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p. 43 of 77 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions 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. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia : South Asia

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Sri Lanka

High oil prices, growing fuel subsidies, and a drought in 2004 all impacted inflation, the budget deficit, and the balance of payments. The year ended in tragedy: more than 35,000 Sri Lankans perished in the tsunami on 26 December. Reconstruction and recovery is the first priority, but urgent economic reforms needed for long-term growth should not be forgotten.

Macroeconomic assessment of 2004

Growth in 2004 moderated slightly to 5.5% and remained driven by domestic consumption and fast-growing exports, with performance underpinned by the continuing cease-fire. Investment growth was not as high as anticipated, as two elections--both the parliamentary election in April, which resulted in a change in government, and a provincial council election in July 2004--produced economic and political uncertainty. A stalled peace process and uncertainty about how the new Government would approach negotiations with the Liberation Tigers of Tamil Eelam (LTTE) added to the prevailing atmosphere of hesitation. Privatization of parts of the retail arm of the Ceylon Petroleum Corporation with a foreign buyer was not carried through, and this brought down FDI inflows to 22.2% below the level of the previous year. Exports grew strongly, but significantly higher imports, mainly due to much larger oil payments, widened the current account deficit.

The mainstay of economic growth, the services industry, continued to thrive, growing rapidly at 8.1%. Banking sector performance, however, was not as strong as in 2003, as profit margins dipped following a reduction in interest rate differentials. Port services and shipping grew strongly, despite growing fears of increasing competition from the Indian market: 67% of cargo traffic is transshipment to or from India. Agricultural output contracted by 1.8%, due to a drought. While not affecting plantation crops, the drought caused paddy production--most of which is on small-scale farms--to fall by 24%. The industry sector’s performance was mixed: generation of hydropower, always prone to wide fluctuations, fell by 2%; but both the textile and garment and the construction subsectors recorded robust growth. Construction, which now accounts for about 7% of GDP, has benefited from a cease-fire building boom, mainly in privately financed projects.

Poverty levels, as measured by the head count poverty ratio, have overall declined only slowly, from 26.1% in 1990 to 22.7% in 2002, according to a survey carried out in each of those years. Given variations in the surveys’ approach, which make direct comparisons difficult, income inequality seems to have increased, with the share of the lowest quintile declining from 5.2% to 4.8% over this period. Across a wide range of social indicators, Uva (the central province covering most tea plantation lands) and the east remain among the most disadvantaged in terms of access to economic opportunities, education, and general infrastructure. Following the availability of new preliminary data for the north and east in 2005 (except for those districts under LTTE control), the devastation as well as inequality in terms of basic services has been documented. For example, in the north, only 3% and 64% have access to water piped into the house and electricity, respectively, compared with 52% and 93% in the relatively wealthy western province.

The hoped-for fiscal consolidation was not achieved and the budget deficit was virtually unchanged at 7.6% of GDP in 2004, owing to weaker than expected expenditure and revenue outturns in equal measure. High levels of fuel, wheat, and fertilizer subsidies to cushion the impact on consumers of sharp global price increases were the primary issue with respect to expenditure pressures, while weak tax administration and leakages continued on the revenue side. Moreover, lower inflows of foreign concessional loans resulted in a much larger than expected rise in domestic borrowing (SLRs65 billion planned as against SLRs119 billion actual) adding steam to an already rapid private sector credit expansion. Central government debt jumped to SLRs2,127 billion or 106.9% of GDP, from SLRs1,864 billion or 105.5%, though the impact of exchange rate changes on the external debt explains some of the increase.

Inflation accelerated sharply during the second half of 2004, reaching 16.8% on a December-to-December basis (Figure 2.20), and up by 7.9% on an annual average basis. Cost-push factors stoked inflationary pressures, especially higher global oil prices (which were slowly and not completely passed on to the consumer in the form of 38% and 23% price rises for diesel and gasoline, respectively) and drought-related food shortages (rice prices alone surged by over 40% in 2004).

Broad money (M2b) increased by 19.6% in 2004. Domestic credit accelerated to 22.4% from 7.6% in 2003, with private sector and net government credit advancing by over 20%. This put pressure on the balance of payments, which deteriorated markedly over the year. Policy lending rates are negative, even though the central bank put up its two key lending rates by 50 basis points in November 2004 to 7.5% and 9.0%, respectively. The average weighted prime lending rates of commercial banks rose to 10.23% at end-2004 from 9.26% 12 months earlier, while 91-day treasury bill rates stayed virtually unchanged (7.25% at end-2004). The stock market performed strongly in 2004: the All Share Price Index rose by 26.6% to end the year at 1,506.9, reflecting a capitalization of SLRs382.1 billion. The index continued its advance in the first quarter of 2005.

