April,2010

SriLankaEconomicUpdate

EconomicPolicyandPovertyTeam
SouthAsiaRegion

TheWorldBank

SriLankaEconomicUpdate1

April2010

This economic update is being prepared almost one year after the civil war ended in Sri Lanka and as a
sense of buoyancy and optimism overrides the perilous macroeconomic situation of 2009. This update
makes three main points:

Despite entering the Global Financial Crisis in a weak macroeconomic situation, the Sri Lankan
economy has recovered rapidly. After contracting2 for two quarters (2008Q4 and 2009Q1), the
economy began growing again in 2009Q2. The rebound was aided by a post-war confidence-bounce,
declining interest rates, expansionary fiscal policy, and large inflows of foreign capital into
government securities as global financial markets thawed. The momentum continued through the
year: In 2009Q4 growth reached 6.2 percent; foreign reserves went to about US$5 billion (sufficient
for six months of imports; inflation was in single-digits, though gradually creeping upward, and the
current account deficit had declined to 0.5 percent of GDP, compared to 9.5 percent in 2008, as
imports declined much faster than exports. Remittances continued to grow briskly, increasing by 14
percent in 2009, compared to 2008.
Near-term growth prospects are strong. 2010 growth is poised to reach the 5-6 percent range as
private investmentswhich dropped 2.1 percent in real terms in 2009will recover, buoyed by low
interest rates. Private consumption is also expected to pick up, especially if inflation can be kept in
check. Reconstruction efforts in the war-torn northand more general economic expansion in that
regionwill also provide stimulus, as will implementation of several large-scale public infrastructure
projects around the country. However, the public sectors impact on growth will be constrained by
the need to reduce the large fiscal deficit, which reached 9.8 percent of GDP in 2009, pushing up the
public debt-to-GDP ratio to over 86 percent. Net exports are expected to be broadly growth-neutral
in 2010, although with a significant down-side risk because exports are expected to recover slowly,
depending on the speed of recovery in the global economy, while imports are likely to grow quite fast
as domestic demand increases.
Medium-term challenges rest on two key issues: enhancement of macroeconomic stability and
acceleration of economic growth. Sri Lanka entered the global financial crisis in a weak
macroeconomic situation with a high fiscal deficit, high debt-to-GDP ratio, and double-digit
inflation. Shoring up the fiscal situation is the most pressing macro-policy agenda item to ensure
economic stability and lay the foundation for future growth. The economic history of Sri Lanka is
replete with examples of crowding out of private investments, inflation spurts and exchange rate
volatility, which are detrimental to growth. A key task of the new government will be to reduce the
fiscal deficit, in particular by reversing the secular trend of a declining revenue-to-GDP ratio, which
dropped to 15.1 percent3 in 2009. The new government has set itself ambitious targets for economic
growth, raising it from the current long-term trend of 5-6 percent to, say, 8 percent. Reaching this
target would require a comprehensive policy response aimed at significantly increasing investments
(by raising domestic savings and/or attracting much higher levels of foreign capital), raising labor
inputs (by a combination of higher labor force participation rates, high employment and
improvements in the skills level of the labor force), and increasing overall productivity growth from
its recent level of around 2 percent per annum to at least 3 percent in the medium term.

Prepared by Claus Astrup, Daminda Fonseka, Francis Rowe, and Kirthisri Wijeweera.
In quarter-to-quarter, seasonally-adjusted terms.
3
Including grants
2

RecentEconomicDevelopments
AVshapedRecoveryfromtheGlobalCrisis
Economic growth rebounded strongly in the second half of 2009, confirming the projected V-shaped
impact of the global financial crisis on the Sri Lankan economy. Seasonally-adjusted GDP contracted in
2008Q4, and again in 2009Q1, before beginning to turn around in 2009Q2. In 2009Q3 the economy
expanded by 3.3 percent (q-o-q, seasonally adjusted), the fastest rate ever recorded since the Department
of Census and Statistics began producing quarterly national accounts, in 2002. Although growth
moderated in 2009Q4, at 1.8 percent, it remained above its historical average, suggesting that short-term
economic momentum remained robust. A variety of leading economic indicators confirm the strong turnaround (see the graphs below), including strong upswings in registration of new motor vehicles (an
indication of improving consumer sentiment), total electricity generation, which is closely correlated with
economic activity, and throughput in Colombo port, suggesting that trade and related services picked up
significantly The recovery was broad-based with most sectors showing accelerating growth rates (see box,
pg 3).
V-shaped recovery
20%

4.0%

QuarterlyGDPgrowth(qoq,seasonallyadjusted)

DomesticContainerThroughputinPorts(TEU,%change,yoy)
15%

3.0%

10%
5%

2.0%

0%

1.0%

-5%
-10%

0.0%
2008Q1

2008Q2

2008Q3

2008Q4

2009Q1

2009Q2

2009Q3

-15%

2009Q4

-20%

1.0%

-25%

2.0%

10%

Newregistrationsofmotorvehicles(%change,yoy)
20%

11/2009

ElectricityGeneration(KwH,%change,yoy)

