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p. 35 of 54 BACK | NEXT I. Developing Asia and the World - Economic Developments and Prospects II. Economic Trends and Prospects in Developing Asia Newly Industrialized Economies Central Asian Republics, Azerbaijan, and Mongolia People’s Republic of China Southeast Asia South Asia Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka The Pacific III. Asia's Globalization Challenge

Asian Development Outlook 2001 : II. Economic Trends and Prospects in Developing Asia : South Asia

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Sri Lanka

The recovery of the world economy helped boost national economic performance in 2000. However, the ethnic conflict has been a heavy burden on fiscal activities and the balance of payments. The Government formulated a poverty reduction strategy, though a detailed work plan for its implementation is required.

Recent Trends and Prospects

The economy grew by 6.0 percent in 2000, compared with 4.3 percent in 1999. The services sector led the improvement. Telecommunications, stimulated by private sector investment, showed strong growth, while wholesale and retail trade recovered, primarily because of greater external trade. Banking and insurance continued to improve, while the number of buses and train locomotives increased. Tourism receipts, however, fell considerably due to the ethnic conflict in the north. The industry sector also showed strong growth, particularly garments and textiles, which were boosted by the world economic recovery and domestic currency depreciation. The agriculture sector slowed, due to (i) record paddy output in 1999 that resulted in the fall of the paddy price in 2000, (ii) unfavorable weather conditions, and (iii) the fact that the Government drew back from its promise to purchase paddy at a reasonable price, which further discouraged paddy production.

The share of gross domestic investment in GDP increased from the 1999 level: in the private sector, Sri Lankan Airlines purchased three aircraft, although public sector investment declined. The share of gross domestic savings in GDP was lower in 2000 than in the previous year, reflecting an increase in the Government’s dissaving. As a result, the resource gap widened in 2000.

The fiscal deficit rose to 9.8 percent of GDP in 2000 from 7.5 percent in 1999 (see Figure 2.17). Expenditure on the conflict was the key factor in the higher deficit. Prior to 2000, defense expenditure had gradually declined from a peak of 6.5 percent of GDP in 1995 to 4.4 percent in 1999. In the initial budget for 2000, it was expected to be as low as 3.9 percent of GDP. However, the worsening of the conflict reversed the trend and defense expenditure increased to 5.1 percent of GDP. In associated measures, the Government raised the national security levy and excise taxes on alcohol and tobacco, and reduced nonessential capital expenditure by about 10 percent.

In order to finance the large fiscal deficit—exacerbated by the delay in the sale of telecommunications shares—the Government turned to domestic financial institutions. This exerted unexpected pressure on credit markets. Consequently, interest rates rose and the private sector was crowded out of the domestic financial market. Utilization of foreign funds was impaired by cumbersome procedures in awarding tenders and the lack of counterpart funds. A decline in public investment and failure to maintain capital assets over the years have seriously reduced the production potential of the economy.

The main aims of monetary policy were to maintain stability in the financial market and keep inflation down. Other objectives included stabilizing interest rates, guaranteeing liquidity in the economy, and preventing volatility in the foreign exchange market. There was pressure to expand domestic credit to finance growing businesses and international trade. On the other hand, the decline in net foreign assets reduced the monetary base and had a contractionary effect on the money supply (M2). The net effect was an overall increase in the money supply of 13.0 percent. The repurchase rate was nearly doubled from 9.25 percent at the end of 1999 to 17 percent at the end of 2000 to take some pressure off currency depreciation. Other market interest rates also increased.

As part of financial sector reform, two state banks were restructured, including a change of management. The consensus built between employees and employers on this matter was a positive step, but implementation of the restructuring may take more time than expected.

Merchandise exports grew by 19.8 percent after a 3.9 percent contraction in 1999. The trend toward diversification of exports away from garments and textiles stalled, as the export growth rate of other industrial products such as ceramics, leather, paper, and other engineering products slowed. Earnings from tea exports increased due to high prices and renewed demand from the Commonwealth of Independent States. However, exports of other agricultural products declined. Merchandise imports surged by 22.4 percent in 2000 after 1.5 percent growth in 1999. Imports of consumer goods, except rice, increased. Intermediate goods imports, representing a little more than 50 percent of total merchandise imports, rose faster than imports of consumer goods and investment goods (excluding aircraft). Imports of petroleum went up by 76 percent.

As a result, the trade deficit widened to 8.7 percent of GDP, while the current account deficit deteriorated to 6.0 percent. The capital account also worsened, because foreign direct and portfolio investment fell and long-term capital flows declined. Reduced inflows of foreign funds required the central bank to draw down on its reserves, with the result that by the end of 2000 official reserves were only sufficient to finance 1.5 months of imports of goods and services.

