sri lanka economic update - world...
TRANSCRIPT
April, 2010
Economic Policy and Poverty Team
South Asia Region
The World Bank
Sri Lanka Economic Update
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 investments—which dropped 2.1 percent in real terms in 2009—will 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 north—and more general economic expansion in that region—will also provide stimulus, as will implementation of several large-scale public infrastructure projects around the country. However, the public sector’s 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. ■
1 Prepared by Claus Astrup, Daminda Fonseka, Francis Rowe, and Kirthisri Wijeweera. 2 In quarter-to-quarter, seasonally-adjusted terms. 3 Including grants
Sri Lanka Economic Update1 April 2010
1
Recent Economic Developments
A Vshaped Recovery from the Global Crisis 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 turn-around (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
‐3.0%
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0.0%
1.0%
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2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 2009Q3 2009Q4
Quarterly GDP growth (qoq, seasonally adjusted)
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Domestic Container Throughput in Ports (TEU, % change, yoy)
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New registrations of motor vehicles (% change, yoy)
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‐8%
‐6%
‐4%
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6%
8%
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Electricity Generation (KwH, % change, yoy)
2
A Broad-Based Recovery—Trends 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 agriculture’s 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.
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 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 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.
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.
4 All 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 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.
-2%
0%
2%
4%
6%
8%
10%
12%
14%
20
07
q1
20
07
q2
20
07
q3
20
07
q4
20
08
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Sectoral GDP growth, percent (yoy)
Agriculture Industry Services
Source: Department of Census and Statistics
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 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$200 million (0.5 percent of GDP) on humanitarian assistance in 2009. In addition, public investments remained strong in 2009, despite the challenging revenue situation. In real terms, public investment is estimated to have increased by 14.5 percent, in large measure because implementation of donor-funded projects kept pace. Sustained high public spending added an estimated 3.7percent to growth in 2009, and was therefore an important factor in preventing the economy from contracting. Of similar magnitude was the effect of the sharp contraction in imports of goods and services, which declined in real terms by 9.1 percent in 2009. Both imports of consumer goods—intermediate goods and investment goods—contracted. Tighter trade credit as banks were extra cautious is likely to have exacerbated the drop in imports. The delayed effect of the steep deterioration in the terms of trade—making imported goods relatively more expensive—would also have dampened imports. Several of the measures implemented under the 2009 budget, including the increase in the Ports and Airports Development Levy (PAL) and various product-specific levies (so-called cesses) on selected imported goods, added to the relative price of imports, providing further impetus to domestic production.
Key Macroeconomic indicatorsReal Growth (percent) 2004 2005 2006 2007 2008 2009
GDP 5.4 6.2 7.7 6.8 6.0 3.5
Consumption 4.7 4.5 7.1 4.5 7.9 4.1 -- Private 3.9 3.1 6.5 3.9 7.5 0.6 -- Public 9.3 12.0 9.6 7.4 9.8 20.2Gross Domestic Fixed Capital Formation 17.8 9.8 12.9 9.1 5.3 1.4 -- Private 19.9 0.7 15.4 5.4 3.9 -2.1 -- Government 3.7 81.9 2.0 27.6 11.1 14.5Trade -- Export of Goods and Services 7.7 6.6 3.8 7.3 0.4 -12.3 -- Imports of Goods and Services 9.0 2.7 6.9 3.7 4.0 -9.1
Contribution to Real GDP growth 1/
Private consumption and Investments 6.1 2.2 7.9 3.6 5.5 0.0Public consumption and Investments 1.2 3.9 1.4 2.3 2.0 3.7Export 2.7 2.3 1.3 2.5 0.1 -3.9Import -4.0 -1.2 -3.0 -1.6 -1.7 3.7
Memorandum Items
GDP US$bn 20.7 24.4 28.3 32.6 40.7 42.0 GDP per capita (US$) 1,062 1,241 1,421 1,629 2,014 2,052 GDP Deflator (percent) 8.8 10.4 11.3 14.0 16.3 5.7Current 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
4
Muted LaborMarket Impact The labor-market impact of the crisis was cushioned by public-sector hiring and growth in the informal sector. After growing 1.9 percent in 2008 (equivalent to 133,000 jobs), employment contracted by 0.7 percent (a drop of 50,000 jobs) in 2009 as a result of the crisis. This modest drop masks, however, a large decline in employment in the formal private sector6, which shed 170,000 jobs, equivalent to a decline of 5.6 percent, as firms, particularly in export-oriented sectors such as garments, rubber manufacturing and the like, cut back on staffing. The decline in private formal 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 working’7. 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.
