183

Institute of Policy Studies of Sri Lanka

Sri Lanka: State of the Economy 2009
Prospects free download / e-version
17. Prospects
Despite the general gloom pervading the
outlook for the global economy, Sri Lanka
has reasons for some optimism. The military
victory ending a 30 year long separatist con-
flict in the country in May 2009 has revived
expectations of long term political stability
that can create a conducive environment for
sustained growth and development. Indeed,
the near term economic outlook has also
brightened. In early July 2009, the Central
Bank of Sri Lanka (CBSL) revised the GDP
growth forecast for the year to a more opti-
mistic 4.5 per cent. Assurances that the first
tranche of the long awaited IMF Stand-By
Arrangement - enhanced from an initial US$
1.9 billion to US$ 2.6 billion - would be
disbursed from July 2009 further boosted
expectations of a better-than- expected
economic recovery.
The anticipated economic dividends from the
conclusion of the war effort are many. In the
immediate short term, the mere revival of
economic activity - in agriculture, fisheries,
etc. - in the previous conflict-affected regions
can stimulate output. In the more medium
term, reconstruction of damaged and
destroyed infrastructure - road/rail networks,
housing, schools, hospitals, etc. - will
provide an additional stimulus. It is quite
likely that active economic participation of
the private sector in the Northern and
Eastern Provinces will inevitably be linked
to progress in restoring large scale
infrastructural needs in energy, transportation,
communication, etc. Private sector investors
may be averse to finance specific investments
- in tourism related facilities, for instance -
until such infrastructure materializes, or there
is a credible commitment to improve facili-
ties. Nonetheless, the emerging evidence
points to strong private sector interest in
entering markets in previously conflict-
affected areas. By mid-June 2009, the CBSL
had already granted approval for 67 new bank-
ing service outlets to be opened in the North-
ern Province - the largest number of approv-
als given during a comparable period.
The economic resurgence of the Northern and
Eastern Provinces are inextricably linked to
ensuring socio-political stability in the
country. Thus, reconstruction needs cannot
be delayed on account of financial constraints
of the government, exacerbated by the
global economic downturn. Not only is Sri
Lanka facing a revenue crunch as economic
activity slows, but bilateral donors are also
distracted by their own domestic economic
concerns. In this context, the enhanced loan
facility of US$ 2.6 billion from the IMF is a
mixed blessing. It will undoubtedly ease Sri
Lanka's external resource constraints, but it
could well impose fiscal restraints on a
speedy reconstruction process. Indeed, the
IMF noted that it supported the government's
goals of "reducing the fiscal deficit to a sus-
tainable level" with the initial announcement
under the Staff Level Agreement.
1
Conditionalities - attaching demanding
conditions that have become shorthand for
austerity - lie at the root of arguments in
favour of and against IMF programmes. In
some instances, such conditionalities are
viewed positively, as imposing external
discipline to macroeconomic management
in the face of lax domestic macroeconomic
1
http://www.imf.org/external/np/sec/pr/2009/pr09265.htm.
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Institute of Policy Studies of Sri Lanka
Sri Lanka: State of the Economy 2009
Prospects free download / e-version
Table17.1
Key Fiscal Developments (January-April)
% Change % of GDP
2008 2009 2008 2009
Revenue 23.5 -9.6 4.8 3.9
Expenditure 24.2 28.0 6.9 8.0
Current 23.5 34.5 5.2 6.2
Public investment 11.4 9.1 1.8 1.7
Overall budget deficit 25.8 113.7 2.1 4.0
Domestic financing 98.8 165.3 1.7 4.0
Source: Ministry of Finance and Planning, Mid Year Fiscal Position Report, various issues.
prudence. Alternatively, the very standard,
"one-size-fits-all" approach can also prove to
be counter-productive in dealing with spe-
cific country situations. This partly explains
why countries prefer to avoid the IMF until
they have run out of options. But it also un-
derlines why it is critical to practise prudent
macroeconomic management, and avoid the
necessity of being subject to lending condi-
tionalities - and thus, surrender some degree
of policy flexibility.