8%
6%

10%

4%
0%
2%
10%

0%
2%

20%

4%

30%

6%
40%

8%

11/2009

10/2009

9/2009

8/2009

7/2009

6/2009

5/2009

4/2009

3/2009

2/2009

1/2009

12/2008

11/2008

10/2008

9/2008

8/2008

7/2008

6/2008

5/2008

4/2008

3/2008

2/2008

1/2008

12/2009

11/2009

9/2009

10/2009

8/2009

7/2009

6/2009

5/2009

4/2009

3/2009

2/2009

1/2009

12/2008

11/2008

9/2008

10/2008

8/2008

7/2008

6/2008

5/2008

4/2008

3/2008

2/2008

10%

1/2008

50%

12/2009

9/2009

10/2009

8/2009

7/2009

6/2009

5/2009

4/2009

3/2009

2/2009

1/2009

11/2008

12/2008

9/2008

10/2008

8/2008

7/2008

6/2008

5/2008

4/2008

3/2008

3.0%

2/2008

1/2008

-30%

A Broad-Based RecoveryTrends in Sectoral GDP Growth

Agriculture grew a solid 5.3 percent in 2009Q4 following a 0.9 percent contraction in 2009Q3, due largely to adverse weather
conditions resulting in a disappointing yala (fall) paddy harvest, which dropped 27.3 percent lower than the bumper harvest of
2008. Growth was boosted by increased tea and rubber production to meet buoyant global prices. Fisheries (up 15.3 percent in
2009Q3 and a further 4.7 percent in 2009Q4), aided by a relaxation in fishing restrictions in the north following the end of armed
conflict, also contributed to agricultures positive growth performance.
Industry showed surprisingly strong growth, at 7.4 percent, in
2009Q4, driven mostly by the domestically-oriented parts of
the manufacturing sector (e.g., food production, which grew
6.8 percent), while the export-oriented textile sector was more
sluggish, at only 3.8 percent. Industry was also buoyed by the
construction sector which grew 7.4 percent and the mining
sector which expanded 19.0 percent.

Sectoral GDP growth, percent (yoy)

14%
12%
10%
8%

Services, which make up almost 60 percent of GDP, grew a

respectable 5.7 percent in 2009Q4. Again the dichotomy
between externally-oriented sub-sectors and domesticallyoriented sub-sectors were apparent. The trade sector, which
makes up about 40 percent of the total service sector,
continued to stagnate, growing only 2.9 percent. But,
unbundling this growth rate shows that import-export trade
services contracted by 1.4 percent, while domestic trade
services expanded by 8.8 percent. Other sectors showed high
growth rates (e.g., telecoms (+12.3 percent), transport (+9.1
percent), and government services (+6.7 percent)). None of
these sectors could however, match activity in the hotel sector,
which expanded 32.0 percent on the back of a large inflow of
tourists after the end of war.

6%
4%
2%
0%

Agriculture

Industry

Source: DepartmentofCensusandStatistics

2009q4

2009q3

2009q2

2009q1

2008q4

2008q3

2008q2

2008q1

2007q4

2007q3

2007q2

2007q1

-2%

Services

Despite the strong recovery in the second-half of the year, overall growth in 2009 was subdued, as
both domestic and global demand fell. GDP growth in 2009 reached 3.5 percent, from 6.0 percent in
2008 and 6.8 percent in 20074. Growth declined as private demand slowed. Real private consumption
growth slowed to only 0.6 percent in 2009, from 2008, the lowest growth in private consumption in more
than a decade. The slowdown in real private consumption was partly the result of a delayed effect of the
erosion of households purchasing power due to a spike in inflation in 2008. Tighter credit markets also
played a role as many durable consumer goods had hitherto been bought on credit. Private investments
contracted by 2.1 percent as market prospect dimmed and real interest rates remained high. The
contraction in world trade also hit Sri Lanka, which saw total export volumes of goods and services drop
about 12.3 percent in 20095. The total effect of the drop in these demand components on economic
growth was equal to -3.9 percent.

All comparative growth figures in this report are year-on-year comparisons, unless stated otherwise.

It should be noted that the national accounts and the trade statistics show a divergent picture of export trends in 2009. While the
two data sources broadly agree on the order of magnitude of the drop in export values (5.9 percent in the National Accounts, as
opposed to 7.7 percent in the Trade Statistics). But, whereas National Accounts data show a concurrent 7 percent increase in the
export price deflation, bringing the drop in export volumes to 12 percent, trade statistics show that the average export unit price
declined by 12.5 percent in 2009, implying an increase in export volumes of about 5 percent.