Swollen by both oil and non-oil products, imports are estimated to have risen by 19.3% in 2004. This led to a significant worsening of the current account deficit from $101 million to $626 million, equivalent to 3.2% of GDP. Exports grew solidly at 12.7%, buoyed as in the past by textiles and garments, but also this year by an impressive performance in rubber and tea, which were underpinned by significant global price increases. Workers’ remittances, traditionally a major source of foreign currency, also continued to grow strongly, to $1.3 billion.

The depreciation of the Sri Lanka rupee against major currencies helped retain market shares in highly competitive textile and garment markets. The exchange rate relative to the dollar at end-2004 (SLRs104.5/$1) was 7.7% lower than a year earlier. Foreign exchange reserves fell sharply by about $0.5 billion to $1.8 billion by the end of the year, offering about 2.4 months of import cover. The reserve position was bolstered during the year by the issue of $250 million of Sri Lanka Development Bonds and by central bank negotiation of credit lines.

Macroeconomic policy developments

The approach of the new Government differs from that of the previous one: it has ruled out privatization of SOEs, but has announced that it is keen on restructuring them. It has also rejected the poverty reduction strategy paper developed by its predecessor, stating that it ignored the worsening regional inequality and failed to tackle poverty at its roots. The Government plans greater emphasis on direct poverty interventions and programs, and a greater role for itself in addressing increasing income inequality. However, it is not yet clear how it plans to tackle the difficult questions of reforming public utilities or of dealing with intractable land and labor issues. Discussions with IMF on a new Poverty Reduction and Growth Facility (PRGF) program are planned to take place during the first half of 2005. Finalization of a World Bank Poverty Reduction Credit was delayed because of a lack of structural reforms.

Previous governments grappled, largely unsuccessfully, with persistently weak performance of the revenue collection agencies, and the new Government also sees an improvement in revenue collection as its main priority. It has rejected the earlier administration’s plans for creating a new autonomous revenue agency to improve revenue collection (a plan that faced significant labor union opposition). Instead, the Government aims to achieve change from within, and a revenue board, comprising members of all revenue collection agencies, is to be set up.

Weak revenue performance has important implications for both the size and efficiency of capital expenditures. This situation arises because new project starts are not sufficiently restricted, such that available revenues become spread too thinly over ongoing projects for them to be completed on time. Weak revenue performance slows donor-financed projects as well, since they generally require counterpart funding from the Government.

The first year’s budget of the new Government presented in November 2004 envisaged further fiscal consolidation to bring down the deficit to 7.5% of GDP in 2005. At the same time, it incorporated much higher capital spending and a substantial real wage increase for civil servants. Fiscal consolidation was to be achieved almost exclusively through stronger revenue collection, primarily by a sharply higher tax on imports, but also by the elimination of most fuel and wheat subsidies in 2005. In addition to the standard 15% VAT rate and zero rate for exports, the budget announced two new rates--a 5% VAT on basic commodities and an 18% VAT on luxury goods. Capital expenditures will be ramped up by a nominal 50% to 5.8% of GDP. In addition, a 31% nominal wage rise in the civil service salary scale was made. The budget also planned a further civil service hiring drive for 30,000 trainees. The immediate impact of this latter effort on the wage bill is, though, relatively small, as the base salary is low, at SLRs3,000-5,000 a month for graduates. Since the new Government assumed office, it has created 70,000 additional government positions.

The end of the MFA on 1 January 2005 has not yet had an identifiable adverse impact on the country’s textile and garment industry. According to industry reports, the order books of the largest exporters are full through the first half of 2005. The Government had pinned hopes on reaching a free trade agreement with the US to reduce the impact of the loss of quotas by giving Sri Lanka’s exports special tariff treatment and thus more preferable access to US markets. These hopes were not realized because national elections in both countries put negotiation of the agreement in abeyance. However, as a result of the tsunami, the EU is likely to include a larger number of textile and garment items in its preferential trade system. Consequently, 90% of textile and garment exports to the EU would then have zero-rated access.

While there is a backlog of important economic legislation that has built up since the February 2004 election, the Government took action in July to create a Strategic Enterprise Management Agency. It is tasked with putting the 13 largest SOEs on a more commercial footing, without privatizing them. All enterprises, including the People’s Bank and Ceylon Electricity Board (CEB), submitted business plans in October. The key issue for most enterprises under the agency’s purview is to delink them from the political process, and allow tariff setting regulated by a fully functional public utility commission, to fully reflect enterprise costs, including an adequate return on invested capital.

In December 2004, the Government announced a phased approach to restructure the People’s Bank, the largest state-owned commercial bank. The bank is burdened with heavy NPLs (over 17% of total loans) and excessive exposure (24% of total loans) in the form of advances to SOEs. The restructuring is tied to specific performance targets, reached in agreement with the People’s Bank’s labor union and management, on achieving levels of profitability and bringing down the NPL ratio to 9.7% by 2008.

