sri lanka economic update - april 2010 full report

8/9/2019 Sri Lanka Economic Update - April 2010 Full Report

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April,2010

EconomicPolicyandPovertyTeaSouthAsiaRegion

TheWorldBank

Sri Lanka Economic Update


2/15

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

Despite entering the Global Financial Crisis in a weak macroeconomic situation, the Sri Lankaneconomy has recovered rapidly. After contracting2 for two quarters (2008Q4 and 2009Q1), theeconomy 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 theyear: In 2009Q4 growth reached 6.2 percent; foreign reserves went to about US$5 billion (sufficientfor six months of imports; inflation was in single-digits, though gradually creeping upward, and thecurrent 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 14percent 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 lowinterest rates. Private consumption is also expected to pick up, especially if inflation can be kept incheck. Reconstruction efforts in the war-torn northand more general economic expansion in thatregionwill also provide stimulus, as will implementation of several large-scale public infrastructureprojects around the country. However, the public sectors impact on growth will be constrained bythe 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-neutralin 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 fastas 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-digitinflation. Shoring up the fiscal situation is the most pressing macro-policy agenda item to ensureeconomic stability and lay the foundation for future growth. The economic history of Sri Lanka isreplete with examples of crowding out of private investments, inflation spurts and exchange ratevolatility, 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, whichdropped to 15.1 percent3 in 2009. The new government has set itself ambitious targets for economicgrowth, raising it from the current long-term trend of 5-6 percent to, say, 8 percent. Reaching thistarget 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 laborinputs (by a combination of higher labor force participation rates, high employment andimprovements 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.

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

SriLankaEconomicUpdate1 April2010


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1

RecentEconomicDevelopments

AV-shapedRecoveryfromtheGlobalCrisis

Economic growth rebounded strongly in the second half of 2009 , confirming the projected V-shapedimpact of the global financial crisis on the Sri Lankan economy. Seasonally-adjusted GDP contracted in2008Q4, and again in 2009Q1, before beginning to turn around in 2009Q2. In 2009Q3 the economyexpanded by 3.3 percent (q-o-q, seasonally adjusted), the fastest rate ever recorded since the Departmentof Census and Statistics began producing quarterly national accounts, in 2002. Although growthmoderated in 2009Q4, at 1.8 percent, it remained above its historical average, suggesting that short-termeconomic momentum remained robust. A variety of leading economic indicators confirm the strong turn-around (see the graphs below), including strong upswings in registration of new motor vehicles (anindication of improving consumer sentiment), total electricity generation, which is closely correlated witheconomic activity, and throughput in Colombo port, suggesting that trade and related services picked upsignificantly The recovery was broad-based with most sectors showing accelerating growth rates (see box,pg 3).

V-shaped recovery

3.0%

2.0%

1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

2 00 8Q 1 2 00 8Q 2 2 00 8Q 3 2 00 8Q 4 2 00 9Q 1 2 00 9Q 2 2 00 9Q 3 2 00 9Q 4

QuarterlyGDPgrowth(qoq,seasonallyadjusted)

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1/2008

2/2008

3/2008

4/2008

5/2008

6/2008

7/2008

8/2008

9/2008

10/2008

11/2008

12/2008

1/2009

2/2009

3/2009

4/2009

5/2009

6/2009

7/2009

8/2009

9/2009

10/2009

11/2009

12/2009

DomesticContainerThroughputinPorts(TEU,%change,yoy)

50%

40%

30%

20%

10%

0%

10%

20%

1/2008

2/2008

3/2008

4/2008

5/2008

6/2008

7/2008

8/2008

9/2008

10/2008

11/2008

12/2008

1/2009

2/2009

3/2009

4/2009

5/2009

6/2009

7/2009

8/2009

9/2009

10/2009

11/2009

12/2009

Newregistrationsofmotorvehicles (%change,yoy)

10%

8%

6%

4%

2%

0%

2%

4%

6%

8%

10%

1/2008

2/2008

3/2008

4/2008

5/2008

6/2008

7/2008

8/2008

9/2008

10/2008

11/2008

12/2008

1/2009

2/2009

3/2009

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6/2009

7/2009

8/2009

9/2009

10/2009

11/2009

ElectricityGeneration(KwH,%change,yoy)


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2

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 weatherconditions resulting in a disappointing yala (fall) paddy harvest, which dropped 27.3 percent lower than the bumper harvest of2008. 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 armedconflict, also contributed to agricultures positive growth performance.

