Underpinned by solid growth and boosted by medium-term fiscal support, the Sri Lankan economy rode out a difficult year in 2016, though government measures to curb spending and boost revenue may impact investment and expansion in the coming year.
According to IMF estimates issued at the end of October, Sri Lanka’s economy was forecast to close out 2016 with GDP growth of 5%. A similar rate of expansion is forecast for 2017, rising to 5.4% by the end of the decade.
A flat growth trajectory and the need to fund economic reform prompted the Sri Lankan government to broker an Extended Fund Facility (EFF) with the IMF, which authorised the provision of $1.5bn in loans over a three-year period.
Under the terms of the EFF, which came into effect at the beginning of June, the government committed to a programme of fiscal consolidation, revenue mobilisation, public financial management reform, state enterprise reform, a transition to flexible inflation targeting, and reforms to the trade and investment regime.
As part of these ongoing measures, the government plans to utilise public-private partnership models to bring efficiency and attract investment to some state-owned enterprises (SOEs), particularly in the tourism, financial services and utilities sectors. According to a report issued by local think tank the Advocata Institute in May, SOEs account for up to 80% of domestic debt.
The IMF released the second tranche of the EFF funding, worth $162.6m, in November after reporting that Sri Lanka had made progress in meeting the terms of the agreement despite challenging circumstances. The report also said that while international reserves were below comfortable levels, overall fiscal performance had been encouraging, with macroeconomic and financial conditions beginning to stabilise.
The government has moved to meet the criteria of its IMF agreement by increasing taxes and reining in spending.
Tabled in mid-November, the budget aims for a deficit of 4.6% next year, compared to an estimated 5.4% in 2016. The government predicts that the gap will be narrowed via a 27% increase in tax revenues and by easing the pace of recurrent spending growth.
Among the measures to be enacted this year are higher levels of corporate and withholding taxes, a 10% capital gains tax to be introduced in April, a hike in value-added tax from 10% to 15%, and an increase in tax payable on earnings from funds, dividends, treasury bills and bonds from 10% to 14%.
While some of this new revenue will be used to scale down the deficit, the 2017 budget also foresees an increase in capital expenditure, with outlays next year of LKR798bn ($5.3bn), up from LKR500bn ($3.3bn) in 2016.
Even with measures introduced to reduce the deficit, the government will enter 2017 with a high debt burden, according to a mid-November report by ratings agency Fitch, with 2016 year-end debt expected to be around 76.5% of GDP.
Borrowing under the 2017 budget will also rise, with the government expecting to tap international markets for LKR353bn ($2.4bn), equivalent to 2.6% of GDP, up from the 2016 total of LKR275bn ($1.8bn) or 2.2% of GDP.
Pressure on the Sri Lankan rupee and concerns over tax reforms to be implemented in the coming year saw investors divest government securities in the fourth quarter.
In the five weeks to November 16, foreign investors sold LKR37.1bn ($247.8m) worth of securities, with the outflow also linked to speculation of a rates rise by the US Federal Reserve.
Following the budget release investor concerns also spread to the Colombo Stock Exchange, whose main index dipped to 6242.68 points in late November, its lowest level since early April. The index has shed 2.77% since the budget was handed down, reflecting uncertainty over the impact of some of the government’s proposed measures.
Risks of a potential shift in investor sentiment were flagged by Fitch in February, when it downgraded Sri Lanka’s long-term foreign and local currency issuer default ratings from “BB-” to “B+”, assigning both a negative outlook. These risks could be mitigated by a greater degree of stability in policy and in tighter fiscal controls and reforms, the agency said.
While average inflation remained below the 4% target in 2016, to help tackle point-to-point inflation – which peaked at 6.4% in June – the Central Bank of Sri Lanka in July upped both its standing deposit facility rate and standing lending facility rate by 50 basis points each, to 7% and 8.5%, respectively.
This was the second rate hike of the year, with the regulator having raised its lending rate from 7.5% to 8% in February.
Following the rate increases, growth in credit to the private sector from commercial banks decelerated to 27.3% year-on-year (y-o-y) in August, down from 28.5% a month previously. Most recent figures show that in October, private credit was LKR79bn ($526.8m) – a 22% decrease y-o-y – with total private credit granted in the first 10 months of the year hitting LKR594bn ($4bn).
Aiming to bring y-o-y expansion down to below 20%, in December the IMF called on the central bank to remain ready to raise rates again if credit growth did not show signs of slowing further.
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