Sri Lanka to achieve economic recovery through trade and policy reforms

 

As the country moves forward with an ambitious development programme, while also navigating a series of internal political challenges, 2019 is set to be an important year for Sri Lanka. The economy has been making progress in recent years, which should place it in good standing during the potentially difficult time ahead. Major efforts have been made to instil greater fiscal discipline, and modernise monetary and exchange rate policy, while steps have also been taken in the management of government expenditure and the maximising of public sector revenue. Meanwhile, trade and foreign direct investment (FDI) have continued to rise, while infrastructure development is gradually moving Sri Lanka towards realising its long-term goal of becoming an essential transportation and trans-shipment centre for the Indian Ocean and South Asian region. There has also been positive progress in establishing the island as a tourism destination and in mobilising the population to help the country cultivate a more entrepreneurial, gender balanced and inclusive economy.

Economic Growth

At the end of the country’s civil conflict in 2009, there was a surge in GDP. According to the World Bank, GDP growth at market prices rose from 3.5% that year to just over 8% in 2010, then 8.4% in 2011 and 9.1% in 2012 – the highest rate since independence in 1948. A combination of pent-up demand, overseas diaspora investment and major government infrastructure projects – largely financed by loans – have pushed the economy dramatically forward.

This high, however, rapidly tailed off. In 2013 GDP growth was back to 3.4%, rising to 4.96% in 2014. In 2015 – an important election year – it rose again to around 5%, yet has been declining since. Figures from the Ministry of Finance and Mass Media (MFMM) showed growth at 4.5% in 2016, then 3.1% in 2017. The estimates for 2018 vary, but figures from the Central Bank of Sri Lanka (CBSL) show GDP growth for the first quarter of 2018 at 3.5%, rising to 3.7% in the second quarter and then falling to 2.9% in the third quarter.

Key Contributors

In terms of sector breakdown, services are the largest contributor to GDP, with CBSL figures showing this segment accounting for 56.7%, or LKR5.3trn ($33.4bn), of the country’s GDP of LKR9.3trn ($58.6bn) in 2017. The second largest contributor was industry, with 26.9%, or LKR2.5trn ($15.7bn), and agriculture was third, on 6.8%, or LKR639.3bn ($4bn). Despite this, 2016 and 2017 were not good years for agriculture, due to weather-related incidents and a general deterioration of agricultural prices worldwide. As a result, the sector shrank by 3.8% in 2016 and 0.8% in 2017. However, it was in recovery in 2018, with the first quarter of 2018 showing 5.6% growth and the next two quarters seeing 4.2% and 3.3% growth, respectively.

Tea is a particularly important part of the agriculture sector in Sri Lanka, responsible for over half of its export earnings. Between January and November 2018, for example, tea earned $1.4bn worth of the total agricultural exports of $2.5bn. Other key products are spices – notably cinnamon – and coconut, with the former earning $373.6m in exports in the January-November 2018 period, and the latter $329m. Seafood is also important, earning $219.1m during the same time.

In services, the segments with the highest growth in 2017 were: information and telecommunications, which expanded by 12%; financial services, which grew by 9.4%; health care, which expanded by 7.2%; insurance services, which grew by 5.7%; food and beverages, increasing by 5%; real estate and professional services, which was up 4.7%; wholesale and retail, which expanded by 3.8%; and personal services, such as arts and entertainment, which grew by 3.2%.

Transport saw marginal growth of 0.9%, while education services grew 0.5%. Public sector services, overall, contracted by 4.8% in 2017, after expanding 5.2% in 2016. This was a result of government policy, which, reinforced by the IMF Extended Fund Facility (EFF) programme that began in 2016, has sought to cut state expenditure while also raising state revenue collection.

In industry, in terms of contribution to GDP, the largest segment is manufacturing, which was responsible for around 58% of the segment total in 2017. Construction made up a further 27%; mining and quarrying 10%; and electricity, steam and air conditioning supply 4%.

Within manufacturing, textiles and garments are by far the largest contributor, with MFMM figures attributing a provisional $5bn of industry’s $8.5bn contribution to GDP in 2017 to this segment. The sector grew by 5.7% that year, while the food, beverages and tobacco manufacturing element grew 1.6%. Chemicals and pharmaceuticals grew 2.6%, while rubber and rubber-based products expanded 8.7%. Non-metallic products were up 8.4%, construction grew 4.4%, mining and quarrying were up 10.1%, while electricity generation was up 2.7%. This was largely fuelled by oil and coal, given that drought conditions severely impaired the functioning of the nation’s hydroelectric power facilities. This also led to an increased import bill, given that Sri Lanka does not have a commercially developed oil and gas industry of its own. This in turn has had a negative effect on the country’s balance of payments.

GDP per capita for the country was around $4073 in 2017, according to the Department of Census and Statistics, which also estimated the total population at around 21.7m in 2018. However, there is considerable regional differentiation; GDP per capita in the Colombo City region is perhaps 4.5 times larger than the average level, according to Colombo-based stock broker JB Securities. The Western region, excluding Colombo, also has a higher than average GDP per capita, whereas the Eastern region has the lowest.