Industry showed surprisingly strong growth, at 7.4 percent, in2009Q4, driven mostly by the domestically-oriented parts ofthe manufacturing sector (e.g., food production, which grew6.8 percent), while the export-oriented textile sector was moresluggish, at only 3.8 percent. Industry was also buoyed by theconstruction sector which grew 7.4 percent and the miningsector which expanded 19.0 percent.

Services, which make up almost 60 percent of GDP, grew arespectable 5.7 percent in 2009Q4. Again the dichotomybetween externally-oriented sub-sectors and domestically-oriented 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 tradeservices contracted by 1.4 percent, while domestic tradeservices expanded by 8.8 percent. Other sectors showed highgrowth rates (e.g., telecoms (+12.3 percent), transport (+9.1percent), and government services (+6.7 percent)). None ofthese sectors could however, match activity in the hotel sector,which expanded 32.0 percent on the back of a large inflow oftourists after the end of war.

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 in2008 and 6.8 percent in 20074. Growth declined as private demand slowed. Real private consumptiongrowth slowed to only 0.6 percent in 2009, from 2008, the lowest growth in private consumption in morethan a decade. The slowdown in real private consumption was partly the result of a delayed effect of theerosion of households purchasing power due to a spike in inflation in 2008. Tighter credit markets alsoplayed a role as many durable consumer goods had hitherto been bought on credit. Private investmentscontracted by 2.1 percent as market prospect dimmed and real interest rates remained high. Thecontraction in world trade also hit Sri Lanka, which saw total export volumes of goods and services dropabout 12.3 percent in 20095. The total effect of the drop in these demand components on economicgrowth was equal to -3.9 percent.

4All comparative growth figures in this report are year-on-year comparisons, unless stated otherwise.

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

-2%

0%2%

4%

6%

8%

10%

12%

14%

2007q1

2007q2

2007q3

2007q4

2008q1

2008q2

2008q3

2008q4

2009q1

2009q2

2009q3

2009q4

Sectoral GDP growth, percent (yoy)

Agr icul ture Industry Services

Source: DepartmentofCensusandStatistics


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3

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 thetrend of recent years of adding staff to the public payroll, including the armed forces. Public employmentincreased 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 inthe spring of 2009. The United Nations system alone (mainly UNHCH, WFP and IOM) spent almostUS$200 million (0.5 percent of GDP) on humanitarian assistance in 2009. In addition, public investmentsremained strong in 2009, despite the challenging revenue situation. In real terms, public investment isestimated to have increased by 14.5 percent, in large measure because implementation of donor-fundedprojects kept pace. Sustained high public spending added an estimated 3.7percent to growth in 2009, andwas therefore an important factor in preventing the economy from contracting. Of similar magnitude wasthe effect of the sharp contraction in imports of goods and services, which declined in real terms by 9.1percent in 2009. Both imports of consumer goodsintermediate goods and investment goodscontracted. Tighter trade credit as banks were extra cautious is likely to have exacerbated the drop inimports. The delayed effect of the steep deterioration in the terms of trademaking imported goodsrelatively 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) andvarious product-specific levies (so-called cesses) on selected imported goods, added to the relative priceof imports, providing further impetus to domestic production.

