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Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia : South Asia
Sri Lanka With the peace dividends from the second year of the cease-fire, economic growth and policy reforms strengthened in 2003. But the promising year ended with unexpected political developments that might slow growth and weaken the economic reform agenda. Economic Assessment A Norwegian-brokered truce, in effect since 23 February 2002, has provided the most promising prospect to date for ending the 20-year civil conflict with the Liberation Tigers of Tamil Eelam (LTTE). Uncertainties over the outcome of peace negotiations and the outlook for the future direction of the economy heightened in November 2003 when the President assumed control of several important ministries, citing policy differences over the peace negotiations. The President dissolved Parliament in early February 2004 and called for new elections on 2 April, 4 years ahead of schedule. In March, an additional area of uncertainty emerged when the eastern region commander broke with the LTTE leadership, although by mid-April the latter appeared to have restored its control over the east. The President’s party secured victory in the recent election and has formed a new Government. However, this Government’s approach to economic policies and to the peace process suggests that peace negotiations and reform implementation will face a period of considerable uncertainty.
In 2003, the economy continued its comeback from the 2001 recession-a year when the economy was battered by the global slowdown, a severe drought, and an attack on Colombo airport. Aided by the Government’s strong financial and structural reform policies, GDP is estimated to have grown by 5.5%, while inflation fell substantially and the budget deficit narrowed further. Tourist arrivals registered record numbers of over 500,000, for a 27.3% increase from 2002. The services sector was the most significant source of growth, accounting for about two thirds of the GDP increase; it was the most rapidly growing sector, at 6.8%, driven mainly by expansion in banking and insurance services. The industry sector, which before the recession had contributed substantially to economic growth, registered a slower comeback than services, growing by 5.8%. An increase in hydropower generation, which forestalled continued load shedding, and further recovery in the garment industry contributed to the expansion. The slowing rate of export orders for garments in the third quarter is partly attributable to ongoing reorganization in the sector to prepare for the phaseout of the MFA in 2005. The sector suffers from falling productivity and high factor costs in comparison with competing countries and faces challenges in the post-MFA environment. Agricultural growth was slow at 1.7%, despite a record rice harvest and a return to more normal weather conditions. Tea production was hampered in the first half of the year by floods, but despite production setbacks, exports were up by 3.6%. The ongoing cease-fire has yet to lead to a significant improvement in private sector investment, which expanded only marginally during 2003. The key sectors attracting what investment there was included power generation, telecommunications, transportation, and retail trade. Uncertainty over the peace process caused investors to continue to wait and see what transpired. On the demand side, the main driving force behind economic growth was private consumption, which accounts for over three quarters of GDP. Consumption spending was partially fueled by rising remittances from overseas workers, which increased by 9.8% in 2003 from $1.3 billion a year earlier. Unemployment in the third quarter fell to 8.4% from 9.1% with jobs being created predominantly in the private sector, since the public sector maintained its hiring freeze. Unemployment among the young however, did not improve and remains structural and entrenched: over two thirds of all unemployed people have never had a job and most are long-term unemployed. Many frustrated job seekers simply left the labor force. Fiscal action during the year was characterized by expenditure streamlining. Attempts to increase tax revenues were disappointing and collection fell about 18% short of the 2003 budget revenue target of SLRs303 billion. The reduction of the fiscal deficit to 8.1% of GDP (from 8.9%) stemmed largely from lower debt-servicing costs and military spending, as well as from underspending on planned capital investments, which were held 22% below the budget target. The cost of debt servicing was reduced because of lower than anticipated prevailing interest rates and restructuring of the public debt through the replacement of expensive commercial debt with concessional loans and long-term government bonds. Military spending fell as a result of the cease-fire agreement. About half of the deficit was financed with domestic debt, the remainder with foreign concessional borrowing, grants, and privatization proceeds. The Government met its target for privatization (SLRs13.5 billion) for the year; receipts included those from the delayed privatization of Sri Lanka Insurance, originally due in 2002, and the partial sale of a government petroleum company to the Indian Oil Corporation. Inflation, as measured by the Colombo CPI, fell to 6.3% from 9.6% in 2002, reflecting increased production and availability of consumer goods, bumper main (maha) and secondary (yala) rice harvests, lower imported inflation, and tight financial policies. As inflation subsided, the central bank reduced its main lending rates three times during the year, and the yield on 91-day treasury bills fell by 257 basis points to 7.35% at end-2003. The decline in rates was followed, albeit sluggishly, by the banking sector lowering deposit and lending rates; the average weighted prime lending rate of 9.26% at end-2003 was down by nearly 300 basis points over the year as was the average weighted fixed deposit rate. The exchange rate vis-à-vis the dollar at end-2003 (SLRs96.6/$1) remained slightly changed (0.5% depreciation) from December 2002. In nominal terms, the rupee depreciated by approximately 10.2% against the Japanese yen and 17.1% against the euro in 2003. Broad money supply (M2b) increased by 15.3%, with about three fifths of the expansion reflecting an increase in net foreign assets. Lower interest rates and