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p. 34 of 68 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 Asia The Pacific III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia : South Asia

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Sri Lanka

With the year-long ceasefire providing much-needed stability at home, the country achieved a moderate economic recovery in 2002. The Government needs to build on this foundation by pursuing the necessary structural reforms for sustained higher growth rates in the medium term.

Macroeconomic Assessment

Sri Lanka entered 2002 with an economy in serious difficulty, battered by both global and domestic events. The previous year had seen the country's worst macroeconomic performance since independence, with the economy contracting by 1.4%, inflation accelerating, and the fiscal position deteriorating. From this perspective, although the 2002 recovery may have been modest, the Government's progress in stabilizing the economy provides a firm foundation for more rapid growth in the medium term.

The Government and the Liberation Tigers of Tamil Eelam (LTTE) entered into a ceasefire to begin negotiations to settle the civil conflict that has ravaged the north and east for nearly 20 years. By midyear, tourism (Figure 2.18) and shipping had recovered to the monthly levels achieved prior to the LTTE attack on the international airport a year earlier, and during the second half of the year posted substantial gains. The ceasefire also opened up opportunities for internal trade and transport services, even though external trade was lagging. For the year, services were the leading growth sector, expanding by 4.6%.

In aggregate, GDP expanded by 3.0% in 2002. The end of the drought brought relief to the agriculture sector, which grew by 2.4% during the year, compared with a decline of 3.0% in the previous year. The one area of continued weakness was the industry sector, where the level of output remained largely unchanged from the previous year, growing by only 0.5%. Power cuts, of up to four hours a day, due to system failures and low water levels in the reservoirs, led to an almost 10% reduction in output from utilities in the first half of the year. Even once this power crisis had subsided, the sector had still not fully recovered lost ground by year-end. The power cuts, combined with weaker than expected global recovery, led to lackluster performance in manufacturing, with this subsector contracting over the first 6 months of 2002 and growing by a mere 1.5% for the whole year. Although an improvement from the 4% contraction in 2001, there is still excess capacity in manufacturing.

Savings and investment rates recovered somewhat in 2002, but significantly higher savings rates will only materialize as fiscal consolidation progresses. The private sector did not generate many new investments, despite the stability from the peace process, because of the excess capacity following the 2001 recession.

The labor market was weak in 2002 despite the recovery in production. The unemployment rate rose by a percentage point to 9.0% for the year. More than 60% of the unemployed have at least a middle school education and nearly 32% have at least a high school education. While conscious of the need to create jobs, the Government is reluctant to turn to the short-term solution of expanding public sector employment, which already accounts for nearly one fifth of the total. A public sector hiring freeze has been in place for more than a year, and some key overstaffed public enterprises have offered voluntary retirement packages.

The primary goal of the 2002 budget was to stabilize the macroeconomy. Unsustainable deficits in the past had led to the depletion of foreign reserves, rising interest rates, and an expanding debt burden. The Government has had some success in reining in the budget deficit. The overall fiscal deficit, excluding grants and privatization proceeds, of 9.0% of GDP is a substantial improvement from the deficit of 10.9% in 2001. Although the main innovations under the budget were on the revenue side, current revenues of 16.5% of GDP were very similar to the performance in 2001. Total expenditures, on the other hand, fell by about 2 percentage points of GDP to 25.5%, about half of which was due to better control of recurrent expenditures.

The budget deficit is financed mainly through domestic borrowing, but the composition of that borrowing in 2002 included a welcome use of longer-term debt instruments: the Government reduced its outstanding balance on overdraft from SLRs38 billion at the beginning of the year to SLRs5 billion at the end. While privatization was budgeted to bring in SLRs21 billion, the largest deal—the sale of the Sri Lanka Insurance Corporation—was deferred to 2003, with the result that less than SLRs5 billion was actually received. The Government has shown flexibility in pursuing its privatization agenda. When no acceptable offers were received for its remaining shares in Sri Lanka Telecoms, it chose to sell a percentage of its shares through an initial public offering on the Colombo Stock Exchange instead. The move had the added benefit of increasing the depth of the stock exchange.

Broad money supply increased by 13.4% in 2002, at a rate similar to the previous year. About half of this was due to a rise in domestic credit to the private sector. Net foreign assets also increased, as the central bank raised its holdings of foreign reserves to bolster the exchange rate. The Government, for its part, has relied on nonbank financing of the fiscal deficit to avoid putting pressure on the money supply. Domestic credit to the public sector accounted for less than 5% of broad money growth. Despite the higher growth in real output, inflation moderated only slightly to an average of 10.2% for the year, in part because of higher world oil prices and adjustments locally in some administered prices, but inflation slowed in the last half of the year. After a slight depreciation in the first quarter, the exchange rate hovered around SLRs96 to the dollar from April 2002, adding stability to traded goods prices. In response to declining trends in inflation and international interest rates, the central bank reduced its interest rates three times during the year, lowering the repurchase rate from 12.0% to 9.75% and the reverse repurchase rate from 14.0% to 11.75%; the interest rates in the secondary market for treasury bonds followed these rates down.

