharply to US$ 1,820 million by end June 2010, as compared to US$ 1,585 million received by end June 2009. At the same time, Sri Lanka's import expen- diture has grown by 42 per cent in the first half of 2010, driven by intermediate goods imports - particularly petroleum - and con- sumer goods. However, despite a widening trade deficit that has expanded by more than 108 per cent to US$ 2,845 million by end June 2010, the outlook for the balance of payments (BOP) performance remains posi- tive. This is largely due to inflows on the capital account such as foreign investment in government debt securities, government foreign borrowing, etc. Table 17.1 GDP Growth (January-June) 2008 2009 2010 Agriculture, forestry & fishing 6.7 4.3 7.1 Tea 20.4 -23.4 27.1 Paddy 7.7 7.6 9.6 Industry 6.5 2.5 8.1 Textiles and garments 1.3 -1.8 4.4 Services 6.7 1.1 7.8 Wholesale & retail trade 6.0 -3.7 7.1 Transport & communications 9.6 4.8 11.7 Banking, insurance & real estate, etc. 6.8 4.6 7.2 GDP 6.6 1.9 7.8 Source: Department of Census and Statistics. 202 Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2010 Prospects free download / e-version Source: Central Bank of Sri Lanka, Monthly Economic Indicators, various issues. The strengthening BOP position has exerted upward pressure on the Sri Lankan rupee. However, the pressure for the currency to appreciate is not reflective of a shift in Sri Lanka's economic fundamentals - i.e., rising demand for the country's goods and services in international markets. An appreciation of the exchange rate has been dictated by the rising volumes of foreign capital inflows - heavily tilted towards government borrow- ing - as opposed to the 'corrective' deprecia- tion of a currency in line with a deteriorat- ing current account deficit. Such 'distortions' can impact adversely on the competitiveness of the country's export sector. Indeed, the Central Bank of Sri Lanka (CBSL) has been compelled to intervene in the foreign exchange market to prevent un- due appreciation of the rupee. The accumu- lation to the monetary base as a result of intervention also has implications for price stability. However, Sri Lanka has been spared the prospect of any resultant inflationary pres- sure owing to the general lackluster demand for credit from the private sector. Credit growth to the private sector has been slow to pick up - recording a growth rate of only 8 per cent by end July 2010 after contracting by more than 7 per cent over the same pe- riod in 2009. This has been despite a steady downward revision of interest rates as evi- dent from Figure 17.2. The continuing high margin between deposit and lending rates prompted the CBSL to request a general low- ering of lending rates by banks in order to spur private sector credit growth. Table 17.2 Select Economic Indicators (January-July) 2007 2008 2009 2010 Exchange rate Rs/$ 111.76 107.53 114.90 112.57 Rate of inflation % 13.3 21.9 10.4 4.2 Credit growth to private sector % 14.0 4.7 -7.2 8.1 Source: Central Bank of Sri Lanka, Monthly Economic Indicators, various issues. Figure 17.1 Trade Flows (January 2009-June 2010) U S $
m n . 0 100 200 300 400 500 600 700 800 Jan Feb Mar Apr May Jun Exports 2009 2010 0 200 400 600 800 1000 1200 1400 Jan Feb Mar Apr May Jun Imports 2009 2010 U S $
m n . 203 Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2010 Prospects free download / e-version Figure 17.2 Trends in Inflation and Interest Rates (January 2009-September 2010) 0 5 10 15 20 25 J a n F e b M a r A p r M a y J u n J u l A u g S e p O c t N o v D e c J a n F e b M a r A p r M a y J u n J u l A u g S e p 2009 2010 % AWPR AWDR CCPI J a n F e b M a r A p r M a y J u n J u l A u g S e p O c t N o v D e c J a n F e b M a r A p r M a y J u n J u l A u g S e p Notes: AWPR = Average Weighted Prime Lending Rate, AWDR = Average Weighted Deposit Rate, and CCPI = Colombo Consumer Price Index (annual average change). Source: Central Bank of Sri Lanka, Monthly Economic Indicators, various issues. Thus, the momentum for economic recov- ery that Sri Lanka has witnessed in the after- math of the end to the conflict in May 2009 has been driven primarily by government investment. Indeed, government investment kept the economy relatively buoyant through- out the height of the conflict and the global economic crisis. Government investment as a percentage of GDP rose steadily from 4.1 per cent in 2006 to 6.6 per cent in 2009, while private investment declined from 23.9 per cent to 17.9 per cent over the same period. 1 Table 17.3 Government Finances (January-July) 2008 2009 2010 Revenue & expenditure (% change) Total revenue 22.7 -3.5 23.4 Recurrent expenditure 16.4 24.7 9.0 Capital expenditure 33.6 -2.8 2.7 Financing (% of total) Domestic 71.8 90.2 75.6 Foreign 28.2 9.8 24.4 Source: Central Bank of Sri Lanka, Monthly Economic Indicators, various issues. 1 Central Bank of Sri Lanka, Annual Report 2009. 