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p. 32 of 81 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia Southeast Asia South Asia Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Central Asian Republics The Pacific III. Preferential Trade Agreements in Asia and the Pacific

Asian Development Outlook 2002 : II. Economic Trends and Prospects in Developing Asia : South Asia

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Sri Lanka

After a year marred by security problems and the worst economic performance ever recorded—in which the currency peg was abandoned, inflation picked up, and foreign finance became scarce—Sri Lanka is poised for a modest private sector-led recovery in 2002. However, the new Government must provide a stable macroeconomic environment if the turnaround is to take on substance and sustain itself.

Macroeconomic Assessment

Sri Lanka’s economy suffered a serious setback in 2001. In the first half of the year, GDP grew by less than 1% over the corresponding period in 2000. This poor performance was largely due to external factors, with the slowdown in global growth dampening demand for the country’s manufactured exports, high oil prices increasing the costs of production and shipping, and a serious drought lowering agricultural yields and hydropower generation. On 24 July, the Liberation Tigers of Tamil Eelam (LTTE) attacked the country’s only international airport. Consequently, tourist arrivals plummeted, while a hefty war-risk insurance surcharge on ships docking at the country’s ports damaged the shipping industry, leading to a contraction of GDP in the second half of the year. Overall, real output declined by 1.3% for the year, the worst performance since the compilation of national accounts (Figure 2.20). This stands in marked contrast to the previous year when the economy achieved 6% growth. Early indicators suggest a rising level of unemployment, particularly in manufacturing and tourism-related services.

Savings and investment rates suffered, mainly due to actions in the public sector. The suspension of Parliament in July and its dissolution in October adversely affected the public investment program, as insufficient funds were available to support many ongoing projects, while the political instability was detrimental to private sector investment. The weak position of the Government also impeded commitments for new public sector projects, particularly those accompanied by strong sector reforms. The run-up to the December elections saw the Government approving a number of costly measures—such as increases in civil service allowances and cuts in taxes—that reduced public saving. Consequently, as a proportion of GDP, fixed capital investment fell from 28% in 2000 to 25.1% in 2001, while the savings rate remained at 17.3%.

Despite the Government’s agreement with IMF to reduce the budget deficit, fiscal performance in 2001 was worse than in 2000. Current revenues remained at around 17% of GDP, even though the Government added a 40% surcharge to import duties and increased the National Security Levy—a turnover tax applied to certain goods—by 1 percentage point for most of the year. Current expenditures continued to rise, to nearly 22% of GDP from 20.3% in 2000. This expansion in current spending was partly offset by poor performance in capital expenditures. The overall deficit, including grants and privatization proceeds, worsened from 9.5% of GDP in 2000 to 10% in 2001. When grants and privatization earnings are excluded, the deficit is in excess of 11% of GDP.

Receipts from privatization increased for the year, but this is due to the Government’s receiving the second $25 million installment from Emirates Airlines for its stake in Sri Lankan Airlines in early 2001, rather than a reflection of progress in the privatization program. In fact, the budget had included the planned sale of a 20% stake in Sri Lanka Telecommunications that was expected to raise $250 million, but this did not push through due to globally depressed telecoms prices and the uncertain domestic political climate. Local events also adversely affected the Government’s ability to attract foreign financing. The Government was preparing a syndicated loan of $200 million in the international market, but increased country risk following the LTTE airport attack prevented this deal from being concluded. Although a dollar-denominated development bond issue was floated at the end of the year, the financing of the overall gap was still heavily dependent on the issuance of domestic bonds and bank financing.

Growth in the money supply (M2) slowed in 2001 to 11.4% from 13% the year before. While the banking system raised its holdings of foreign assets, the bulk of the monetary expansion came from an increase in domestic credit. Due to the large fiscal deficit, domestic credit to the public sector rose by 14%. Following 2 years of reserve losses, and as it could no longer provide a defense against attacks on a fixed rate, the central bank floated the rupee in January 2001, when official reserves had fallen to $918 million, or only about 5 weeks of import cover. Although the exchange rate spiked immediately, the trend became less volatile, with the local currency depreciating by 16% over 2001.

Consumer prices rose by 11% in 2001, up from 1.2%, despite the drop in world oil prices toward the end of the year. The acceleration in inflation was driven by increases in key administered prices (diesel and power in particular) and the depreciation of the rupee, with poor weather also generating high domestic food prices. However, the continued high rate of monetary expansion paints a worrying picture for future inflation.

Sri Lanka’s export performance paralleled the slowdown in the global economy. The country’s largest source of foreign exchange, the textile and garment industry, experienced a drop in volume and earnings from May 2001, mainly due to lower demand from the US and EU. Tea exports, the country’s third largest generator of foreign exchange, were affected by a drought in the first half of the year and a drop in international prices.