6 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.
Recent Employment trends2007 2008 2009 2008 2009 2008 2009
Total Employment 7,042 7,175 7,125 1.9 -0.7 133 -50Of 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 58Note: "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
1/2005 9/2005 5/2006 1/2007 9/2007 5/2008 1/2009 9/2009
Sri Lanka: Real Wage Index
5
Sharp Improvement in the External Balance External balances improved dramatically. The current account deficit improved significantly to an estimated 0.5 percent of GDP in 2009, from 9.5 percent in 2008. Much of the improvement was driven by the fall in international commodity prices, which contributed to the near 28.0 percent drop in the total import bill 2009. The decline in exports was somewhat smaller, at 12.7 percent. Textiles and apparel exports, which made up 42 percent of total exports in 2008, fell only by 5 percent. However, apparel exports to the United States declined 17.5 percent, as Sri Lankan firms lost market share to competitors from Bangladesh, India and China9. Tea exports—Sri Lanka’s second largest export item—fell 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.
9 Total 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
Millions of USD
Sri Lanka: Trade Balance
Trade Balance Exports fob Imports cif
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 about export-competitiveness. While there seems to have been a trend-decline in Sri Lanka’s 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.
THE MACROPOLICY RESPONSE
Easing of Monetary Policy
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.
0
100
200
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D
Mn
Sri Lanka: Remittances
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
20
08
m8
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0
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2
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20
10
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80
90
100
110
120
130
140
150
2005M1 2005M9 2006M5 2007M1 2007M9 2008M5 2009M1 2009M9
Sri Lanka: Real Effective Exchange Rate (2000=100) + = appreciation
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
Sri Lanka: Export Share in World Exports
Share of Textiles and Garments in World Exports
7
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.
Monetary expansion is slowly filtering through to the private sector, but banks are likely to remain cautious. Total advances to the private sector grew for two consecutive months, in November and December 2009, compared to the same months in 2008, with outstanding facilities growing by 0.7 percent and 1.0 percent respectively. For the year as a whole, however, sluggish credit market conditions—reflecting both 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 credit continued to grow in 2009, owing to a substantial increase in public-sector credit. Total public-sector 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,
10 Which excludes volatile food and energy prices.
4%
6%
8%
10%
12%
14%
16%
18%
20%
31
.03
.20
10
11.0
3.2
01
02
2.0
2.2
01
00
2.0
2.2
01
011
.01
.20
10
21
.12
.20
09
02
.12
.20
09
12
.11
.20
09
23
.10
.20
09
06
.10
.20
09
16
.09
.20
09
27
.08
.20
09
10
.08
.20
09
21
.07
.20
09
02
.07
.20
09
15
.06
.20
09
27
.05
.20
09
06
.05
.20
09
16
.04
.20
09
24
.03
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09
04
.03
.20
09
12
.02
.20
09
22
.01
.20
09
02
.01
.20
09
11.1
2.2
00
82
1.1
1.2
00
80
3.1
1.2
00
81
3.1
0.2
00
82
3.0
9.2
00
80
3.0
9.2
00
81
5.0
8.2
00
8
Short term interest rates
Call rate Reverse Repo Repo
0%
5%
10%
15%
20%
25%
30%
20
04
M1
20
04
M7
20
05
M1
20
05
M7
20
06
M1
20
06
M7
20
07
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20
07
M7
20
08
M1
20
08
M7
20
09
M1
20
09
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20
10
M1
Inflation, %
Core CPI CPISource: CEIC data
-20%
0%
20%
40%
60%
80%
100%
20
08
m1
20
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20
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20
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20
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20
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20
09
m3
20
09
m5
20
09
m7
20
09
m9
20
09
m11
20
10
m1
Credit Growth
Private Credit Public Credit Total Credit
8
it still accounted for a high 40 percent of outstanding domestic credit—a 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 economy—with growth averaging 7 percent in FY2005/07 and over 6.5 percent in the first 3-quarters of 2008—and 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 percent—more 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 sector’s 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 system—including tier 1 and tier 2—was 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.