better business conditions lifted growth in credit to the private sector to 16.9% from 12.0% in 2002. Buoyed by the peace process and general prevailing optimism, the stock market was among the best performing in Asia. The events in November Export growth of 10.5% and import growth of 13.0% in 2003 showed marked improvement from the performance of the previous 2 years. The beginning of global recovery led to increased demand for the country’s exports: garments and textiles (about half of total exports) were up by 6.3% and other industrial products (about 27% of total exports) increased more rapidly by 16.1%. Buoyant domestic demand expanded imports of capital, intermediate, and consumer goods. The traditionally substantial trade deficit widened to $1.7 billion. The US and EU remained the most important export markets. With the ironing out of problems in the free trade agreement with India, that country has become the second largest source of imports after the EU, displacing the US. Increased services receipts, mainly from tourism, and larger transfers in the form of worker remittances held the current account deficit to $416 million (2.2% of GDP), an outcome broadly in line with expectations. Overseas workers, predominantly based in the Middle East, stepped up their remittances during the year, apparently in response to their unsettled employment situation. The surplus on the financial account was bolstered by improved aid utilization and new program loans, though net inflows fell marginally to $226 million in 2003, in contrast to 2002 when the cease-fire and privatization of government assets spurred FDI inflows. The overall balance-of-payments surplus increased to $390 million for the year. Official foreign reserves increased to $2.3 billion, providing 4.2 months of import cover. Policy Developments The Government’s progress toward a peace settlement and commitment to economic reforms caught international attention as never before. A donor group, meeting in June 2003 and co-chaired by the US, EU, Norway, and Japan, pledged $4.5 billion for reconstruction and development. The disbursement of funds was to be closely linked to progress in the peace process. New lending from the International Bank for Reconstruction and Development and ADB approved during the year supports the Government’s goal of reducing the national poverty rate from 25% to 20% and the rural rate, where 90% of the poor reside, from 27% to 22% by 2006. Aid efforts would also focus on reconstructing conflict-affected areas. Moreover, a PRGF lending arrangement with IMF, which outlines a macroeconomic framework for a 3-year period, was agreed in April 2003, although it may be reviewed in light of recent developments. The budget for FY2003 had revenue reforms and control of public expenditures high on the agenda. The Fiscal Responsibility Act passed in December 2002 committed the Government to reducing the budget deficit to 5% of GDP and the public debt from 100% to 85% of GDP by 2006. Since interest payments alone now account for over 7% of GDP, or over 30% of budget revenues, these are crucial objectives. Implementation of reform plans for the year was mixed. The politically controversial introduction of VAT on wholesale and retail trade and the plan to remove the tax division of the Board of Investment (BOI), which can grant companies exemptions outside internal revenue laws and regulations, was passed by Parliament but has not yet been implemented. In contrast, the Government succeeded in restructuring public debt by converting SLRs33.5 billion of high interest rate rupee loans into long-term treasury bonds and by retiring expensive unauthorized off-budget overdrafts. Debt restructuring efforts will continue in 2004, although the new Government has yet to announce its intentions in this respect. The Government also introduced a tax amnesty in the 2003 budget, and as a result 10,000 new tax files were opened during 2003. However, a rigorous follow-up on the new files will be required if the tax amnesty is to have a positive effect on revenues. In November, the Government passed a reform-oriented budget for 2004. The budget outlined in greater detail reforms to achieve ambitious revenue targets and plans to establish a new revenue authority, restructure the civil service, and broaden the tax base. With the passage of this budget, IMF was about to conclude its PRGF review and release an $80 million loan installment in December. This was postponed though because implementation of one of the major program components-the new revenue authority-became doubtful. The central bank began to introduce inflation targeting in March, and contained liquidity and broad money growth in line with the targets of about 13%. The monetary stance was broadly accommodative to boost the economy, and key interest rates were lowered in line with falling inflation. The central bank also conducted open-market operations to contain excess liquidity, which remained high throughout the year due to the substantial foreign exchange inflows. Banking reform progressed, albeit slowly, and toward the end of the year the cabinet approved the Asset Management Law. This provides the basis for the largest state-owned bank shifting its NPLs to an asset management company. The domestic environment for FDI remains difficult because of the mixture of political uncertainty, regulation, inflexible labor laws, and infrastructure problems, which deters investors. To help overcome some of these hurdles, the Government set up the BOI. It is, perhaps, telling that the largest and most active department of the BOI is the one dealing with government bureaucracy, customs clearance, and license applications. Other problems facing FDI are less easy to solve, and require determined political will. Some changes to labor laws that impede the hiring and firing of new staff and were due to be passed in 2003 are still with Parliament. For example, laying off staff except for well-documented disciplinary reasons is illegal, unless a substantial compensation package is provided to the employee; neither is there any transparency in the size of the compensation package, which is set on a case-by-case basis by the labor commissioner, and a company has no recourse to appeal against the decision. The garment industry is undergoing restructuring to be able to face the phaseout of the MFA at the end of this year. A recent study shows that high