For instance, Sri Lanka at present needs to
retain a degree of fiscal flexibility to respond
effectively to the reconstruction needs of the
previously conflict-affected areas, not least
on political-economy considerations. Fiscal
developments so far in 2009 have been
unfavourable. Revenue growth has contracted
sharply by 9.6 per cent during January-April
2009 compared to a growth of 24 per cent in
the corresponding period in 2008, while ex-
penditure has grown at 28 per cent - slightly
above the 24 per cent growth recorded in the
corresponding period in 2008 (Table 17.1).
As a result, the overall budget deficit esti-
mate for the period has doubled to 4 per
cent of GDP relative to the 2.1 per cent re-
corded in the same period of 2008. These
developments suggest that Sri Lanka's fiscal
situation is set to weaken considerably, con-
trary to the optimistic fiscal deficit target of
6.5 per cent of GDP announced in Novem-
ber 2008 in the government budgetary esti-
mates for 2009. Indeed, the revised fiscal
target of 7 per cent of GDP announced fol-
lowing the Letter of Intent with the IMF also
looks to be similarly optimistic.
The deficit financing pressures will be sig-
nificant, with more immediate implications
for monetary policy management as well. The
entirety of the deficit bridging needs during
January-April 2009 has been met through
domestic financing (Table 17.1). While the
government has rightly appointed a Presiden-
tial Taxation Commission with a view to
strengthening revenue generation in the me-
dium term, there is limited room to raise
additional revenues in the near term. Busi-
nesses are struggling in the current economic
environment, while consumers have seen an
erosion of their real incomes in view of the
high inflationary environment of recent years.
The Nation Building Tax (NBT) introduced
through the 2009 budget proposals, for in-
stance, has been raised already from 1 to 3
per cent as of May 2009. Thus, the immedi-
ate response calls for rationalization of ex-
penditures - cutting back on any profligate
expenditure - so that priority areas are not
unduly affected.
The rapid decline in inflationary pressures
seen in recent months - initially as a response
to the tighter monetary policy stance that sub-
sequently coalesced with the impacts of the
global economic crisis - should not be re-
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Institute of Policy Studies of Sri Lanka
Sri Lanka: State of the Economy 2009
Prospects free download / e-version
ignited. The annualized rate of inflation still
stands high at 10.4 per cent in July 2009.The
risks for continued price stability are two-
fold: domestic borrowing pressures from the
fiscal side, and the potential for oil prices to
recover as the global economic recession bot-
toms out.
These factors - the global economic down-
turn and the accompanying commodity price
glut - have been a mixed blessing for Sri Lanka.
While the global downturn undoubtedly im-
pacted negatively by hurting the country's
export sector, the sharp drop in oil prices
allowed the country to avert a looming for-
eign exchange crisis. During January-June
2009, Sri Lanka's trade deficit contracted by
60 per cent to US$ 1,249 million - primarily
on the back of a sharp drop in the import
expenditure bill. While export earnings
dropped by 18 per cent, the reduction in
imports was much more pronounced at 37.7
per cent over the period (Figure 17.1).
The much reduced import expenditure bill
and general slowdown in economic activity
eased mounting pressure for an adjustment
in the exchange rate. Sri Lanka's depleted
foreign exchange reserves hit a low of US$
1,272 million in March 2009 on the back of
Figure17.1
Trends in Trade Flows (September 2008-June 2009)
0
200
400
600
800
1000
1200
1400
Sep Oct Nov Dec J an Feb Mar Apr May J un
2008 2009
Exports Imports
Source: CBSL, Monthly Economic Indicators, various issues.
an ill advised attempt to prop up the cur-
rency in spite of a rapidly worsening foreign
exchange gap. Having approached the IMF
for a Stand-By Arrangement of US$ 1.9 bil-
lion in February 2009, the CBSL eased its
involvement in the foreign exchange market.
