Reforms leading to sustainable, long-term economic development in Sri Lanka

Sri Lanka benefits from its strategic geographic position along a critical Indian Ocean trade route, strong base of industrial and cash crop exports, and rapidly expanding non-agricultural economy. High levels of public expenditure and rapid industrial expansion supported recent robust macroeconomic growth, averaging more than 6% between 2008 and 2014, as the country embarked on a period of post-war reconstruction and expansion. However, GDP growth has moderated in recent years, with subdued exports and investment, unsustainably high public debt and climate change weighing on the economy in 2016 and 2017.

Corrective monetary and fiscal policies have helped the country maintain economic stability, although Sri Lanka’s trade and budget deficits remain elevated, with subdued foreign direct investment (FDI), sluggish export growth and low government revenue increasing pressure on public finances. High levels of borrowing are expected to continue in the near term, as the government moves to stave off a balance of payments crisis, pushing public debt and interest obligations to critical levels.

Reform Efforts

These concerns have prompted the government to embark on a series of ambitious reforms, with the Vision 2025 economic development agenda and its associated multibillion-dollar infrastructure investment programme expected to take centre stage in 2018. Vision 2025 targets major structural reforms to help the country attain upper-middle-income status over the medium term, supported by rising FDI and exports, with the long-term goal of transforming Sri Lanka into a knowledge-based, social market economy.

Fiscal consolidation programmes should also help the government improve its balance sheet in 2018, with the Inland Revenue Act expected to augment government revenue (see analysis). The country has already witnessed some reform successes, having attained a primary surplus for the first time in decades in 2017, with ongoing reforms paving the way for sustainable, inclusive long-term growth.

At a Glance

Nearly a decade after the civil war ended, Sri Lanka has emerged as a qualified economic success story in South Asia, with its economy growing by an average of 6.2% per year between 2010 and 2016, and GDP per capita at constant prices rising from $2810 in 2010 to $4065 in 2017, according to World Bank data. In 2017 economic growth was somewhat slower, at 3.1%.

The country has also made considerable progress in attaining inclusive economic development, and its social indicators are among the highest in South Asia. The World Bank has reported that Sri Lanka, a lower-middle-income country, is on a par with middle-income economies in many respects – for example, according to the Department of Census and Statistics (DCS), the national poverty headcount ratio fell from 15.2% in 2006/07 to just 4.1% in 2016.

The Department of Commerce (DoC) reported that services account for the largest share of the economy, with the sector’s GDP contribution standing at LKR5.12trn ($33.4bn) in constant prices in 2016, or 56.7% of GDP, against the industrial sector at 26.6% (LKR2.4trn, $15.7bn) and agriculture at 7.1% (LKR644bn, $4.2bn). This trend largely persisted in 2017, when services made up 56.8% of GDP, or LKR5.29trn ($34.5bn), industry 26.8% (LKR2.49trn, $16.3bn) and agriculture 6.9% (LKR639.3bn, $4.2bn).

In Transition

In its November 2017 “Sri Lanka Development Update”, the World Bank wrote that Sri Lanka’s economy is transitioning from being rural-based to urbanised, with manufacturing and services the primary growth drivers in recent years.

This transition is evident in data from the Central Bank of Sri Lanka (CBSL), which reported that services grew by 4.7% in 2016, supported by 12.3% growth in financial services, 5.5% in transport activities, and 2.5% in wholesale and retail trade, to account for 56.7% of GDP.

This trend continued but moderated in 2017, when services grew by 3.2%. Within this sector, financial services had slower growth of 9.4%, and transport grew by only 0.9%. Meanwhile, wholesale and retail trade accelerated from its 2016 growth rate to 3.8% The industrial sector rose by 5.8% in 2016 to comprise 26.6% of GDP, with manufacturing accounting for the bulk of industry’s GDP contribution, or 15.5% of total GDP. In 2017 manufacturing made up a slightly larger share of the economy, accounting for 15.7% of GDP. Industry’s growth slowed somewhat in 2017, expanding by 3.9%. The CBSL reported that agriculture contracted by 3.8% in 2016, with rice, tea and rubber production declining by 31.3%, 11.2% and 10.7%, respectively. Agriculture continued to contract, albeit at a slower rate of 0.8%, in 2017.

In January 2018 the DCS reported that unemployment fell to 4.2% during the third quarter of 2017, down from 4.5% in the same period of 2016, with agriculture’s share of total employment shrinking to 24.3% from 27.1% in the third quarter of 2016, while industrial employment rose from 2.14m to 2.37m – increasing from 26.8% to 29.1% – and services sector employment from 3.69m to 3.81m over the same period. Services accounted for the largest share of employment in the third quarter of 2017, at 46.6%.

Growth Challenges

After averaging 6.5% between 2010 and 2015, GDP growth slipped to 4.5% in 2016, according to the DCS, as severe drought, high public debt and rising fuel imports weighed on revenue and spending plans. In January 2018 the IMF reported that weather-related supply shocks and contracting agriculture caused easing GDP growth.