Key Macroeconomic indicators

Real Growth (percent)

2004

2005

2006

2007

2008

2009

GDP
Consumption
-- Private
-- Public
Gross Domestic Fixed Capital Formation
-- Private
-- Government
Trade
-- Export of Goods and Services
-- Imports of Goods and Services

5.4
4.7
3.9
9.3
17.8
19.9
3.7

6.2
4.5
3.1
12.0
9.8
0.7
81.9

7.7
7.1
6.5
9.6
12.9
15.4
2.0

6.8
4.5
3.9
7.4
9.1
5.4
27.6

6.0
7.9
7.5
9.8
5.3
3.9
11.1

3.5
4.1
0.6
20.2
1.4
-2.1
14.5

7.7
9.0

6.6
2.7

3.8
6.9

7.3
3.7

0.4
4.0

-12.3
-9.1

6.1
1.2
2.7
-4.0

2.2
3.9
2.3
-1.2

7.9
1.4
1.3
-3.0

3.6
2.3
2.5
-1.6

5.5
2.0
0.1
-1.7

0.0
3.7
-3.9
3.7

20.7
1,062
8.8
-3.1

24.4
1,241
10.4
-2.7

28.3
1,421
11.3
-5.3

32.6

1,629
14.0
-4.2

40.7

2,014

16.3
-9.5

42.0
2,052
5.7
-0.5

Contribution to Real GDP growth 1/

Private consumption and Investments
Public consumption and Investments
Export
Import
Memorandum Items
GDP US$bn
GDP per capita (US$)
GDP Deflator (percent)
Current account, (percent of GDP)

1/ Due to rounding, numbers might not add up to total real GDP growth

Expanding public spending and a sharp contraction in imports prevented GDP from contracting.
Real public consumption increased by a whopping 20 percent in 2009, as the government continued the
trend of recent years of adding staff to the public payroll, including the armed forces. Public employment
increased by over 60,000 during 2009. Public consumption also increased, in view of the need for
spending on the large number of internally-displaced persons from the military campaign in the north in
the spring of 2009. The United Nations system alone (mainly UNHCH, WFP and IOM) spent almost
US$200 million (0.5 percent of GDP) on humanitarian assistance in 2009. In addition, public investments
remained strong in 2009, despite the challenging revenue situation. In real terms, public investment is
estimated to have increased by 14.5 percent, in large measure because implementation of donor-funded
projects kept pace. Sustained high public spending added an estimated 3.7percent to growth in 2009, and
was therefore an important factor in preventing the economy from contracting. Of similar magnitude was
the effect of the sharp contraction in imports of goods and services, which declined in real terms by 9.1
percent in 2009. Both imports of consumer goodsintermediate goods and investment goods
contracted. Tighter trade credit as banks were extra cautious is likely to have exacerbated the drop in
imports. The delayed effect of the steep deterioration in the terms of trademaking imported goods
relatively more expensivewould also have dampened imports. Several of the measures implemented
under the 2009 budget, including the increase in the Ports and Airports Development Levy (PAL) and
various product-specific levies (so-called cesses) on selected imported goods, added to the relative price
of imports, providing further impetus to domestic production.

MutedLaborMarketImpact
The labor-market impact of the crisis was
SriLanka:RealWageIndex
cushioned by public-sector hiring and growth in
190.0
the informal sector. After growing 1.9 percent in
180.0
2008 (equivalent to 133,000 jobs), employment
170.0
contracted by 0.7 percent (a drop of 50,000 jobs) in
160.0
2009 as a result of the crisis. This modest drop
150.0
masks, however, a large decline in employment in
140.0
6
the formal private sector , which shed 170,000 jobs,
130.0
equivalent to a decline of 5.6 percent, as firms,
120.0
particularly in export-oriented sectors such as
110.0
garments, rubber manufacturing and the like, cut
100.0
back on staffing. The decline in private formal
1/2005
9/2005
5/2006
1/2007
9/2007
5/2008
1/2009
9/2009
employment was partly compensated by increasing
public employment, which grew by 62,000, or 4.9
percent, and a 2.0 percent increase in informal employment, as job-seekers resorted to own-account
working7. Overall, labor markets remained relatively tight, however, even if the average unemployment
rate (excluding Northern Province) rose marginally to 5.8 percent in 2009, from 5.4 percent in 2008. The
continued tight labor market supported modest real wage growth. Real wages of the private sector8 rose
by 1.6 percent in 2009, following growth of 2.6 percent in 2008 and 4.1 percent in 2007. At 5.7 percent,
real wages in the public sector grew faster than those of the private sector in 2009, but this came on the
back of declining public-sector real wages in 2008, where a modest nominal increase of 7.5 percent was
insufficient to cover inflation (over 20 percent) leading to a real-wage erosion of about 12.5 percent.
Recent Employment trends

Total Employment
Of which
-- Public Sector
-- Private Sector
-- Formal
-- Informal

2007
2008
2009
--------mill. persons -------7,042
7,175
7,125
1,197
5,845
2,958
2,887

1,252
5,923
3,025
2,899

2008
2009
2008
2009
-Percent change p.a.- -- change p.a. (1,000 persons)-1.9
-0.7
133
-50

1,314
5,811
2,855
2,957

4.6
1.3
2.2
0.4

4.9
-1.9
-5.6
2.0

55
78
66
11

62
-112
-170
58

Note: "Formal" employment is defined as the sum of "private sector wage employees" and "Employers", while "informal"

is defined as the sum of "own account workers' and 'unpaid family workers".