With the sluggish global economy, exports continued to flounder, declining by 2.4% to $4.7 billion, after falling by 12.8% in 2001. Textiles and apparel, which are heavily dependent on demand from the US and EU, were particularly hard hit. Imports expanded somewhat to $6.1 billion, due mainly to increasing imports of intermediate goods. Consequently, the trade deficit widened from 7.4% of GDP in 2001 to 8.5%. Trade in services—benefiting from recoveries in tourism and shipping—and remittances helped offset the gap in merchandise trade such that the current account deficit was at a manageable level of 2.5% of GDP. The overall balance of payments was in surplus, increasing official reserves from $1.3 billion (2.2 months of import cover) to $1.7 billion (2.9 months of import cover).

Policy Developments

The Government's initiative toward solving the civil conflict augurs well for the country's development and has received favorable responses from the international community, including donors. On 24 December 2001, the LTTE declared a unilateral ceasefire, which was reciprocated by the Government. Facilitated by the Norwegian Government, the two parties signed a formal ceasefire agreement on 22 February 2002 that included several confidence-building measures as precursors to formal peace negotiations. In September 2002, the Government lifted its ban on the LTTE to pave the way for face-to-face talks. During the year, three rounds of peace talks were held: two in Thailand and one in Norway. Both parties have agreed to seek a federal solution within a united Sri Lanka to end the country's long-standing civil conflict. Although the talks have not yet reached the stage for large-scale reconstruction to begin, a year without serious fighting between the two sides has allowed economic activity to blossom in the north and east and opened the door for internally displaced persons to move back to the area.

The Government's 2002 budget—approved only in April due to Parliamentary elections—focused on stabilization through fiscal consolidation. The deficit target of 8.5% of GDP, excluding grants and privatization proceeds, was to be achieved mainly through revenue reforms. Wide-ranging changes were made to simplify tax administration and widen the tax base, the cornerstone of which was the replacement of the goods and services tax and national security levy with a two-tiered VAT. However, slow growth in trade led to shortfalls in customs receipts and changes in other taxes caused temporary shortfalls during the adjustment period. In the third quarter of 2002, the Government initiated some additional cuts in recurrent expenditures to achieve a revised deficit target of 8.9% of GDP. The 2003 budget announced in November will continue the process of fiscal consolidation, aiming to reduce the deficit further to 7.5% of GDP. Revenue reforms are still high on the agenda, most notably expanding the coverage of VAT to include wholesale and retail trade, thus bringing the complete supply chain under this tax. To bring interest expenditures down, the Government has been paying off expensive overdraft borrowings and floating longer-term debt.

Underutilization of foreign aid is a chronic problem in Sri Lanka. In 2002, the Government introduced a "pool fund" for capital expenditures, through which projects that disbursed more quickly than expected could draw on these counterpart funds without having to wait for a supplementary budget passed by Parliament. However, many agencies were not fully aware of the operations of the pool and so it was not widely used. In 2003, the pool arrangements will be refined and information on them more broadly disseminated among spending agencies. While the pool fund should ensure that adequate counterpart funds are readily available for ongoing projects, it does not address the systemic problems in project management and inefficient tender procedures that prevent more effective use of aid resources in the country.

Since the floating of the Sri Lanka rupee in January 2001, the monetary authorities have been accumulating foreign reserves, both through official sources such as IMF and direct purchases from the foreign exchange market. The increase in reserves has allowed the restrictions on foreign exchange transactions that were instituted at the time of the float to be relaxed.

With the passage of the 2002 budget, the Government was able to revive the IMF standby arrangement, which had been suspended the previous year, receiving $60 million in balance-of-payments support in April. Moreover, Sri Lanka successfully completed the final review of the facility and the final tranche of $64 million was released in September 2002. IMF is now discussing with the Government a possible Poverty Reduction and Growth Facility (PRGF) for the country, the basic parameters of which were outlined in the 2003 budget. The Government has prepared its poverty reduction strategy paper, in consultation with various stakeholders, to provide an overall framework for poverty reduction efforts in the country. The PRGF will likely focus on needed structural reforms in the labor and financial markets. The World Bank is planning a poverty reduction support credit to complement the PRGF.