Unemployment, meanwhile, stood at 4.5% in the first quarter of 2018, up from 4.1% in the same period of 2017, with the labour force participation rate also falling between those two quarters, from 54.7% to 52%. Services is the largest employer, providing 45.2% of all jobs in the first quarter of 2018, followed by industry providing 27.9% and agriculture with 26.9%.

Structure & Oversight

As of February 2019, debate has been ongoing in parliament over plans to reshape and resize the Cabinet. Nevertheless, a number of key ministries are likely to continue their vital roles in the country’s economy. In addition to the MFMM, the Ministry of National Policies, Economic Affairs, Resettlement and Rehabilitation, Northern Province Development, Vocational Training and Skills Development and Youth Affairs has a wide-ranging portfolio and is headed by Prime Minister Ranil Wickremesinghe. The Ministry of Public Enterprise, Kandyan Heritage and Kandyan Development also holds an important mandate to restructure state-owned enterprises. Meanwhile, the Ministry of Power, Energy and Business Development oversees the Ceylon Electricity Board, while the Ministry of Housing, Construction and Culture Affairs manages around 26 agencies including the Central Cultural Fund.

Meanwhile, the CBSL is mandated to maintain economic, price and financial sector stability, via its Monetary Board. It oversees the banking and non-banking financial institutions sector, while the insurance sector is overseen by the Insurance Regulatory Commission of Sri Lanka, and the capital markets are overseen by the Securities and Exchange Commission.

Planning Ahead

The government’s central development plan, Vision 2025, was launched in September 2017. Its targets are ambitious, including the raising of per capita GDP to $5000, the creation of 1m new jobs and the growth of FDI to $5bn per year by the end of the period. It also aims to double exports to $20bn a year.

At the same time, Vision 2025 sets out major structural changes to the economy, with a shift towards further liberalisation. The private sector is the engine of future growth, with international trade and investment a vital part of becoming a hub for the wider Indian Ocean region. There is also an emphasis on combatting corruption and ensuring greater transparency and accessibility of state institutions. ICT will play an important part in achieving this, particularly the adoption of new digital financial services.

Economic Policy

At the beginning of the current administration in 2015, the economy was experiencing a downswing following several years of high growth in the immediate post-conflict era. Sri Lanka had – and continues to have – a high debt burden, partly as a result of government borrowing to finance giant infrastructure projects, but also due to high state spending and declining state revenue collection. In 2016 the new government thus began a programme of fiscal tightening, backed by the IMF EFF. This has required meeting a number of structural reform targets, as well as monetary and fiscal policy goals.

The fiscal deficit stood at 7.6% of GDP in 2015, with the deficit falling to 5.5% in 2017, when there was also a small primary surplus of around LKR2bn ($12.6m). This has grown since, hitting LKR46bn ($289.7m) in the first half of 2018. On the revenue side, the introduction in 2018 of a new tax code – the Inland Revenue Act – in addition to improvements to the VAT system in 2016 have helped boost tax collection, with an overall rising trend in government revenue.

In the first nine months of 2018 total government revenue and grants stood at $8.6bn, down from $8.7bn in the same period of 2017. At the same time, the government has been attempting to reduce its spending, with capital expenditure and net lending falling from LKR452bn ($2.85bn) in January-September 2017 to LKR441.7bn ($2.78bn) over the same period of 2018. Recurrent costs, however, continued to rise – from LKR1.4trn ($8.8bn) to LKR1.6trn ($10.1bn) during the period in question. In the January-April 2018 period, the largest component of recurrent expenditure was interest payments with 40%, up from the share of 39% in the January-April 2017 period. This was followed by salaries and wages at 31%, down from the share of 32%. Indeed, interest payments are now crowding out capital expenditure for the government, with government debt high compared to Sri Lanka’s peers. At the end of 2017, this stood at LKR10.3trn ($64.9bn), while by the end of September 2018, it had reached LKR11.3trn ($71.2bn). Financing this has required major efforts, with the IMF estimating external debt at approximately $51.9bn at the end of 2017, or 59.3% of GDP.

The country has resorted to both domestic and foreign sources to finance this, with total foreign borrowing in the first half of 2018 equal to around 35.8% of GDP. In 2018 domestic debt servicing reached a recent high, due to a large number of government securities and development bonds reaching maturity. Debt servicing has reached a record high, however, with the Appropriation Bill that allocates LKR2.2trn ($13.9bn) for debt repayments presented to Parliament in February 2019. These repayments will continue to be high through 2022, likely pushing the total debt-to-GDP ratio higher. At the end of 2018, it was 78%.

The suspension of the IMF EFF has been complicating the debt repayment schedule, which had been due to disburse the final $500m of its total $1.5bn allocation when the October 2018 political crisis began. Talks were ongoing to revive the programme, as of February 2019. The crisis also prompted ratings agencies Fitch and Standard & Poor’s to downgrade Sri Lankan sovereign grades in November and December 2018. This makes raising finance for the debt more challenging, with a $1bn international sovereign bond issue in 2014 being mostly repaid by proceeds from the divestment in the Hambantota Port. The year ahead will likely see Sri Lanka approaching international lenders such as China and India to assist with a tough debt financing schedule.