The Sri Lankan labor force survey does not enable a very exact definition of formal vs. informal employment, so a somewhat
generalized definition has been used here (see the note in the table above).
7
Although the statistics are poor, overseas employment appears to have continued to function as a safety valve for the domestic
labor market. Available data suggests that about 0.25 million people left for overseas employment during 2009. However, data
for the number of people returning from overseas employment is not available, making it impossible to ascertain the net impact
on domestic labor markets.
8
As measured by the minimum wage rate indices of the formal private sector, in Wages Board Trades.

Sharp Improvement in the External Balance

MillionsofUSD

External balances improved dramatically. The

SriLanka:TradeBalance
current account deficit improved significantly to an
1,500
estimated 0.5 percent of GDP in 2009, from 9.5
1,000
percent in 2008. Much of the improvement was
driven by the fall in international commodity prices,
500
which contributed to the near 28.0 percent drop in
0
the total import bill 2009. The decline in exports
was somewhat smaller, at 12.7 percent. Textiles and
500
apparel exports, which made up 42 percent of total
1,000
exports in 2008, fell only by 5 percent. However,
1/2007 5/2007 9/2007 1/2008 5/2008 9/2008 1/2009 5/2009 9/2009
apparel exports to the United States declined 17.5
TradeBalance
Exportsfob
Importscif
percent, as Sri Lankan firms lost market share to
9
competitors from Bangladesh, India and China .
Tea exportsSri Lankas second largest export
itemfell by 9percent, but this was due mainly to supply-side factors, as unusually dry weather hurt
production. It is likely that the trade deficit will widen: the recent rise in international food and energy
prices, planned infrastructure investment in the north and east of the country, and rebounding domestic
demand can be expected push up the import bill. Moreover, in February 2010, the European Union (EU)
formally notified the government of the temporary suspension of its access-to-trade privileges under the
Generalized System of Preferences Plus (GSP+) program, effective August 15, which, if implemented,
would negatively affect Sri Lankan exporters price-competitiveness in the EU market. Important
mitigating factors that might mitigate a deterioration in the current-account balance would be a continued
increase are expected continued increase in tourism, and rising remittances, the latter having amounted to
US$3.3 billion in 2009.
The risks in financing a modestly rising current-account deficit appear low at the moment. Through
most of 2009, the main thrust of the Central Bank of Sri Lanka (CBSL)s exchange-rate management was
to prevent the rupee from appreciating. In the face of a surplus in the current account and substantial
inflows into the capital account the CBSL was an active purchaser of foreign exchange in 2009 in order to
shore up reserves to around six-month cushion by the end of that year. The intervention ensured a stable
exchange rate of around Rs115/US$ during the second half of 2009 and in early 2010. Foreign financing
flows have been robust since the war ended, in May last year, and the signing of the IMF program in
October 2009. Gross foreign exchange reserves remain near historical highs. A couple of risks remain,
however: if the IMF program should stall much longer, it could trigger a re-evaluation of the sovereign
rating by international rating agencies; if global recovery should stall, or global risk-aversion returns, it
could also hurt capital inflows.

Total US imports of apparel declined by 11.8 percent in 2009.

900

Sri Lanka: Remittances

$6,000

800
700

$5,000

USD Mn

600
$4,000

500
400

$3,000

300
$2,000

200
100

$1,000

2009q3

2010m2

2009m12

2009m10

2009m8

2009m6

2009m4

2009m2

2008m12

2008m10

$0

2008m8

2009q1

2008q3

2008q1

2007q3

2007q1

2006q3

2006q1

2005q3

2005q1

2004q3

2004q1

2003q3

2003q1

2002q3

2002q1

The real effective exchange rate (REER) saw a welcome depreciation in 2009, after having
appreciated by about 30 percent in FY2007-08. An appreciating REER can raise concerns about
export-competitiveness. While there seems to have been a trend-decline in Sri Lankas share of world
exports in recent years, that trend was interrupted during the global economic crisis, when global exports
plummeted, allowing Sri Lanka to regain market share. The same pattern is observed in the textile and
garment sector. Recent data (though volatile) indicate that the pre-crisis trend may be resuming, giving
rise to concern about the real exchange rate.
SriLanka:ExportShareinWorldExports