Export earnings contracted by nearly 13%, from $5.5 billion in 2000 to $4.8 billion. The decline in imports was even more dramatic—from $7.3 billion to $5.9 billion—in part because the slowdown in exports reduced the demand for imported intermediate and investment goods. Consequently, the trade deficit narrowed to 7.5% of GDP from 11% in 2000. Although the tourism sector, the second largest source of foreign exchange, was on track for a record year, the LTTE attack caused tourist arrivals to plunge such that full-year tourism earnings fell by 15.5%. However, the initial tranche release of an IMF standby arrangement helped boost the level of official reserves to $1.3 billion, compared with $1 billion at the end of 2000, or about 2.7 months of import cover.

Policy Developments

To support the transition to a floating currency regime in January 2001 and to bolster official reserves, the Government negotiated a standby arrangement with IMF. Conditions for the support focused on the underlying factors placing pressure on the exchange rate, namely the fiscal deficit and losses of key SOEs.

The 2001 budget targeted a reduction in the overall deficit, excluding grants and privatization proceeds, to 8.5% of GDP from nearly 10% in the previous year. To reach this goal, expenditure growth generally was to be slowed and defense expenditures were to be reduced. Revenue measures included increases in customs duties and the National Security Levy as well as an ambitious target for privatization receipts. Although this target was agreed with IMF, the budget became a victim of politics in the latter part of the year. In the run-up to the elections, the Government instituted a series of costly measures, such as increasing public sector allowances, reducing administered prices, and regularizing temporary public employees. The cost of these measures in 2001 was around SLRs10 billion, or nearly 1% of GDP, but the bulk of the impact will be felt in future budgets. Moreover, the Government’s inability to sell part of its holding in Sri Lanka Telecommunications left a large gap in its financing plan. As a result, the deficit actually increased from the 2000 level, violating the standby arrangement with IMF, which then put the arrangement on hold.

The elections brought in a new administration, led by the former opposition United National Party. Its platform is more pro-business than that of the other parties, and should therefore be a positive influence for reform in the areas of labor legislation, tax administration, and infrastructure investment. The most promising postelection development has been the ceasefire signed between the Government and the LTTE. Both parties are now working toward a negotiated settlement, with the Government of Norway acting as mediator.

Outlook for 2002-2003

With improvements in the external environment, the economy is likely to turn around in the second half of 2002, but the key for the first half of the year is to stop the decline in macroeconomic performance and to focus on stability. Export production will continue to sag for the first half of 2002, as the country’s main foreign markets emerge from the current economic downturn. The expected break in the drought should lead to improved performance in the agriculture and hydropower sectors. For the year, the recovery should be modest, with GDP expanding by 3.5%, and with potential for higher growth in 2003 if a stable macro environment is in place. While increases in some administered prices—notably power—will raise inflationary pressure, stable food and oil prices will mitigate the effect, bringing inflation down to 8.5%. The recent adoption of an automatic pricing formula for petroleum products means that price changes for such goods will evolve more smoothly over time.

Slower money supply growth is needed to contain inflation, a key factor in which is controlling the fiscal deficit, to eliminate pressure for monetary expansion to fill the financing gap. Lower interest rates and the current ceasefire will help keep recurrent expenditures in check, but for the sake of medium-term growth, public investment in basic infrastructure needs to be accelerated. While revenues will likely grow more slowly, the Government’s commitment to privatization of SOEs will help bring the overall deficit down to 8.5% of GDP in 2002, which should fall further in 2003. A stable macroeconomic environment should attract higher rates of investment, leading to a widening of the current account deficit as capital import growth accelerates. The recovery in exports, which are forecast to grow by 7% in 2002, will be more than matched by import growth to support the higher investment rates.

Looking beyond the short-term stabilization issues, Sri Lanka needs to achieve high and sustainable rates of growth in per capita income to make substantial inroads in reducing poverty and to provide new jobs for entrants to the labor force. The private sector will need to take the lead in realizing more rapid economic expansion, with the Government providing an appropriate legal and regulatory environment. To this end, reforms in land and labor markets are needed to free the flow of these critical factors of production and to increase economic efficiency. Eliminating market distortions will also entail a reduction in the Government’s direct involvement in commercial activities.

In the medium term, the Government needs to strive for a more commercial orientation in the remaining SOEs, reversing the losses in some cases and preparing the way for their eventual transition to private sector operations. The Government faces many challenges ahead, and it will need to prioritize its reform agenda to optimize the use of its scarce planning and management resources.

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