The rupee depreciated to a high of Rs. 120
to the US dollar in March 2009, before be-
ginning to recover, as the demand for dollars
dropped sharply with the fall in import de-
mand.
In addition, Sri Lanka continued to see a rela-
tively healthy inflow of remittance inflows.
After an initial drop in the first quarter of
2009, private remittances remained steady
at US$ 1,505 million in the period January-
June 2009 (up 5.4 per cent over the corre-
sponding period in 2008). As anticipated,
remittance inflows are unlikely to see an
immediate reversal on account of the global
economic crisis. At the same time, Sri Lanka
will also not have the benefit of the robust
growth in remittance inflows of approxi-
mately 15 per cent per annum seen in recent
years.
The resulting liquidity in the domestic for-
eign exchange market allowed the CBSL to
mop up dollars. This not only prevented an
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Institute of Policy Studies of Sri Lanka
Sri Lanka: State of the Economy 2009
Prospects free download / e-version
undue appreciation of the rupee in view of
the already uncompetitive real exchange ap-
preciation of recent times, but also helped
the CBSL to re-build the country's foreign
reserves position. By June 2009, official re-
serves stood at US$ 1,618 million, equiva-
lent to 1.7 months of imports. By mid-Au-
gust 2009, net foreign exchange purchased
by the CBSL in the domestic market is esti-
mated to have exceeded US$ 600 million.
Excluding the first tranche of the IMF dis-
bursement, official reserves had thus crept
up to US$ 2.3 billion. A steady increase in
net foreign inflows to the Treasury bills and
bonds market of US$ 270 million by mid-
August 2009, received a further boost with
an inflow of US$ 850 million from an esti-
mated US$ 1.2 billion commitment from an
international hedge fund in the US. Addi-
tionally, a new allocation of the reserves of
the IMF saw Sri Lanka receive an equivalent
of US$ 475 million to push the country's
official reserves to an estimated US$ 4 bil-
lon by end August 2009.
Despite the significant improvement in net
inflows of foreign capital, Sri Lanka's exter-
nal payments position will need to be
watched carefully in the near term. There are
inherent risks of capital flight related to port-
folio investment flows - such as those in gov-
ernment debt securities - as experienced in
the fourth quarter of 2008. The country still
has to meet outstanding settlements on bi-
lateral lines of credit, oil price hedging, for-
eign borrowing, etc., in the course of 2009-
10. It is in that context that the long delayed
agreement between the IMF and the GOSL
for the disbursement of a Stand-By Arrange-
ment saw Sri Lanka's stock market rallying
immediately. The proposed disbursement of
a US$ 2.6 billion facility (amounting to 400
per cent of the country's quota) - in eight
tranches over 20 months, and at an interest
rate of approximately 1.5 per cent - is a
boost to medium-term investor confidence
in the economy.
Figure17.2
Changes in Inflation and Policy Rates (September 2008-July 2009)
0
5
10
15
20
25
30
Sep Oct Nov Dec Jan Feb Mar Apr May June July
2008 2009
%
Repo CCPI (Annual) CCPI (Point-to-point)
Source: CBSL, Monthly Economic Indicators, various issues.
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Institute of Policy Studies of Sri Lanka
Sri Lanka: State of the Economy 2009
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The 'mopping' up of liquidity from the for-
eign exchange market has ensured that infla-
tionary pressures remain under control, and
the easing of interest rates could continue.
The CBSL which began to use policy rate
adjustments in February 2009 once more, after
a lapse of one year, had successively cut the
repurchase rate (Repo) by 200 basis points
by June 2009 (Figure 17.2). By end 2009, it
is quite likely that Sri Lanka's annual rate of
inflation will fall to single digit levels for
the first time since 2004.
However, medium term inflationary pressures
will need to be watched closely. Inflation is
expected to pick up in the second half of
2009, despite the anticipated decline of an-
nual inflation to single digits by year end.