SriLanka:RealEffectiveExchangeRate

0.08

(2000=100)+=appreciation

0.07

150

0.06

140

0.05

130

0.04

120

0.03

110

0.02

100

80
2005M1

ShareofTextilesand
GarmentsinWorldExports

0.01

90

2005M9

2006M5

2007M1

2007M9

2008M5

2009M1

2009M9

THEMACROPOLICYRESPONSE
EasingofMonetaryPolicy
Monetary policy has eased considerably. Prior to the global financial crisis, monetary policy was
gradually tightened in response to a sharp increase in inflation, due largely to the global commodity-price
hike. The policy stance was reversed by the end of 2008; from February 2009 the benchmark repurchase
and reverse-repurchase rates were lowered successively, by 300bp (to 7.5 percent) and 225bp (to 9.75
percent). Moreover, after the second lowering, in late 2008, the statutory reserve requirement (SRR) on
commercial banks was lowered in 2009 by a further 75bp, to 7 percent. No policy rate adjustments were
made in the first quarter of 2010.

Inflation has gradually ticked upward since September 2009. Inflation fell rapidly with the onset of
the GFC from a peak of 28 percent in June 2008 to 0.7 percent in September 2009. However, the gradual
uptick in inflation since September 2009 resulted in year-on-year inflation reaching 6.9 percent in
February 2010 (the highest in 11 months) before moderating somewhat in March, to 6.3 percent. Nearly
two-thirds of the growth in inflation during this period has come from increased food prices, which
account for 47 percent of the consumer price index (CPI). Overall CPI inflation in 2009 recorded 3.4
percent, compared to 22.6 percent in 2008. The impact of demand pressures on rising inflation is apparent
in the gradual increase in core inflation10, which reached 8.0 percent in February 2010. Inflation is
expected to stay relatively low in 2010, due partly to positive base and supply-side effects from increased
agricultural production in the North, which will help contain food prices. However, towards the end of
2010, inflationary pressures will mount, in step with the expected rise in global commodity prices and the
lagged effects of fiscal and monetary stimuli during the crisis. Against this background, it can be expected
that the monetary authorities will initiate measured monetary tightening during 2010.
Inflation, %

Short term interest rates

20%
30%

18%
25%

16%
14%

20%

12%

15%

10%

10%

8%
5%

6%

Reverse Repo

2010M1

2009M7

2009M1

2008M7

2008M1

2007M7

2007M1

Core CPI

Source:CEICdata

Repo

2006M7

2006M1

2005M7

2005M1

2004M1

15.08.2008
03.09.2008
23.09.2008
13.10.2008
03.11.2008
21.11.2008
11.12.2008
02.01.2009
22.01.2009
12.02.2009
04.03.2009
24.03.2009
16.04.2009
06.05.2009
27.05.2009
15.06.2009
02.07.2009
21.07.2009
10.08.2009
27.08.2009
16.09.2009
06.10.2009
23.10.2009
12.11.2009
02.12.2009
21.12.2009
11.01.2010
02.02.2010
22.02.2010
11.03.2010
31.03.2010

Call rate

2004M7

0%

4%

CPI

10

Which excludes volatile food and energy prices.

2010m1

2009m11

2009m9

2009m7

2009m5

2009m3

2009m1

2008m11

2008m9

2008m7

2008m5

2008m3

2008m1

Credit Growth
Monetary expansion is slowly filtering through
100%
to the private sector, but banks are likely to
remain cautious. Total advances to the private
80%
sector grew for two consecutive months, in
60%
November and December 2009, compared to the
40%
same months in 2008, with outstanding facilities
growing by 0.7 percent and 1.0 percent
20%
respectively. For the year as a whole, however,
0%
sluggish credit market conditionsreflecting
both lack of credit demand and banks caution
-20%
(see box)resulted in a decline of 5.7 percent
(yoy) in overall private-sector credit in 2009.
Despite this weakness, total domestic credit
Private Credit
Public Credit
Total Credit
continued to grow in 2009, owing to a substantial
increase in public-sector credit. Total publicsector credit (including lending to public corporations) peaked in July, at about 84 percent higher than that
of the previous year. Since the resumption of foreign inflows into government securities and the issue of
the second sovereign bond in October, outstanding public-sector credit has declined. But, by the end 2009,

it still accounted for a high 40 percent of outstanding domestic credita reflection of persistent deficitfinancing needs.
Banking Sector Developments
Leading up to the global financial crisis, in the preceding three years, the domestic banking sector was riding on a robust
economywith growth averaging 7 percent in FY2005/07 and over 6.5 percent in the first 3-quarters of 2008and an asset price
boom. It was a time noted also for persistent negative real-interest rates, which made an ideal environment for the banks to grow
their balance sheets. Indeed, during this period the banks were growing their lending portfolios much faster than in the previous
years. The compounded annualized growth in the banking sector loans & advances during FY2005/07 amounted to 23.2
percentmore than twice the average during the period 2001-04. However, in 2008, the pace of loan growth moderated to 7
percent as concerns of possible bubble-bursts rose and monetary policy direction turned towards aggressive tightening. In 2009,
in the backdrop of the global crisis, loan growth turned negative and recorded a 4 percent drop. However, the shrinking of
portfolios in 2009 did not have significant impact on banks profitability as they managed to maintain their profitability by
retaining their net-interest margins (NIM) and reaping significant one-off gains from trading government securities in an
environment of falling interest rates. The banking sectors NIM stayed relatively unchanged at 4.5 percent in 2009 while income
from non-lending activities rose 12 percent.
Banking sector assets and profitability

18%
1,800

38%

16%

1,600

36%

1,400

14%

34%
1,200
1,000

30%

800
600

Rs. Mill.