External Sector

Foreign exchange reserves are a sensitive area. Sri Lanka also runs a trade deficit, which rose in 2017-18. Imports such as vehicles and oil and gas are dollar denominated, with these a major part of the import bill. CBSL figures showed a negative trade balance at LKR1.5trn ($9.4bn) for January-November 2018, an increase on the trade deficit of LKR1.3trn ($8.2bn) for the same period of 2017. Two major positives in the external sector, however, are tourism and remittances. The former has been rising in recent times, up from $3.9bn in 2017 to an estimate of $4.4bn in 2018.

Remittances have averaged around $7bn per annum in recent years, with 2017 seeing a total of $7.2bn received from overseas. For the first 10 months of 2018, remittances were down by around 0.5%, year-onyear. However, this can be attributed to some extent to the government increasing the age limit on exit visas for females, leading to a drop in the number of workers moving overseas. The country has therefore run a current account deficit in recent years, with this at $2.3bn in 2017 and $1.8bn in the first half of 2018.

Meanwhile, however, FDI inflows have been picking up recently. Some $1.9bn of inflows were recorded in 2017, with 2018 likely to also show growth, as the CBSL figure for the first half of 2018 showed inflows of $1.4bn. At the end of 2018 Sri Lanka had foreign exchange reserves of some $6.9bn, which were then reduced by the $1bn international sovereign bond payoff in January 2019. Some $4.9bn more in debt was due to be paid off by the end of the year, highlighting the need for Sri Lanka to boost its reserves, while also finding more ways of financing its debt repayment burden.

Monetary Policy

The CBSL is responsible for the conduct of monetary policy, with a goal of ensuring monetary and financial stability. In FY 2001/02, the central bank began a major modernisation programme that still continues. This has involved updating systems and methods of working, as well as a move away from a managed, floating exchange rate to a market-based, floating regime. The CBSL continued to intervene to defend the rupee, however, until relatively recently, with the last major episode in 2015. Since then, the CBSL has said that it will no longer act that way, and will only intervene to bolster its own foreign exchange reserves.

In 2018 the rupee continued to depreciate. Between 2005-14, it fell by an average 2.8% per year against the US dollar – although the CBSL was able to build up its reserves at the same time from $2.7bn to $8.2bn. Since 2015, however, the rate of depreciation has accelerated, averaging 9.2% per year up to September 2018, while the level of reserves has remained relatively flat, reaching $8.4bn by the end of that period. This is partly because the US dollar has increased in value, with Federal Reserve rate hikes, stronger US growth and a general souring of sentiment towards emerging markets, causing a general outflow.

Meanwhile, increasing fuel prices – the government introduced a cost-reflective pricing mechanism in 2018 to make subsidised fuel more reflective of market rates – have pushed inflation upwards during the year, although food price-related inflation came down as the impact of poor weather in 2016 and 2017 eased. The headline national consumer price index (CPI) stood at 125.1 in November 2018, up 2.7% on where it had been in November 2017. Prices are also usually measured separately for the capital, with the Colombo headline CPI up 4.3% for the full year. At the same time, while the rate of growth of broad money has been declining – it expanded 17.9% in November 2017, but 13.9% in the same period of 2018 – private sector credit growth has grown faster, at 16.2% in November 2018.

With currency outflows leading to tight overnight liquidity conditions, inflationary pressures and high credit growth, the CBSL hiked its rates in November 2018. The standing deposit facility rate started the year at 7.3%, but ended it at 8%, while the standing lending facility rate, which came down in April from 8.8% to 8.5%, ended 2018 at 9%. The CBSL has thus reined in inflation – from 7.5% between November 2016 and November 2017 to 2.7% a year later – with the central bank more confident that it can move to a longer term objective of inflation targeting. A consequence, however, has been to make the capital markets less attractive, given that banks offer such high deposit rates.

Moving Forward

Sri Lanka is continuing with a number of key infrastructure projects, two of which are part of China’s Belt and Road Initiative, linking the country to a trans-global network. In the south, Hambantota Port, which lies a few kilometres from some of the busiest sea lanes in the world, is moving forwards after the Sri Lanka Ports Authority sold a major stake to China Merchant Port Holdings, which is now developing an industrial zone at a site adjacent to the existing port and airport. In Colombo, the $1.4bn Port City project, developed by China Harbour Engineering Company, announced the completion of land reclamation in January 2019. The first location will be the Colombo International Financial City, which is positioning itself as a centre for finance between Dubai and Singapore. In February 2019 the government also began negotiating a $1bn loan to develop a new highway from Colombo to Kandy.

Outlook

Vision 2025 is banking on the country’s resilience and strength, as well as on economic restructuring and reform, to deliver its ultimate goals. The temptation to loosen the fiscal belt is undoubtedly there, with 2019 also likely to be a test of policy discipline and resolve. Nonetheless, Sri Lanka can point not only to its potential, but also to its achievements, as Colombo and other regions grow more prosperous.

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The Report: Sri Lanka 2019

Economy chapter from The Report: Sri Lanka 2019

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