Key Macroeconomic indicators

Real Growth (percent) 2004 2005 2006 2007 2008 2009

GDP 5.4 6.2 7.7 6.8 6.0 3.5

Consumption 4.7 4.5 7.1 4.5 7.9 4.1

-- Private 3.9 3.1 6.5 3.9 7.5 0.6

-- Public 9.3 12.0 9.6 7.4 9.8 20.2

Gross Domestic Fixed Capital Formation 17.8 9.8 12.9 9.1 5.3

1.4

-- Private 19.9 0.7 15.4 5.4 3.9 -2.1

-- Government 3.7 81.9 2.0 27.6 11.1 14.5

Trade

-- Export of Goods and Services 7.7 6.6 3.8 7.3 0.4 -12.3

-- Imports of Goods and Services 9.0 2.7 6.9 3.7 4.0 -9.1

Contribution to Real GDP growth 1

Private consumption and Investments 6.1 2.2 7.9 3.6 5.5 0.0

Public consumption and Investments 1.2 3.9 1.4 2.3 2.0 3.7

Export 2.7 2.3 1.3 2.5 0.1 -3.9

Import -4.0 -1.2 -3.0 -1.6 -1.7 3.7

Memorandum Items

GDP US$bn 20.7 24.4 28.3 32.6 40.7 42.0GDP per capita (US$) 1,062 1,241 1,421 1,629 2,014 2,052GDP Deflator (percent) 8.8 10.4 11.3 14.0 16.3 5.7

Current account, (percent of GDP) -3.1 -2.7 -5.3 -4.2 -9.5 -0.5

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


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4

MutedLabor-MarketImpact

The labor-market impact of the crisis was

cushioned by public-sector hiring and growth in

the informal sector. After growing 1.9 percent in2008 (equivalent to 133,000 jobs), employment

contracted by 0.7 percent (a drop of 50,000 jobs) in2009 as a result of the crisis. This modest dropmasks, however, a large decline in employment inthe formal private sector6, which shed 170,000 jobs,equivalent to a decline of 5.6 percent, as firms,particularly in export-oriented sectors such asgarments, rubber manufacturing and the like, cutback on staffing. The decline in private formalemployment was partly compensated by increasingpublic employment, which grew by 62,000, or 4.9percent, and a 2.0 percent increase in informal employment, as job-seekers resorted to own-accountworking7. 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. Thecontinued tight labor market supported modest real wage growth. Real wages of the private sector8 roseby 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 theback of declining public-sector real wages in 2008, where a modest nominal increase of 7.5 percent wasinsufficient to cover inflation (over 20 percent) leading to a real-wage erosion of about 12.5 percent.

6 The Sri Lankan labor force survey does not enable a very exact definition of formal vs. informal employment, so a somewhatgeneralized 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 domesticlabor market. Available data suggests that about 0.25 million people left for overseas employment during 2009. However, datafor the number of people returning from overseas employment is not available, making it impossible to ascertain the net impacton domestic labor markets.8 As measured by the minimum wage rate indices of the formal private sector, in Wages Board Trades.

Recent Employment trends

2007 2008 2009 2008 2009 2008 2009

Total Employment 7,042 7,175 7,125 1.9 -0.7 133 -50

Of which

-- Public Sector 1,197 1,252 1,314 4.6 4.9 55 62

-- Private Sector 5,845 5,923 5,811 1.3 -1.9 78 -112-- Formal 2,958 3,025 2,855 2.2 -5.6 66 -170

-- Informal 2,887 2,899 2,957 0.4 2.0 11 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".