Sharply Widened Fiscal Deficit
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
0
200
400
600
800
1,000
1,200
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24%
26%
28%
30%
32%
34%
36%
38%
19
98
19
99
20
00
20
01
20
02
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03
20
04
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05
20
06
20
07
20
08
*
31
.03
.09
*
30
.06
.09
*
30
.09
.09
*
Rs.
Mill
.Banking sector assets and profitability
Gross Loans and Advances (right axis) NOPBT /Equity
4%
6%
8%
10%
12%
14%
16%
18%
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
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20
06
20
07
20
08
*
31
.03
.09
*
30
.06
.09
*
30
.09
.09
*
Total Capital Adequacy Ratio Gross NPA
9
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 government’s 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 2008—and lower capital expenditure.
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 Source: Department of Fiscal Policy; Ministry Of Finance & Planning
Looking Ahead: Ensuring MacroStability and Accelerating Growth
The Fiscal Challenge
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 year’s 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 ambitious—but probably more realistic—assessment of the likely cut-back 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 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 IMF’s SBA program documentation. 12 However, a small leeway for reconstruction spending in the North and East is likely to increase the target somewhat.
10
The interim ‘Vote on Accounts (VOA)’ budget provided a generous spending envelope for the first four months of 2010. In November 2009, the government—in the context of upcoming general elections and the dissolution of the parliament—proposed 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 full-year 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. Reversing the long-term secular decline in the revenue is a crucial objective. Years prior to the global economic crisis, revenue was on a downward trend (see graph, right). During the 1990s, the main reason for the declining revenue-to-GDP ratio was a fall in import duties, as the tariffs were lowered. In recent years, import taxes have picked up, due partly to a large number of ad-hoc, product-specific taxes and levies. Unfortunately, this stabilization has been compromised by declining VAT revenues, where an expanding array of exceptions and inadequate collection efficiency has hollowed out the tax 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.
Decomposing Revenue‐to‐GDP ratio
Percentage point change
1991 1996 2001 2008 1991‐96 1996‐01 2001‐08
Total Revenues 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: Tax on imports includes VAT on imported goods and services.
12%
13%
14%
15%
16%
17%
18%
19%
20%
21%
22%
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
Total Fiscal Revenue, % of GDP
Source: Central Bank of Sri Lanka
11
The growth challenge
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 relatively low interest rates envisaged in the Central Bank’s Monetary Policy Roadmap for 2010 (see ‘Monetary Roadmap’ box below). Increasing FDI inflows might add to private investments, although foreign investors, until now, seem to have adopted a cautious attitude to investing in Sri Lanka. A pick-up in private consumption can be expected—in line with improving employment prospects, partly as a result of job-creation in the tourism sector, which is set to continue to expand in the near term—and the expected continued buoyant inflows of remittances. Finally, continued robust public investments—for reconstruction in the north and for other large-scale infrastructure projects—will 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 Lanka’s 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 CBSL’s 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 14 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).
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
0%
1%
2%
3%
4%
5%
6%
7%
8%
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
GDP growth and output gap, %
Output Gap (Right Axis) GDP growth
Source: Department of Census and Statistics and World Bank estimates
12
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 2013—broadly in line with the Government’s 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 factors—the input of labor, the level of investments, and the rate of overall productivity growth—would 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 percent—equivalent 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 annum—about 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:
2%
3%
4%
5%
6%
7%
8%
9%
10%
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
20
14
20
15
20
16
20
17
20
18
20
19
20
20
Target GDP Growth Rate, %
46%
47%
48%
49%
50%
51%
52%
53%
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
20
14
20
15
20
16
20
17
20
18
20
19
20
20
Required Labor Force Participation Rate, %
Note: Data for 2006 is interpolated using average of 2005 and 2007
20%
22%
24%
26%
28%
30%
32%
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
20
14
20
15
20
16
20
17
20
18
20
19
20
20
Required investment-to-GDP ratio
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
20
14
20
15
20
16
20
17
20
18
20
19
20
20
Required TFP growth
13
ANNEXURE 1: SELECTED WORLD BANK ASSISTANCE TO SRI LANKA IN FY10
Product Name
IDA Million US$
Current Status
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 13
AAA
“Towers of Learning”—Higher 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