12%

32%

10%
8%

28%
400

6%

200

NOPBT /Equity

Total Capital Adequacy Ratio

Gross NPA

30.09.09*

30.06.09*

31.03.09*

2007

2008*

2006

2005

2004

2003

2002

1998

2001

4%

30.09.09*

30.06.09*

31.03.09*

2007

Gross Loans and Advances (right axis)

2008*

2006

2005

2004

2003

2002

2001

2000

1999

1998

2000

24%

1999

26%

With the bottoming out of interest rates, banks once again would be looking to grow their lending portfolios to generate income.
However, they will face two constraints to growing the lending portfolios: (a) the deteriorated asset quality position warranting
more caution and (b) possible erosion in the capital adequacy position with the shift of portfolios from low-risk assets
(government securities and cash) to riskier assets (loans and advances). The overall gross non-performing asset ratio in the
banking system at the end of 2009 is estimated to have risen to around 8 percent, compared to nearly 6 percent at the start of the
crisis. At the same time, overall provision-cover has declined to around 50 percent of total delinquent assets, compared to nearly
70 percent at the start of the crisis. Growth in lending portfolios would warrant increased level of provisioning (both general
and also possibly specific if asset quality continue to deteriorate), whilst banks would also need to build provision cover back
to pre-crisis levels. Total capital adequacy (CA) of the banking systemincluding tier 1 and tier 2was estimated at a relatively
healthy 14.9 percent by end 2009, marginally up from the 14.4 percent at the end of 2008. However, in the face of increased
balance sheet risk, banks may experience deterioration in their CA position in 2010, unless they raise additional capital.

SharplyWidenedFiscalDeficit
The fiscal deficit slipped considerably from original targets. According to provisional estimates of the
Department of Fiscal Policy in the Ministry of Finance, the 2009 deficit (after grants) reached 9.8 percent
of GDP against a (revised) target of 7.0 percent of GDP (see table). This deviation from target was almost
entirely the result of higher public expenditure, driven primarily by higher interest expenditure, higher
rehabilitation-and-reconstruction expenses following the war, and the acceleration of infrastructure

development projects. The revenue outturn fell short by a marginal 0.2 percent of GDP (Rs23 billion) as
opposed to the revised budget. This is explained mostly by steeper falls in trade-related taxes and income
taxes. The governments original budget for 2009, presented in November 2008, did not fully anticipate
the impact of the global financial crisis, especially in terms of lower tax revenues, and therefore included
a highly ambitious revenue target of 16.4 percent of GDP, while expecting the overall budget deficit to be
limited to 5.9 percent of GDP. However, the revised budget moderated revenue expectations
considerably, while at the same time recognizing additional upward pressure on recurrent expenditures
partly in recognition of fiscal stimulus measures announced at the end of 2008and lower capital
expenditure.
Fiscal Outcomes 2009, percent of GDP
Revenue & Grants
Recurrent Exp.
Capital Exp. & Net Lending
Budget Deficit

Revised Budget11
15.2
16.9
5.3
7.0

Original Budget
17.0
15.8
7.1
5.9

Outcome
15.1
18.2
6.7
9.8

Source: Department of Fiscal Policy; Ministry Of Finance & Planning

LookingAhead:EnsuringMacroStabilityandAcceleratingGrowth
TheFiscalChallenge
The robust growth outlook provides a good opportunity for much-needed fiscal consolidation.
While high growth in public consumption was important to sustain the economy in 2009, it will be
important to consolidate the fiscal position in 2010. Continued high fiscal deficits would not only increase
concerns about the overall sustainability of the fiscal situation, but would also result in upward pressure
on interest rates, and crowd out private investments. Considering the robust underlying growth
momentum, last years fiscal stimulus can be curtailed without seriously jeopardizing growth prospects.
The current fiscal target under the IMF program is for the fiscal deficit to decline to 6 percent of GDP in
201012, while the Ministry of Finance, in its pre-election budget report, projected a higher fiscal deficit of
7.5 percent, mainly due to a less ambitiousbut probably more realisticassessment of the likely cutback in recurrent expenditures (see table, pg. 11). Expenditure rationalization is challenging, in view of
the limited size of discretionary expenditures: difficult-to-change items like the public wage bill,
pension payments and other transfers and interest expenditures make up the bulk of total recurrent
expenditures.
Percent of GDP
Revenue & grants
Recurrent Expenditure.
Capital Expenditure & Net Lending
Budget Deficit

MoF Projections for 2010

15.4
17.0
6.0
7.5

IMF Program Targets for 2010

15.5
15.8
5.7
6.0

Sources: Ministry of Finance & Planning; IMF

11

12

As published in the IMFs SBA program documentation.