The financial position of the CEB, the state-owned energy utility, has deteriorated substantially. Tariff increases of well over 40% would now be necessary to prevent it from incurring a loss. An attempt to raise the average tariff by 3% in November 2004 failed and the matter is now under consideration in the courts. Reform of the power sector was started in 1996 with the ultimate goal of unbundling CEB to improve efficiency, linked with a least-cost power generation expansion plan. This reform has not been seen through and no major additional power generation capacity (above 300 megawatts) is likely to come on line before 2009, a prospect that risks holding back economic growth.

Despite the mixed performance in 2004, the economy has proved remarkably resilient in the past, and continued to grow despite two decades of civil war. Its educated workforce, geographic location (next to a booming India), and its openness to international trade are important strengths. However, key policy issues--restrictive land regulations, expensive and unreliable power supplies, low agricultural productivity, rigid and nontransparent labor laws, as well as an overstaffed bureaucracy and inefficient public services--need to be tackled for the country to fulfill its substantial long-term growth potential.

Outlook for 2005-2007 and medium-term trends

The 26 December tsunami struck more than 1,000 kilometers, or two thirds, of Sri Lanka’s coastline. Coastal infrastructure--as well as a large number of houses--was destroyed or significantly damaged, with an overall asset loss estimated at $1.0 billion, or 4.5% of GDP. Reconstruction costs, including upgrades, are estimated at $1.5 billion-1.6 billion. While the human loss was staggering, the impact on GDP growth might be relatively small, perhaps shaving less than 0.5 percentage point off expected growth in 2005 for an outturn of 5.2%. This is because neither the port of Colombo--through which most of the country’s exports are channeled--nor the main production and exporting industries were affected. Only the fishing, tourism, and tourism-related subsectors, which together account for only about 3% of GDP, suffered extensive damage. Moreover, reconstruction activities, which are expected to be funded mainly by aid, and the easier access to EU markets should have an important offsetting impact.

Assuming reconstruction plans are implemented speedily, economic growth is likely to be 5.8% in 2006 and then rise to 5.9% in 2007. This expansion will be underpinned by strong growth in construction, the key sector in post-tsunami reconstruction activities. But tourism--which was in fact less damaged than fishing--should recover quickly, assuming that rebuilding and cleaning-up activities along the coast are not delayed.

In 2005 imports are estimated to increase by 17.2%, with much of the expansion attributable to reconstruction needs, but also by a higher oil bill. This suggests that the current account deficit for the year will nearly double to almost 6% of GDP, or about $1.3 billion. After the first year of tsunami-related imports, import growth is projected to fall to about 6.0-8.5% in 2006-2007. Export growth is projected at 9.0% in 2005 growing at 11.0-12.0% in the 2 subsequent years. The export performance assumes a solid performance of the textile and garment industry that will benefit both from government programs to enhance productivity and preferential EU access.

The fiscal impact of the tsunami will be reflected in the budget over time. On 9 March 2005, a meeting of the Paris Club decided to grant a 1-year debt repayment moratorium for Sri Lanka. Interest rates, to be negotiated on a bilateral basis, will be capitalized. The precise details still have to be worked out, but the Government was due to pay some $500 million for debt amortization and service in 2005, including amounts due to international institutions. This will give it considerable fiscal breathing space.

With this relief and larger aid, the fiscal deficit is projected to increase only moderately from the original budgeted 7.5% of GDP to 8.0% in 2005 and 2006, and decline to 7.0% in 2007. Given the large pledging of donor funds, both from bilateral and multilateral sources, the Government should be able to finance reconstruction costs without resorting to domestic borrowing to the extent that it did in 2004. A framework to meet annual requirements and monitor assistance over the medium term is being established.

During the forecast period, numerous factors will put upward pressure on prices. These include the Government’s commitment to reducing subsidies, especially for fuel; rises in utility tariffs; the substantial civil service wage increase in the 2005 budget; and the influx of donor funds that will work to raise salaries. Already, anecdotal evidence suggests that high demand for skilled labor from international agencies is leading to labor shortages; prices of construction materials are also reported to have increased. Inflation is projected at about 2 percentage points above earlier expectations at 12.0% in 2005. It will then likely moderate to 9.0% and to 7.5% over the next 2 years.

The greatest risks to growth stem, as in the past, from uncertainty in the peace process. Official peace talks between the LTTE and the Government have not taken place since April 2003, although both sides remain committed to maintaining the cease-fire, and to finding a peaceful solution. This uncertainty continues to stymie domestic and foreign investment. A wide-ranging investment climate survey conducted by ADB and the World Bank in 2004 identified the key impediments to private sector growth as weak infrastructure (e.g., lack of reliable power and reasonable roads), uncertainty over macroeconomic policies, and red tape. But following the tsunami, there is now an elevated risk that key economic reforms and investment in infrastructure will receive less attention than before, as more resources of both the Government and other stakeholders are focused on reconstruction.

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