--------mill. persons -------- -Percent change p.a.- -- change p.a. (1,000 persons)--

100.0

110.0

120.0

130.0

140.0

150.0

160.0

170.0

180.0

190.0

1 /2 00 5 9 /2 00 5 5 /2 00 6 1/2 00 7 9 /2 00 7 5 /2 00 8 1 /2 00 9 9 /2 009

SriLanka:RealWageIndex


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5

Sharp Improvement in the External Balance

External balances improved dramatically. Thecurrent account deficit improved significantly to anestimated 0.5 percent of GDP in 2009, from 9.5percent in 2008. Much of the improvement was

driven by the fall in international commodity prices,which contributed to the near 28.0 percent drop inthe total import bill 2009. The decline in exportswas somewhat smaller, at 12.7 percent. Textiles andapparel exports, which made up 42 percent of totalexports in 2008, fell only by 5 percent. However,apparel exports to the United States declined 17.5percent, as Sri Lankan firms lost market share tocompetitors from Bangladesh, India and China9.Tea exportsSri Lankas second largest exportitemfell by 9percent, but this was due mainly to supply-side factors, as unusually dry weather hurtproduction. 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 domesticdemand 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 theGeneralized System of Preferences Plus (GSP+) program, effective August 15, which, if implemented,would negatively affect Sri Lankan exporters price-competitiveness in the EU market. Importantmitigating factors that might mitigate a deterioration in the current-account balance would be a continuedincrease are expected continued increase in tourism, and rising remittances, the latter having amounted toUS$3.3 billion in 2009.

The risks in financing a modestly rising current-account deficit appear low at the moment. Throughmost of 2009, the main thrust of the Central Bank of Sri Lanka (CBSL)s exchange-rate management wasto 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 toshore up reserves to around six-month cushion by the end of that year. The intervention ensured a stableexchange rate of around Rs115/US$ during the second half of 2009 and in early 2010. Foreign financingflows have been robust since the war ended, in May last year, and the signing of the IMF program inOctober 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 sovereignrating by international rating agencies; if global recovery should stall, or global risk-aversion returns, itcould also hurt capital inflows.

9Total US imports of apparel declined by 11.8 percent in 2009.

1,000

500

0

500

1,000

1,500

1/2007 5/2007 9/2007 1/2008 5/2008 9/2008 1/2009 5/2009 9/2009

MillionsofUSD

SriLanka:TradeBalance

TradeBal anc e Ex po rtsfob Impor tscif


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6

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 aboutexport-competitiveness. While there seems to have been a trend-decline in Sri Lankas share of worldexports in recent years, that trend was interrupted during the global economic crisis, when global exportsplummeted, allowing Sri Lanka to regain market share. The same pattern is observed in the textile andgarment sector. Recent data (though volatile) indicate that the pre-crisis trend may be resuming, givingrise to concern about the real exchange rate.

THEMACRO-POLICYRESPONSE

EasingofMonetaryPolicy

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

0

100

200

300

400

500

600

700

800

900

2002q1

2002q3

2003q1

2003q3

2004q1

2004q3

2005q1

2005q3

2006q1

2006q3

2007q1

2007q3

2008q1

2008q3

2009q1

2009q3

U

SD

Mn

Sri Lanka: Remittances

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

2008m8

2008m10

2008m12

2009m2

2009m4

2009m6

2009m8

2009m10

2009m12

2010m2

80

90

100

110

120

130

140

150

2 0 05 M1 2 0 05 M9 2 0 06 M5 2 0 07 M1 2 0 07 M9 2 0 08 M5 2 0 09 M1 2 0 09 M9

SriLanka:RealEffectiveExchangeRate(2000=100)+=appreciation

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

SriLanka:ExportShareinWorldExports

ShareofTextilesand

GarmentsinWorldExports


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7

Inflation has gradually ticked upward since September 2009. Inflation fell rapidly with the onset ofthe GFC from a peak of 28 percent in June 2008 to 0.7 percent in September 2009. However, the gradualuptick in inflation since September 2009 resulted in year-on-year inflation reaching 6.9 percent inFebruary 2010 (the highest in 11 months) before moderating somewhat in March, to 6.3 percent. Nearlytwo-thirds of the growth in inflation during this period has come from increased food prices, whichaccount 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 apparentin the gradual increase in core inflation10, which reached 8.0 percent in February 2010. Inflation isexpected to stay relatively low in 2010, due partly to positive base and supply-side effects from increasedagricultural production in the North, which will help contain food prices. However, towards the end of2010, inflationary pressures will mount, in step with the expected rise in global commodity prices and thelagged effects of fiscal and monetary stimuli during the crisis. Against this background, it can be expectedthat the monetary authorities will initiate measured monetary tightening during 2010.