The level of the exchange rate has been frequently debated over the last few years. The Government has opposed devaluation on the grounds that it would affect the budget deficit by increasing interest and debt repayments. However, a widening of the currency band was a major step toward market orientation of the exchange rate regime. The practice of making daily announcements of the buying and selling rates was discontinued. During the year, the domestic currency depreciated by 7.2 percent. The external debt burden increased marginally, from 57.4 percent of GDP in 1999 to 57.7 percent in 2000.

Inflation increased to 6.2 percent in 2000 from 4.7 percent in 1999, mainly because of price increases of agricultural products, including food. Unemployment remained on its declining trend of the last few years, and fell to about 7 percent in 2000. However, unemployment among new graduates was very high.

GDP is forecast to grow by 4.5 percent in 2001, a lower rate than in 2000, but it should strengthen to 5.0 percent in 2002. Any improvement in the agriculture sector will be limited in 2001, largely due to droughts that affected production in some areas in 2000. Agricultural output should pick up again in 2002, returning to the trend growth rate. Currency devaluation and increases in the administered prices of diesel, gas, and electricity will have a large impact on price levels in 2001, and they are likely to push inflation to about 8 percent in 2001 and to about 6 percent in 2002.

The rate of investment is likely to fall slightly in 2001. The previous decline in investment (excluding aircraft) was due mainly to a lack of investment opportunities and not to high interest rates or economic uncertainties. Because of this, investment cannot recover quickly, though some improvement may be seen in 2002. Domestic savings will likely decline marginally in 2001. The Government has to take strong action to cut expenditures to reduce the budget deficit. The projection is for a slight improvement in the budget deficit in 2001–2002.

It is projected that, in 2001, growth of exports will fall substantially to just over 3 percent; and that of imports to below 3 percent. The slow expansion of trade is the result of a combination of factors, including slower growth in import demand of industrial countries for textiles and garments and a downturn in the import of capital goods. The current account of the balance of payments is forecast to improve in 2001–2002, merely because large import volumes are unlikely. Stronger services sector earnings and steadily increasing private remittances are likely to be contributory factors.

Issues in Economic Management

Although the formation of provincial councils was allowed for by an amendment to the constitution adopted in 1987, national-provincial fiscal relations are still not clearly defined due to a lack of understanding about the devolution of powers. The amendment transferred development and many administrative functions to the provincial councils. An arrangement largely mirroring that of the central Government was established in the provinces, and the Finance Commission drew up criteria to allocate funds to the provinces. Nevertheless, some conflicts arose between the center and the provinces.

Many provincial councils, due to lack of experience in handling development activities on their own, failed to use the funds in a rational way, or spent the funds without control on, e.g., vehicles. Since then, some controls have been introduced and central government line ministries have taken over development activities. Provincial councils have not been allowed to take part in many of the line ministries’ actions.

Understanding this situation and the weak capacity of the provincial councils, the Finance Commission began allocating funds as special grants to provincial councils in 1997, and issued guidelines for using the funds. However, in the utilization of funds, unwarranted political interference and the lack of commitment to strategic planning were demonstrated again. Beginning in 2000, funds were allocated based on projects developed by the provinces; training is now provided to ensure better implementation. For 2001, the Finance Commission asked the provincial councils to prepare specific development plans. However, certain provincial governments prefer block grants without specifying projects.

Policy and Development Issues

The Government prepared its Framework for Poverty Reduction after a two-year analytical and consultative process involving many government agencies, donors, research institutes, and nongovernment organizations. Based on an analysis of the poverty situation, the Framework advocates a strategy of three main thrusts: reducing poverty by creating opportunities for pro-poor growth, strengthening the social protection system, and empowering the poor and strengthening governance.

The first thrust signals a fundamental shift in the role of the Government with regard to poverty reduction. Its new role is to create an enabling environment for poverty reduction, not to attempt to solve poverty directly through public spending. The Framework provides an array of measures aimed at enhancing opportunities for the poor to participate in the growth process, and seven sets of strategic initiatives were defined.

As part of the second thrust, the Framework calls for social safety net reform to reduce the mistargeting and adverse incentive effects that have characterized past programs, including better protection for those displaced by the conflict and a shift from cash grants to social insurance. The third thrust focuses on the need to transform governance and empower the poor. Institutional governance is to be strengthened by upgrading management practices in public service. Macroeconomic governance will be improved by tightening financial accountability. Decentralization is to be promoted, while regional fiscal imbalances are addressed and procedures for local government public expenditure management are improved. Community-based initiatives will still be supported, but with greater local cost sharing and in clear response to initiatives articulated by the poor. The Framework also proposes asset redistribution to enable hard-core socially excluded groups to rejoin the economic mainstream.

Specific approaches are outlined in each of the three main thrusts. If successfully implemented, these approaches will greatly improve the impact of the efforts of the Government, international agencies, and civil society to reduce poverty. However, the Framework does not include a work plan for implementing the strategy, nor does it pay enough attention to the link between the ethnic conflict and poverty reduction.

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