201

Institute of Policy Studies of Sri Lanka

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
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600
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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
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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.