Monetary expansion is slowly filtering throughto the private sector, but banks are likely to

remain cautious. Total advances to the privatesector grew for two consecutive months, inNovember and December 2009, compared to thesame months in 2008, with outstanding facilitiesgrowing by 0.7 percent and 1.0 percentrespectively. For the year as a whole, however,sluggish credit market conditionsreflectingboth lack of credit demand and banks caution(see box)resulted in a decline of 5.7 percent(yoy) in overall private-sector credit in 2009.

Despite this weakness, total domestic creditcontinued to grow in 2009, owing to a substantialincrease in public-sector credit. Total public-sector credit (including lending to public corporations) peaked in July, at about 84 percent higher than thatof the previous year. Since the resumption of foreign inflows into government securities and the issue ofthe second sovereign bond in October, outstanding public-sector credit has declined. But, by the end 2009,

10Which excludes volatile food and energy prices.

4%

6%

8%

10%

12%

14%

16%

18%

20%

31.0

3.2

010

11.0

3.2

010

22.0

2.2

010

02.0

2.2

010

11.0

1.2

010

21.1

2.2

009

02.1

2.2

009

12.1

1.2

009

23.1

0.2

009

06.1

0.2

009

16.0

9.2

009

27.0

8.2

009

10.0

8.2

009

21.0

7.2

009

02.0

7.2

009

15.0

6.2

009

27.0

5.2

009

06.0

5.2

009

16.0

4.2

009

24.0

3.2

009

04.0

3.2

009

12.0

2.2

009

22.0

1.2

009

02.0

1.2

009

11.1

2.2

008

21.1

1.2

008

03.1

1.2

008

13.1

0.2

008

23.0

9.2

008

03.0

9.2

008

15.0

8.2

008

Short term interest rates

Call rate Reverse Repo Repo

0%

5%

10%

15%

20%

25%

30%

2004M1

2004M7

2005M1

2005M7

2006M1

2006M7

2007M1

2007M7

2008M1

2008M7

2009M1

2009M7

2010M1

Inflation, %

Core CPI CPI Source: CEICdata

-20%

0%

20%

40%

60%

80%

100%

2008m1

2008m3

2008m5

2008m7

2008m9

2008m11

2009m1

2009m3

2009m5

2009m7

2009m9

2009m11

2010m1

Credit Growth

Private Credi t Public Credi t Total Credi t


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8

it still accounted for a high 40 percent of outstanding domestic credita reflection of persistent deficit-financing 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 priceboom. 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.

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 theDepartment of Fiscal Policy in the Ministry of Finance, the 2009 deficit (after grants) reached 9.8 percentof GDP against a (revised) target of 7.0 percent of GDP (see table). This deviation from target was almostentirely the result of higher public expenditure, driven primarily by higher interest expenditure, higherrehabilitation-and-reconstruction expenses following the war, and the acceleration of infrastructure

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

24%

26%

28%

30%

32%

34%

36%

38%

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008*

31.0

3.0

9*

30.0

6.0

9*

30.0

9.0

9*

Rs.

Mill.

Banking sector assets and profitability

Gross Loans and Advances (right axis) NOPBT /Equity

4%

6%

8%

10%

12%

14%

16%

18%

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008*

31.0

3.0

9*

30.0

6.0

9*

30.0

9.0

9*

Total Capital Adequacy Rat io Gross NPA


11/15

9

development projects. The revenue outturn fell short by a marginal 0.2 percent of GDP (Rs23 billion) asopposed to the revised budget. This is explained mostly by steeper falls in trade-related taxes and incometaxes. The governments original budget for 2009, presented in November 2008, did not fully anticipatethe impact of the global financial crisis, especially in terms of lower tax revenues, and therefore includeda highly ambitious revenue target of 16.4 percent of GDP, while expecting the overall budget deficit to belimited 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 expenditurespartly in recognition of fiscal stimulus measures announced at the end of 2008and lower capitalexpenditure.