In its Vision 2025 economic development plan, the government identified major structural obstacles to achieving growth in the medium term. It argues that persistent fiscal and external account deficits have damaged investor confidence, with most investment allocated to real estate and related sectors, or to uncompetitive import substitutes. Uncompetitive exchange rates are highlighted as a major contributing cause for the country’s anti-export bias, as well as high effective protection rates, including para-tariffs (see Trade & Investment chapter).

The country’s export base is too concentrated on a few low-technology products, such as tea and rubber, according to Vision 2025, while high levels of public debt restrict growth by increasing uncertainty, with investors prone to over-taxation and indirect taxation. This diverts resources from social and infrastructure investment and leaves the country vulnerable to shocks. Vision 2025 also highlights regulatory barriers, land acquisition challenges, labour market inefficiencies, burdensome border tax laws and inadequate infrastructure as major growth challenges, as well as low credit access, especially for small and medium-sized enterprises (SMEs).

The World Bank, meanwhile, reported that Sri Lanka’s economy is not competitive enough, with a decade of restrictive trade policies resulting in a strong anti-trade bias, and a growth model based on non-tradeable sectors and public investment. This is reflected in numbers released by the DCS, which show that the public debt, current account deficit and budget deficit remained elevated in 2017.

International investment will support future growth. “With increasing macroeconomic stability, Sri Lanka will continue to be an attractive destination for foreign investment,” Dilshan Wirasekara, CEO of investment bank First Capital, told OBG. That being said, while FDI inflows increased in 2017, they have often fallen short of government targets.

Deficits

Sri Lanka’s budget deficit has moderated since 2009 but remains relatively high, with the CBSL reporting it fell as a percentage of GDP from 9.9% in 2009 to 7% in 2010, 6.2% in 2011, 5.6% in 2012 and 5.4% in 2013. The deficit rose again in 2014 and 2015, reaching 5.7% and 7.6% of GDP, respectively, although it dropped once again to 5.4% in 2016, as the government moved to rein in spending with an IMF-backed fiscal consolidation programme.

The Ministry of Finance (MoF) and World Bank both reported that Sri Lanka would miss its budget deficit target of 4.6% in 2017, as flood, disease and drought pressured public finances. The MoF projected that the deficit fell to 5.5% of GDP in 2017.

According to CBSL numbers, the current account deficit rose by 3.1% in 2016 to hit $1.94bn, or 2.4% of GDP, remaining stable from 2.5% in 2014. In January 2018 the IMF reported that the current account deficit widened once again to 3.5% of GDP in the first half of 2017, as severe drought continued to weigh on output and push up fuel and food imports (see Energy chapter). While restored access to preferential trade with the EU in August 2017 helped lift exports, workers’ remittances and tourism receipts were weak, with extreme weather reversing growth in tourism exports (see Trade & Investment chapter).

Trade & Investment

The CBSL reported that relatively low commodity prices, subdued demand for Sri Lankan exports and disruptions to domestic agricultural production – the country experienced severe flooding, landslides and one of the worst droughts since the 1970s in 2016 and 2017 – all weighed on export earnings over this period.

Although estimates vary, CBSL numbers show that exports bounced back in 2017, reaching an all-time high of $11.4bn. This was a welcome change after two consecutive years of decline, from $11.1bn in 2014 to $10.5bn in 2015 and $10.3bn in 2016, as a result of low global commodity prices and weak demand for Sri Lankan products (see Trade & Investment chapter). However, the country remains in a trade deficit: imports rose by 9.4% in 2017 to hit $21bn, driven by a 15.9% increase in intermediate goods imports, including fuel, textiles and metals. The domestic trade deficit thus widened to $9.6bn, from $9.1bn in 2016 and $8.4bn in 2015.

While FDI inflows approved by the Board of Investment hit a record high of $1.71bn in 2017, double 2016’s levels, the World Bank reported that Sri Lanka attracted a much lower volume of FDI than peer economies, stating that its investment climate shortcomings – including a burdensome import-export regime, government inefficiency and land acquisition challenges – deter investment. The government aimed to have $2.5bn of FDI inflows in 2017.

Government Debt

Public debt is another major challenge to near-term economic growth. The country’s reliance on public investment and spending has profoundly affected government debt levels, with the World Bank reporting in August 2017 that Sri Lanka’s financing model had become increasingly unsustainable. The large amount of loan payments due in 2019 are set to necessitate another large borrowing programme in 2018.

CBSL data shows the central government’s debt-to-GDP ratio rose from 77.6% in 2015 to 79.3% at the end of 2016, and grew by 10.4% in nominal terms to hit LKR9.39trn ($61.3bn) over that period. Central government debt increased further in the first three quarters of 2017, reaching LKR10.3trn ($67.3bn) by the end of September. The bank reported that between 2015 and 2016 domestic debt stock rose by 7.7% to hit LKR5.34trn ($34.9bn), or 56.9% of the total, while currency depreciation – the rupee lost 3.83% of its value against the US dollar in 2016 – added LKR186.6bn ($1.2bn) of new debt, with foreign debt rising by 14.2% year-on-year (y-o-y) to hit LKR4.05trn ($26.4bn). This trend continued in the first three quarters of 2017, with domestic debt rising to LKR5.63trn ($36.8bn) and foreign debt reaching LKR4.64trn ($30.3bn) by end-September.