labor and energy costs, the lack of functioning trade services, and weaknesses in infrastructure seriously impede competitiveness. Unbundling the power sector is moving ahead, but the process of approval for a new power plant, in the planning stage since 1988, has not moved forward as the site location remains hotly contested. This means that the essential large-scale load generation plant required to reduce prohibitively high power tariffs and to ensure reliable supply cannot enter into service before 2009 at the earliest. If demand increases as currently projected, and no new capacity is added to the system by 2005, it is likely that the power outages that so adversely affected the economy in 2001 will return by 2006. The economy has important advantages that should help it meet the targets of the Government’s ambitious long-term strategy, outlined in “Regaining Sri Lanka,” of 8-10% annual growth, although it is not yet clear if the new Government will retain that strategy. These are high literacy rates, a relatively high human development index, location next to a fast expanding and large economy, and the goodwill of the international community that pledged record assistance to the country’s reconstruction and development. To achieve its growth targets, the new Government will need to continue moving from an economy with large-scale government involvement in production to one where the private sector becomes the key source of economic growth. It needs to continue targeting four critical reform areas: a mismanaged power sector and consequent high electricity prices, restrictive land and labor laws, protective tariffs stifling growth and efficiency, and a weak regulatory framework that has led to low tax revenues and distortions in investment. The long-term strategy must also continue an ambitious privatization program, a streamlining and gradual reduction of the huge civil service, and a gradual and sustained lowering of public debt. Outlook for 2004-2005 Assuming broadly supportive political mandate for continued economic reform, the economy is expected to record solid growth over the next 2 years, but projections have been recently revised downward because of the persistent drought in early 2004, an anticipated power shortage, and the need to generate expensive emergency power, as well as a slowdown in legislating economic reforms due to the delay caused by the elections. Domestic investment activities might not be as strong as had been expected earlier, though stronger growth in the key export markets of the US and EU should help counterbalance this. Tourism has proved to be quite resilient, growing steadily through end-January and is expected to continue to expand rapidly. Even though the pressure of high global oil prices is expected to abate somewhat, a major uncertainty is the availability of sufficient hydropower. Water levels in reservoirs at end-2003 were already low and power cuts are likely unless supplemented by expensive emergency power from thermal power plants. Electricity demand is projected to increase by about 9% in 2004 and a very heavy reliance on thermal sources would be costly and disruptive to industrial growth. Given all these factors and the still uncertain global environment, projections for GDP growth are 5.0% for 2004, and 5.5% in 2005. Several factors will put upward pressure on prices in 2004. These include the possibility of the drought being prolonged (pushing up agricultural prices), power shortages (raising electricity tariffs and manufacturing costs), increases in VAT rates (on some goods), wage pressures (stemming from electioneering), and a likely greater depreciation of the rupee against the dollar (raising the cost of imports). The Government’s inflation targets are ambitious, with a minimal increase to 7.0% in 2004 and then a 1 percentage point decline to 6.0% in 2005, but they could indeed be achieved with continuing strong fiscal and monetary discipline. The original target for 2004 was to narrow the budget deficit to 6.8%, reducing recurrent expenditures while increasing capital expenditures as a share of GDP. The Finance Secretary’s Pre-Election Budgetary Position Report (mandated under the Fiscal Management Act and issued on 27 February) indicated likely revisions to the 2004 budget; revenues would likely be 3.6% lower than initial estimates, mainly due to legislative delays, and would now amount to 15.6% of GDP, while expenditures would increase to 22.9% of GDP. This would bring the estimated deficit to 7.3% of GDP. Although this revision in the deficit would continue to indicate some further fiscal consolidation during the year, the Report noted risks that included the effects of political uncertainty and the possibility of a prolonged impasse in the peace process affecting investment. While the revised budget deficit estimate for 2004 is used in the ADO 2004 projection, given the current political environment the Government might have to resort to making more substantial cuts than anticipated in the Report in capital expenditures to achieve the targeted deficit. Reflecting the established policy direction, the fiscal deficit for 2005 is tentatively projected at 6.5% of GDP. The current account deficit is projected to widen steadily to 3.0% in 2004 and to 3.5% in 2005. Growth of merchandise exports depends crucially on developments in the textile sector, and demand for textiles should pick up with higher growth in the global economy. Export growth in 2004 is projected at about 10% and then about 9% in 2005, the first year that the country’s textile exports have to compete fully on a price basis and are not governed by MFA import quotas. But imports of capital goods, intermediate goods-including crude oil for power generation-and consumer goods will increase faster than exports; import growth during the next 2 years is expected to be about 12% each year. The widening trade gap will be somewhat offset by expected continued strong growth in tourism receipts and worker remittances. Anticipated foreign assistance and other capital inflows, including larger FDI inflows, are expected to more than fully cover the current account deficit.
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disrupted the seemingly unstoppable rise, but the All-Share Price Index at year-end was nevertheless 30.3% higher than 12 months earlier (Figure 2.20).
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