Fiscal Outcomes 2009, percent of GDP

Original Budget Revised Budget11 Outcome

Revenue & Grants 17.0 15.2 15.1

Recurrent Exp. 15.8 16.9 18.2

Capital Exp. & Net Lending 7.1 5.3 6.7

Budget Deficit 5.9 7.0 9.8

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

LookingAhead:EnsuringMacro-StabilityandAcceleratingGrowth

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 beimportant to consolidate the fiscal position in 2010. Continued high fiscal deficits would not only increaseconcerns about the overall sustainability of the fiscal situation, but would also result in upward pressureon interest rates, and crowd out private investments. Considering the robust underlying growthmomentum, 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 in201012, while the Ministry of Finance, in its pre-election budget report, projected a higher fiscal deficit of7.5 percent, mainly due to a less ambitiousbut probably more realisticassessment of the likely cut-back in recurrent expenditures (see table, pg. 11). Expenditure rationalization is challenging, in view ofthe 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 recurrentexpenditures.

Percent of GDP MoF Projections for 2010 IMF Program Targets for 2010

Revenue & grants 15.4 15.5

Recurrent Expenditure. 17.0 15.8

Capital Expenditure & Net Lending 6.0 5.7

Budget Deficit 7.5 6.0

Sources: Ministry of Finance & Planning; IMF

11 As published in the IMFs SBA program documentation.12

However,asmallleewayforreconstructionspendingintheNorthandEastislikelytoincreasethetarget

somewhat.


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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 electionsand the dissolution of the parliamentproposed an interim budget (or, VOA) to provide for expenditurein the first four months of 2010. The VOA projected a fiscal deficit, after grants, of 4.5 percent (of full-year GDP) for the four months, which was around 12 percent higher than actual realization in thecorresponding 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.

Reversing the long-term secular decline in the

revenue is a crucial objective. Years prior to theglobal economic crisis, revenue was on adownward trend (see graph, right). During the1990s, the main reason for the declining revenue-to-GDP ratio was a fall in import duties, as thetariffs were lowered. In recent years, import taxeshave picked up, due partly to a large number ofad-hoc, product-specific taxes and levies.Unfortunately, this stabilization has been

compromised by declining VAT revenues, wherean expanding array of exceptions and inadequatecollection efficiency has hollowed out the taxbases (see table, below). The government hascommitted to reform and streamline the taxsystem 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 taxcollection, auditing and enforcement, and a general simplification of the system. The committee deliveredan interim report in November 2009, and the main recommendations are expected to be incorporated intothe 2010 budget. These are expected to focus on broadening and streamlining VAT, clarifying the Boardof Investment tax-exemption system for FDI, and simplify or reform the trade-tax regime and taxadministration system.

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

Non

tax

0.9

0.7

0.6

1.2

0.2

0.1

0.6

Note: TaxonimportsincludesVATonimportedgoodsandservices.

12%

13%

14%

15%

16%

17%

18%

19%

20%

21%

22%

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Total Fiscal Revenue, % of GDP