204 Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2010 Prospects free download / e-version Such higher government spending had an ex- pansionary impact. Sri Lanka's fiscal deficit expanded from 6.9 per cent of GDP in 2007 to 9.8 per cent in 2009. An expansionary fiscal policy stance can be excused in the midst of shrinking aggregate demand in the economy. As the global economic downturn took hold, the Sri Lankan economy too be- gan to feel the impact from mid-2008. How- ever, as both the global and domestic eco- nomic recovery takes effect, fiscal consoli- dation efforts have to receive the highest pri- ority if growth is to take place within a stable macroeconomic environment. Fiscal consolidation efforts to reach the esti- mated deficit target for 2010 of 8 per cent of GDP appear to be on track. Revenue collec- tion has improved significantly in the period January-July 2010 while recurrent spending growth has been held down to 9 per cent as compared to 24.7 per cent over the same period in 2009 (Table 17.3). While the do- mestic borrowing requirement to finance the deficit has been heavy, it has been accom- modated without igniting inflation given the muted demand for credit from the private sector. The government budget for 2011 to be pre- sented in November 2010 will give a fuller account of the medium term fiscal policy framework within which the government's development initiatives - particularly its heavy infrastructure investment drive - will be implemented. The government appears con- fident in meeting its fiscal consolidation objectives in line with the Stand-By Arrange- ment arrived at with the International Mon- etary Fund (IMF). With the implementation of the recommen- dations of the Presidential Taxation Com- mission, the revenue-to-GDP ratio is expected to rise to 15.5 per cent in 2011 and to a further 16.5 per cent in 2012. Enhanced rev- enue collection and a reduction in recurrent spending by 0.5 percentage points is expected to see Sri Lanka recording a fiscal deficit of 6.8 per cent in 2011. This is expected to be reduced further to 5 per cent by 2012. 2 In arriving at fiscal deficit targets, the nature and quality of spending adjustments matter. Rationalization to recurrent spending related to wages and salaries, and subsidies and transfers in particular can be linked directly to improved efficiency. Where these are ab- sent, fiscal consolidation per se can deliver macroeconomic stability, but fail to harness a more effective re-allocation of resources and related productivity gains that will al- low economic output to expand rapidly in a sustainable manner. With promised fiscal consolidation efforts in 2011, the near term outlook for the Sri Lankan economy is bright. While inflation is likely to pick up in 2011, if fiscal targets are adhered to, inflationary pressures will be manageable. Additionally, with healthy vol- umes of official reserves and inflows of for- eign capital - for instance, the US$ 1 billion Sovereign Bond and the IMF facility - Sri Lanka can withstand any unanticipated ex- ternal shocks and expect to maintain a fairly stable exchange rate. A favourable macro- economic environment and policy continu- ity associated with a strongly entrenched government will begin to provide investors a sense of stability to undertake investment decisions. Private investment will pick up even as the government forges ahead with its public infrastructure development drive. In this backdrop, achieving a targeted GDP growth rate of around 7 per cent in the near term will not be a too onerous task. 2 www.cbsl.gov.lk 205 Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2010 Prospects free download / e-version The greater challenge will be to transform the economic recovery to a long term sus- tainable path. This can be fraught with more complex issues. A growth boom fuelled by an infrastructure-led investment drive that relies overtly on foreign borrowing can run up against problems. For instance, high eco- nomic growth can in turn fuel rapid growth in import expenditure and raise issues of ex- ternal debt sustainability in the medium term. The most prudent course of action is to strengthen the regulatory environment to at- tract increased volumes of other forms of foreign capital such as foreign direct invest- ment (FDI). For Sri Lanka to achieve and maintain a sus- tained growth momentum of 7-8 per cent over the long term requires a substantive in- crease in its rate of investment, as well as the efficiency of such investment. Even a moderate rise in Sri Lanka's current rate of domestic savings will not be sufficient to bridge the savings-investment gap. FDI re- mains the most attractive source for raising the rate of investment in the country. Recognizing the critical role of FDI, the gov- ernment has initiated efforts to address con- straints in the approval process and other bottlenecks and 'red tape' that foreign inves- tors might face in Sri Lanka. This includes plans to revamp the Board of Investment (BOI) and the incentive regime for FDI that is currently in force. While these are laud- able initiatives, if Sri Lanka is to raise its FDI inflows substantively, regulatory impedi- ments that impact adversely on the country's investment climate - the policies, regulations and institutions that can encourage active private sector participation - need to be ad- dressed. These include reforms to improve public sector service delivery, reforms to improve the flexibility of labour market con- ditions, education sector reforms to enhance the skills set of the workforce in line with market needs, etc. These reforms are particu- larly relevant as Sri Lanka gears to promote itself as a hub in selected services sectors, with the aim of drawing in FDI and FDI- related transfer of technology and other skills. Harnessing the rapid recovery of Sri Lanka's post-conflict economy with a transformative process of economic reforms holds out the most promising outcome for sustained long term growth. The country has made a posi- tive start and with a prudent management of the economy and related policy reforms, it stands poised to reap the full economic divi- dends of a post-conflict phase of develop- ment.