However,asmallleewayforreconstructionspendingintheNorthandEastislikelytoincreasethetarget
somewhat.

The interim Vote on Accounts (VOA) budget provided a generous spending envelope for the first
four months of 2010. In November 2009, the governmentin the context of upcoming general elections
and the dissolution of the parliamentproposed an interim budget (or, VOA) to provide for expenditure
in the first four months of 2010. The VOA projected a fiscal deficit, after grants, of 4.5 percent (of fullyear GDP) for the four months, which was around 12 percent higher than actual realization in the
corresponding period of 2009. A formal budget for 2010 is expected to be approved around mid-year
2010, following the completion of the election and formation of a new government.

DecomposingRevenuetoGDPratio

Percentagepointchange

1991
1996
2001
2008
199196 199601 200108
TotalRevenues
20.5
19.0
16.3
14.9
1.4
2.7
1.5
Taxes
18.3
17.0
14.4
13.3
1.4
2.6
1.1
Import
5.3
3.3
1.8
2.2
2.0
1.5
0.4
Domestic
2.8
2.5
1.3
2.3
0.3
1.2
1.0
Excises
3.0
4.7
5.1
2.4
1.7
0.4
2.7
Income
2.8
2.9
3.1
2.3
0.0
0.3
0.8
Other
2.6
2.7
2.4
2.9
0.1
0.3
0.5
Nontax
0.9
0.7
0.6
1.2
0.2
0.1
0.6
Note:TaxonimportsincludesVATonimportedgoodsandservices.

10

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

22%
Reversing the long-term secular decline in the
Total Fiscal Revenue, % of GDP
21%
revenue is a crucial objective. Years prior to the
20%
global economic crisis, revenue was on a
19%
downward trend (see graph, right). During the
18%
1990s, the main reason for the declining revenue17%
to-GDP ratio was a fall in import duties, as the
16%
tariffs were lowered. In recent years, import taxes
15%
have picked up, due partly to a large number of
14%
ad-hoc, product-specific taxes and levies.
13%
Unfortunately, this stabilization has been
12%
compromised by declining VAT revenues, where
an expanding array of exceptions and inadequate
collection efficiency has hollowed out the tax
Source: Central Bank of Sri Lanka
bases (see table, below). The government has
committed to reform and streamline the tax
system and administration, which would yield higher revenue. To this end it initiated, in the 2009 budget,
a Presidential Tax Commission to review current tax policies and recommend measures to strengthen tax
collection, auditing and enforcement, and a general simplification of the system. The committee delivered
an interim report in November 2009, and the main recommendations are expected to be incorporated into
the 2010 budget. These are expected to focus on broadening and streamlining VAT, clarifying the Board
of Investment tax-exemption system for FDI, and simplify or reform the trade-tax regime and tax
administration system.

Thegrowthchallenge

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

GDP growth and output gap, %

The short-term prospects for the Sri Lankan
8%
4%
economy are positive, for several reasons.
7%
3%
Domestically, private investment growth can be
6%
2%
expected to pick up in response to the relatively
low interest rates envisaged in the Central
5%
1%
Banks Monetary Policy Roadmap for 2010 (see
4%
0%
Monetary Roadmap box below). Increasing
3%
-1%
FDI inflows might add to private investments,
2%
-2%
although foreign investors, until now, seem to
1%
-3%
have adopted a cautious attitude to investing in
0%
-4%
Sri Lanka. A pick-up in private consumption
can be expectedin line with improving
Output Gap (Right Axis)
GDP growth
employment prospects, partly as a result of jobSource:Department ofCensus andStatisticsandWorldBankestimates
creation in the tourism sector, which is set to
continue to expand in the near termand the
expected continued buoyant inflows of
remittances. Finally, continued robust public
investmentsfor reconstruction in the north
and for other large-scale infrastructure projectswill provide added impetus to growth in 2010.
Significant part-funding for these projects has already been committed by bilateral and multilateral
donors. Net-export s are expected to have a broadly neutral impact on growth in the near-term, as a
modest increase in exports in step with an improving global economy will be counter-balanced by higher
import growth for consumption and investment purposes.