Source: Central Bank of Sri Lanka


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Thegrowthchallenge

The short-term prospects for the Sri Lankan

economy are positive, for several reasons.Domestically, private investment growth can be

expected to pick up in response to the relativelylow interest rates envisaged in the CentralBanks Monetary Policy Roadmap for 2010 (seeMonetary Roadmap box below). IncreasingFDI inflows might add to private investments,although foreign investors, until now, seem tohave adopted a cautious attitude to investing inSri Lanka. A pick-up in private consumptioncan be expectedin line with improvingemployment prospects, partly as a result of job-creation in the tourism sector, which is set tocontinue to expand in the near termand the

expected continued buoyant inflows ofremittances. Finally, continued robust publicinvestmentsfor reconstruction in the northand 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 multilateraldonors. Net-export s are expected to have a broadly neutral impact on growth in the near-term, as amodest increase in exports in step with an improving global economy will be counter-balanced by higherimport 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 accommodativemonetary policy stance to lend further impetus to the economic recovery process. As in previous years, monetary policy is to beanchored in a reserve money target, which aims at 7 percent real economic growth, 6 percent inflation13 and allows for monetaryexpansion to broaden the finances of the previously war-hit territories in the north. Accordingly, the CBSL expects an averagereserve-money growth of 14.5 percent, against a small contraction of 0.7 percent in 2009. This takes account of a continuedincrease 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 operations 14

which is likely to sustain the CBSLs large negative net-domestic-asset position through 2010. With the money-multiplierexpected 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 Lankaneconomy. A standard growth-accounting framework illustrates how this can be achieved15. Within this

13 As measured by the GDP deflator14 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 functionsof physical and human capital, as follows: Y=AF(K,H), where: Yis gross domestic product in constant prices; A is an index oftotal factor productivity;Kis gross domestic capital stock in constant prices;His human-capital-adjusted labor input, defined as,

H=L xD xPx exp (phi x S).L is population,D is share of population, age 15-64,Pis labor-force participation rate, Sis averageyears-of-education-per-worker, phi is a parameter that measures returns on education. Calculations are based on a Cobb-Douglasproduction function with possibly-constant returns to scale: F (K, H) = K alpha x H (1 - alpha)\ (for further description, seePREMnote 42).

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

0%

1%

2%

3%

4%

5%

6%

7%

8%

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

GDP growth and output gap, %

Output Gap (Right Axis) GDP growth

Source: DepartmentofCensus andStatisticsandWorldBankestimates


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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 improvementsaffecting the efficiency of use of human and physical capital. TFP improvements can happen in manyways (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 fromagriculture to industry or services).

An illustrative scenario is presented in the graphs below. The scenario takes as starting point thatgrowth will gradually accelerate to 8 percent by 2013broadly in line with the Governments mediumterm targets. It then asks, what are the requirements to the three underlying drivers of growth to achievethis target? It is clear that all factorsthe input of labor, the level of investments, and the rate of overallproductivity growthwould have to increase well beyond the levels of the past year. Specifically, thelabor-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 ofjobs necessary to absorb the underlying population growth. In terms of capital accumulation, an increasein 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 itwould also probably require an increase in national savings. Finally, TFP would have to increase toaround 3 percent per annumabout 1 percentage point higher than its average level during the recenthigh-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:

2%

3%

4%

5%

6%

7%

8%

9%

10%

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

Target GDP Growth Rate, %

46%

47%

48%

49%

50%

51%

52%

53%

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

RequiredLaborForceParticipationRate,%

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

20%

22%

24%

26%

28%

30%

32%

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

Required investment-to-GDP ratio

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

Required TFP growth


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

ProductName

IDA

Million

US$ CurrentStatus

LENDING

Second Community Development and

Livelihood Improvement Project

75 Approved September 19,

2009

Emergency Northern Recovery Project 65 Approved December 17, 2009

Provincial Roads Project 105 Approved December 17 2009

Sustainable Tourism Project 18 Expected Board on May 13

North and East Services Improvement 78 Expected Board on May 13

Higher Education Project 40 Expected Board on May 13AAA

Towers of LearningHigher Education Released in July 2009

Connecting People to Prosperity Economic Report Released in March 2010

Country Environmental Analysis Preparation

Infrastructure Assessment Preparation

Health Service Delivery System Report Preparation

sri lanka economic update - april 2010 full report

Documents