Outlook for 2003-2004

Now that progress has been made in establishing macroeconomic stability, Sri Lanka is expected to enjoy rising GDP growth in 2003, particularly during the second half. Rising external demand from industrial countries, mainly in the second half of 2003, should provide a much-needed boost to the export sector. Tourism and shipping have shown the strongest recoveries as a consequence of the ongoing peace negotiations, and they are very likely to continue expanding in 2003. Investment as well should improve due to the cessation of hostilities and lower interest rates.

High oil prices would act as a damper on industrial growth, but the end of the drought that plagued the country over the last several years should help keep electricity prices in check, as generation need not rely as much on expensive thermal plants. Moreover, electricity supply should become more reliable with the commissioning of an additional 165 megawatts of generation capacity in the first half of 2003. Agricultural production has also shown resurgence in recent months and should perform well in the first half of 2003. With continued favorable weather, the economy is expected to grow by 5.0% in 2003 with somewhat higher growth of 5.5% in 2004. This forecast is a bit more conservative than the Government's projection of 5.5% growth in 2003 and 6.5% in 2004, reflecting uncertainty in the strength of the global environment.

Geopolitical events notwithstanding, international oil prices, while high at the start of 2003, should stabilize at a lower level and so reduce the pressure on prices. Local prices should also have fully adjusted to the tax reforms implemented in 2002 such that inflation will be on a downward trend over 2003. The inflation rate should fall to 8.5% for the year; however, money supply growth needs to be kept in check for this to happen. In this respect, the Government's progress in bringing the fiscal deficit down to a sustainable level is a notable achievement. The target budget deficit of 7.5% of GDP in 2003 is ambitious, but feasible. As recurrent expenditures—which are dominated by wage and pension payments and interest charges—have limited scope for short-term reductions, the Government needs to make a concerted effort to increase tax receipts if further deficit reductions are to be attained.

As the world economy strengthens, the dollar value of Sri Lanka's exports is forecast to rise by 6.5% in 2003, with most of the improvement occurring in the second half of the year. However, because of the increase in investment, high oil prices in the early part of the year, and rising consumption, merchandise import growth will be even more rapid, expanding by 9.0% over the whole year. The widening trade gap will be offset somewhat by increased services income—due to the recoveries in shipping and tourism—and the rise in private remittances. However, overall the current account deficit will widen over time in the medium term, a reflection of the rising investment needs outstripping the gains in public-sector saving.

Much of the country's ability to achieve these projections hinges on external factors. Slower recovery in the US and EU—Sri Lanka's main export markets—would have a negative impact on manufacturing. Failure in either of the monsoons would limit agricultural output and cause the power sector to rely more on thermal generation.

The economy is also vulnerable to volatility in oil prices stemming from the conflict in Iraq, and the effect on shipping and global tourism could handicap Sri Lanka's recovery. The level of remittances, which are the country's largest source of foreign exchange earnings, may also be adversely affected by the aftermath of the conflict, given the large number of Sri Lankans who are working in the Gulf.

On the domestic front, the stability arising from the ongoing peace process is a key element for sustaining development. While a breakthrough is unlikely in the near term, steady progress needs to be made in the peace talks to target the needs of the poor in the north and east and to foster investor confidence in the country generally. At this point, the macroeconomic forecasts do not include the impact of major relief and rehabilitation works, the financing of which will need to come from abroad given the tight constraints on domestic resources.

The projections assume relative political stability during the period, but the cohabitation between the Government and the president, who is a member of the main opposition party, is very insecure. Moreover, the president can now dissolve Parliament at her discretion as a year has passed since the last Parliamentary elections. Holding elections at this point would pose risks for the peace process, in addition to the usual pressure on government spending and delays in public investment. In this context, it is important for the Government to bring inflation under control, as this has been one of the main criticisms from the opposition.

The Government eliminated load shedding of power in mid-2002, but system instability still causes occasional outages. Therefore, ensuring sufficient and reliable power supply is also a priority for maintaining higher rates of growth. The Government has also begun to address some of the structural impediments hindering more rapid economic growth. It passed legislation in early 2003 that will make the labor market more flexible and reduce delays in arbitrating in disputes between workers and employers. Work has also begun on developing a social safety net for displaced workers as a precondition for further labor reforms.

The groundwork has been laid for utilities to be regulated by an independent commission to eliminate political interference in these commercial activities, and the vertically integrated state-owned electricity company will be unbundled and corporatized for greater competition and efficiency in the power sector. The petroleum sector has been liberalized, and competitors to the state-owned petroleum company began operations in 2003. The Government's progress on its structural reform agenda is promising, but a clear set of priorities needs to be in place to better manage the process.

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