The Central Bank of Sri Lankas Monetary Roadmap for 2010

In its Monetary Road Map for 2010, the Central Bank of Sri Lanka (CBSL) advocated a continuation of an accommodative
monetary policy stance to lend further impetus to the economic recovery process. As in previous years, monetary policy is to be
anchored in a reserve money target, which aims at 7 percent real economic growth, 6 percent inflation13 and allows for monetary
expansion to broaden the finances of the previously war-hit territories in the north. Accordingly, the CBSL expects an average
reserve-money growth of 14.5 percent, against a small contraction of 0.7 percent in 2009. This takes account of a continued
increase in net foreign assets of the CBSL (through the absorption of foreign exchange inflows into the balance of payments).
However, in order to mitigate the demand impact, the CBSL is also expected to carry out offsetting sterilization operations14
which is likely to sustain the CBSLs large negative net-domestic-asset position through 2010. With the money-multiplier
expected to remain stable, the growth in the monetary base is expected to grow broad money supply. Under current projections,
this may be slightly higher than the previously-projected growth in nominal GDP, prompting a moderate uptick in inflation.

Raising the long-term growth rate in Sri Lanka to 8 percent would require a comprehensive policy
agenda. The government has committed itself to raising the long-term growth rate of the Sri Lankan
economy. A standard growth-accounting framework illustrates how this can be achieved15. Within this

13

As measured by the GDP deflator

Through measures such as sale of government securities, sale of CBSL-own securities, and foreign exchange SWAPS.
15
In the traditional growth accounting framework used here, it is assumed that GDP can be expressed independently as functions
of physical and human capital, as follows: Y = AF (K, H), where: Y is gross domestic product in constant prices; A is an index of
total factor productivity; K is gross domestic capital stock in constant prices; H is human-capital-adjusted labor input, defined as,
H = L x D x P x exp (phi x S). L is population, D is share of population, age 15-64, P is labor-force participation rate, S is average
years-of-education-per-worker, phi is a parameter that measures returns on education. Calculations are based on a Cobb-Douglas
production function with possibly-constant returns to scale: F (K, H) = K^alpha x H^(1 - alpha)\ (for further description, see
PREMnote 42).
14

11

framework, growth can increase by any combination of: (i) accelerated human capital accumulation,
either through increase labor force participation and employment or improvements in the quality of labor
(more or better schooling); (ii) accelerated physical capital-accumulation through higher investments, or
(iii) higher total-factor-productivity (TFP), which is the catch-all residual for structural improvements
affecting the efficiency of use of human and physical capital. TFP improvements can happen in many
ways (e.g., as a result of efficiency gains at the level of the individual business or factory or, e.g., as a
result of sectoral shifts in the economy, from lower- to higher-productivity sectors, such as from
agriculture to industry or services).
An illustrative scenario is presented in the graphs below. The scenario takes as starting point that
growth will gradually accelerate to 8 percent by 2013broadly in line with the Governments medium
term targets. It then asks, what are the requirements to the three underlying drivers of growth to achieve
this target? It is clear that all factorsthe input of labor, the level of investments, and the rate of overall
productivity growthwould have to increase well beyond the levels of the past year. Specifically, the
labor-force participation rate would have to gradually increase from its current level of around 49 percent,
to 52-53 percentequivalent to 500,000 jobs created in the next decade, over and above the number of
jobs necessary to absorb the underlying population growth. In terms of capital accumulation, an increase
in the ratio of investments-to-GDP from the current level of about 25 percent, to around 30 percent,
would be required. Some of this increase may be financed by foreign direct investment (FDI), but it
would also probably require an increase in national savings. Finally, TFP would have to increase to
around 3 percent per annumabout 1 percentage point higher than its average level during the recent
high-growth period from 2004-08, and well above its historical average since 1980.
What does it take to sustain 8 percent growth?an illustrative montage:
RequiredLaborForceParticipationRate,%

Target GDP Growth Rate, %

10%

53%

9%

52%

8%

51%

7%

50%

6%

49%

5%

48%

4%

47%

3%

2019

2020

2019

2018

2017

2016

2015

2014

2013

2011

2012

2010

2009

2008

2007

2006

2018

2020

2019

2018

2017

2016

2015

2014

2013

2011

2012

2010

2009

2008

2007

2006

2005

2004

2005

2004

46%

2%

Note: Data for 2006 is interpolated using average of 2005 and 2007

Required investment-to-GDP ratio

Required TFP growth

3.5%

32%

3.0%

30%
2.5%

28%
2.0%

26%

1.5%

1.0%

24%

0.5%

22%

12

2020

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2020

2019

2018

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2005

2004

0.0%

20%

ANNEXURE 1: SELECTED WORLD BANK ASSISTANCE TO SRI LANKA IN FY10

IDA
Million
US$

ProductName

Second Community Development and

Livelihood Improvement Project

LENDING
75

Emergency Northern Recovery Project

Provincial Roads Project
Sustainable Tourism Project
North and East Services Improvement
Higher Education Project

65
105
18
78
40

AAA
Towers of LearningHigher Education
Connecting People to Prosperity Economic Report
Country Environmental Analysis
Infrastructure Assessment
Health Service Delivery System Report

13

CurrentStatus

Approved September 19,

2009
Approved December 17, 2009
Approved December 17 2009
Expected Board on May 13
Expected Board on May 13
Expected Board on May 13
Released in July 2009
Released in March 2010
Preparation
Preparation
Preparation