Sri Lankan Economy: the challenge of sustaining high growth at times of global turbulence

Saman Kelegama Institute of Policy Studies of Sri Lanka www.ips.lk

High Growth amidst Global Turbulence

From 3.5% growth in 2009 Sri Lanka picked up to recording 8% growth in 2010 and 8.3% growth in 2011 According to the ESCAP report many Asia-Pacific economies recorded a lower growth rate in 2011 compared to 2010, except a few like Sri Lanka, Bangladesh, Maldives, Indonesia, Loa, Cambodia, etc. These A-P countries had brought inflation under control and were able to pursue growth-oriented strategies; Sri Lanka is now in a post-war high growth trajectory. The question is its sustainability

High Growth of Imports in 2011

The high growth had a large domestic consumption element with a large influx of imports Import bill amounted to 34.3% of GDP in 2011 compared to 27.2 % of GDP in 2010 and 24.7% of GDP in 2009 Investment and intermediate goods imports increased due to increase in development activities in the economy 25% of imports is oil and the oil imports increased due to the increase imports of motor vehicles which was facilitated by the low interest rates and the highly appreciated exchange rate Overall imports grew by 50% in 2011 far exceeding the export growth

Export Performance
Sri Lankan exports, although grew by 22% in 2011 it is far below some neigbouring countries (India 29.3%, Bangladesh 41.5%, Pakistan 29.3%, Maldives 82%, etc) Sri Lankas global export share has remained stagnant at 0.06% and exports as a percentage of GDP has declined over the last 7 years Overvalued exchange rate during the last 5 years contributed to this outcome Imports growth far exceeding the export growth contributed to a major imbalance in the external sector

Macroeconomic Stability had to be restored

So the high overall growth was accompanied by a major imbalance in the external balance which was reflected in the trade deficit of 16% of GDP and C/A deficit of 7.8% GDP This was not sustainable without cutting imports and increasing exports, thus a depreciation of the exchange rate according to market forces was necessary This was done partially starting mid-November -- 3% depreciation and thereafter implementing a flexible exchange rate policy after 9th February 2012 and we are now in the correct track

Policy Framework for Stability

Exchange depreciation alone was inadequate to curb the imports, thus it had to be combined with a tighter monetary policy higher interest rate and higher taxes on non-essential imports This tightening is essential to bring stability to the economy This stability will come via curbing imports, increasing exports and other foreign capital inflows

Reducing Imports ?
Due to exchange rate depreciation, higher interest rates, and higher vehicle taxes, motor vehicle imports, for instance, will reduce from US$ 1.7 bn in 2011 to less than half of US$ 0.7 bn in 2012 So will many other imports belonging to the consumer durable category, investment and intermediate goods but due to increase in commodity prices in the global market the price effect will nullify the import volume reduction effect and the estimated import flows in 2012 is US$ 20.9 bn compared to US$ 20.3 bn in 2011

Increasing Exports ?
Exports should have differentiation and capture new markets and reduce overwhelming dependence on the US and EU markets ESCAP report says that increasingly growing Southern markets should be looked at as new export markets, in particular the growing AsiaPacific region Sri Lanka should make maximum use of existing regional arrangements such as SAFTA, APTA, India-Sri Lanka FTA, and Sri Lanka-Pakistan FTA

Remittances: On the Increase and Looking Positive

Remittances is the largest source of foreign exchange earnings to Sri Lanka, increasing to US $ 5.1 bn in 2011 (8% of GDP) compared to US$ 4.1 bn in 2010 While measures taken by the government to tap informal remittances to formal channels and other schemes did play a role, the ESCAP report shows that many South Asian countries like Pakistan, Bangladesh, etc., experienced an increased inflow of remittances in 2011 compared to 2010 The report attributes this to remittances being dominated by unskilled jobs which have been less vulnerable to global economic downturns and migrant recipient countries in West Asia having strategies to retain migrant workers The outlook for remittance flows in the coming years is positive: aging population in North East Asia and Russia, FIFA World Cup in Qatar in 2022, oil price increase based prosperity in West Asia, etc.

FDI and other Capital Inflows

Sri Lanka is expecting about US$ 7 bn capital inflows in 2012 via FDI and other capital inflows (excludes exports and remittances) FDI close to US$ 2bn and tourist earnings close to US$ 1 bn will constitute a major component of that US$ 7 bn according to official estimates ESCAP report warns of increased volatility of global financial markets and periodic bouts of volatility, which can complicate macroeconomic planning and these factors have to be accommodated in building Sri Lankas earned reserves in the coming years

FDI Inflows: The Challenge

For 8% growth we required 32% of GDP investment (assuming an ICOR ratio of 4) In 2011, investment was 30% of GDP while national savings was 22% of GDP and it is this gap that was partly reflected in the external current account deficit Assume national savings increase to about 26% in the coming years, then to obtain that additional investment we need more FDI US$ 2 bn FDI inflows has to be increased to about at least US$ 6-8 bn in the coming years to support the 8% sustainable growth this is a challenge as it requires policy consistency, predictability, and stability

Stability in the Domestic Finance Sector

ESCAP report highlights the need for fiscal space to respond for unexpected global turbulence Sri Lankas fiscal deficit declined from 8% GDP in 2010 to 6.8% GDP in 2011 and the aim is to reduce it to 6.2% of GDP in 2012 Since capital expenditure is maintained around 6% of GDP, Sri Lanka will acquire a position where it borrows only to fund capital expenditure and maintains a balance in the current account of the Budget The current account deficit declined from 2.1% GDP in 2010 to 1.1% GDP in 2011 and is expected to be zero in 2012, which will be a positive feature of budgetary management

Challenges on the Fiscal Side

Public Debt per GDP was brought down below 80% GDP level in 2011 and this too is a positive sign in managing public debt But revenue declined from 14.6% of GDP in 2010 to 14.3% of GDP in 2011 and the expected revenue in 2012 is 14.7% of GDP As there are limitations in cutting expenditures due to political economy reasons, more revenue enhancement via implementing the recommendations of the Presidential Taxation Commission report becomes all the more important to meet the set target for the budget deficit in 2012

Challenges on the Monetary Policy

Interest rates have been increased to bring about the required stability in the external trade sector Will curtail the borrowing and reduce the overheating of the economy, the challenge is to ensure that this happens Reduced borrowing will ensure that inflation is maintained at a single digit level and not overshoot and that the recent price adjustments of oil and price increases due to depreciation of currency will be oneoff phenomena The stability that will come with high interest rates will permit to relax monetary policy in a the future

Growth with Stability

2012 growth is expected to be in the range of 6 to 6.5% High growth can be sustainable, if such growth is accompanied by macroeconomic stability In 2011 that stability was disturbed by the large external trade deficit and thus the 8% growth could not be sustained, and thus adjustments had to be made in the economy to bring that much needed stability Stabilization policies have their costs and this the public has to bear until the required adjustment comes about in the economy ESCAP report highlights risks and opportunities for 2012 and provides many policy lessons and compare one country with another in the policy making process

Overall Challenge
Euro crisis, commodity price fluctuations (including oil), behaviour of the weakening dollar, Iranian embargo, political developments (Geneva resolution related LLRC recommendations implementation) are the perceived risks for the Sri Lankan economy in 2013 Post-war euphoria, infrastructure developments, growing business opportunities, tourism and construction activities, growing Asia-Pacific economies, high growth in neighbouring India, are opportunities How effectively Sri Lanka can minimize risks and maximize on the opportunities will determined the sustainability of the high growth trajectory

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