The latter will materialize as the lagged ef-
fects of the sharp decline on a point-to-point
basis seen in the first half of 2009 (reaching
0.9 per cent in June 2009) gets reflected in
the more gradual decline in the annualized
rate by end 2009. As previously mentioned,
the outlook on inflation for the more me-
dium term will depend on fiscal develop-
ments, and external conditions related to
international oil price trends.
As evident from the discussion earlier, Sri
Lanka's developing fiscal situation in 2009
looks fragile. The IMF funding will go a long
way to easing external resource constraints,
and thus help towards fiscal consolidation
by easing the need to resort to costly short
term commercial borrowing. Nonetheless,
the magnitude of funding needed for the re-
construction process will be quite significant.
For instance, the re-building of roads alone
in the Northern and Eastern Provinces is esti-
mated to cost US$ 750 million. In addition,
the country is also likely to experience the
general tendency towards some degree of fis-
cal slippage associated with electoral cycles.
Presidential and General Elections are widely
expected to be held by end-2009 or early
2010. Past experience in this regard high-
lights the risks; the 14-month Stand-By Ar-
rangement entered into with the IMF in April
2001 fell apart before the General Elections
of end 2001, before it was rescued once more
by the incoming new government.
Sri Lanka will undoubtedly hope to tap bi-
lateral donors and international development
agencies for reconstruction related finance.
But, there is always a considerable time gap
- of at least 12 months or more - between
the issuance of pledges/commitments and
their translation to the actual disbursement
of funds. In the interim, the government will
have to take the lead in financing reconstruc-
tion and rehabilitation related needs. These
developments can hold inflationary impli-
cations.
Other risks to macroeconomic stability have
also to be considered. A significant inflow
of foreign capital can cause destabilizing ef-
fects on exchange rate policy management.
Apart from bilateral/international develop-
ment agency support for the reconstruction,
capital inflows can also come by way of
many other channels. With the re-bounding
of the Colombo Stock Exchange - with stocks
up by 60 per cent so far in mid-2009 - "hot
money" can flow in to take advantage of in-
vestor opportunities. With the improvement
to Sri Lanka's sovereign credit rating follow-
ing the IMF agreement, the government may
resort once more to foreign currency denomi-
nated borrowing to ease pressure on domes-
tic sources of funding.
A heavy inflow of foreign capital - some of
it of a likely volatile nature - will compli-
cate attempts to sustain macroeconomic sta-
bility in the longer term. If policy is geared
to exchange rate stabilization, central banks
intervene in the foreign exchange market and
increase their holding of reserves - as done
by the CBSL in recent months. However, ris-
ing net foreign assets become a major source
of money supply growth. To ensure price sta-
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Institute of Policy Studies of Sri Lanka
Sri Lanka: State of the Economy 2009
Prospects free download / e-version
bility, governments can resort to sterilization
of domestic monetary expansion. Sri Lanka
does not maintain a fully liberalized capital
account, and thus, there is still some leeway
to implement both monetary and exchange
rate stabilization policies. For instance, even
if open market operations result in higher
interest rates, domestic borrowers are con-
strained from accessing funds from abroad.
Nonetheless, whilst such a policy thrust may
help stabilize short run macroeconomic equi-
librium, it can also raise the long run risks of
instability.
Over the 20 month period of disbursement
agreed with the IMF, the loan conditionali-
ties will be aimed at keeping Sri Lanka on a
fairly tight fiscal and monetary policy path -
to achieve the targeted fiscal deficit of 5 per
cent of GDP by 2011. In that constricted
policy space, addressing weaknesses in fis-
cal management - raising revenue and cut-
ting down on unnecessary expenditures - to
support the reconstruction drive in the North-
ern and Eastern Provinces will be critical. It
is only from a platform of sound macroeco-
nomic fundamentals that the country will
be able to reap the full economic dividends
of the end to the 30 year separatist conflict.