In May 2017 the BBC reported that Sri Lanka’s debt had reached $64bn, with 95% of all government revenue being channelled into debt payments, while ratings agency Moody’s reported in December 2017 that interest payments alone accounted for 36% of government revenue in 2016. According to Moody’s, Sri Lanka has one of the highest interest burdens out of all the nations it rates.

The IMF reported that public debt, including government, guaranteed and fund credit outstanding, hit 87% of GDP in 2017, with gross financing needs forecast to reach 20% of GDP in 2018. The rupee hit an all-time low of 157.9 against the US dollar in March 2018, further hindering the government’s ability to meet its repayment obligations.

SOE Effect

A September 2016 report in Forbes suggested that debt could be higher than reported, as state-owned enterprise (SOE) debt is not counted on the government balance sheet. Forbes estimated that SOE debt stood at $9.5bn in 2016.

According to the World Bank, Treasury-guaranteed SOE debt has risen quickly to reach 7.1% of GDP in 2016, noting that the proportion of guarantees given to SOEs with sufficient revenue capacity fell from 90% in 2006 to 36% in 2016, while guarantees to SOEs dependent on the state budget for expenditure have risen over the same period. Total SOE debt, excluding financial institutions, reportedly hit LKR1.3trn ($8.5bn) at the end of 2015, equivalent to 12% of GDP, with major SOEs including the Ceylon Electricity Board (CEB), Ceylon Petroleum Corporation (CPC), Sri Lankan Airlines and the Sri Lanka Ports Authority struggling to attain profitability (see Transport and Energy chapters).

For example, the CEB incurred substantial losses in 2016 as a result of low hydroelectricity generation caused by drought conditions, with losses hitting LKR14bn ($91.4m). Meanwhile, IMF numbers indicate that SOE debt reached 13.7% of GDP in 2015, before moderating to 11.9% of GDP in 2016, and the combined losses of the CPC, CEB and Sri Lankan Airlines hit LKR52bn ($339.1m) in the first half of 2017.

Repayment Plans

In November 2017 the MoF announced that the coming years will be challenging for fiscal managers, with LKR7trn ($45.7bn) of loan payments due before 2021, including LKR600bn ($3.9bn) of sovereign bonds maturing every year. Around 43% of the country’s debt is foreign currency-denominated, meaning depreciation remains a risk to fiscal stability, with the MoF reporting that the government’s ability to invest would be limited in 2018 as a result. In January 2018 the Cabinet announced it approved plans to borrow $5bn in 2018, including $2bn in sovereign bonds sales, as it moves to avert a debt crisis as major loans are due.

According to Reuters, Sri Lanka must repay LKR1.97trn ($12.9bn) in 2018 – a record high – including $2.9bn of foreign loans and LKR823bn ($5.4bn) of interest payments. Banks that had lead-managed Sri Lanka’s $1.5bn sovereign bond issuance in 2016 reported that the country was likely to be able to sell 10- to 30-year bonds with a 5. 5-6.5% interest rate in early 2018. The CBSL expects total foreign currency outflows to hit $5.6bn in 2018 as the US Federal Reserve moves to hike rates again, reporting Sri Lanka had $8bn in foreign exchange reserves as of January that year.

Monetary Policy

Rising debt payments mean the CBSL is set to continue its tight monetary policy stance in 2018, with the IMF reporting that it kept this policy in 2017 to pre-empt the build-up of excessive demand pressures and adverse inflation expectations. Inflation on the Colombo Consumer Price Index averaged 4.6% in 2015 and 4.5% in 2016, but spiked to 7.1% in 2017, according to the CBSL, which has targeted inflation of 4-6% in 2018.

The CBSL rolled out a series of rate hikes in 2016, including a 100-basis-point increase in policy interest rates and a 1.5 percentage point increase in the statutory reserve ratio, later moving to boost its policy rate by 25 basis points in March 2017.

Most market interest rates increased as a result, although short-term rates were adjusted downwards as a result of increased liquidity in the domestic money market. This caused private sector commercial credit growth to slow to 16.2% in October 2017, against a peak of 28.5% in July 2016, with the IMF projecting credit expansion to decelerate further as the government ramps up fiscal, trade, investment and public finance management reform efforts. In January 2018 the CBSL forecast private credit growth would hit 13.5% in 2018.

Mid-Term Reform Agenda

The government has moved to address its growth challenges and set a mid-term strategy with a series of reforms. This is part of a loan agreement with the IMF, a new trade policy unveiled in February 2017 (see Trade & Investment chapter), Vision 2025 and the 2018 Blue-Green budget. The latter introduces plans to mitigate the effects of climate change, protect ocean resources, support fisheries development and build up a robust talent pool to support its transformation into a knowledge-based economy.

Fiscal consolidation and restructuring will play an important role in supporting Vision 2025, and the government is rolling out a major IMF-backed reform initiative after having signed a three-year, $1.5bn extended fund facility (EFF) programme in March 2016. The programme entails short- and mid-term reforms to maintain economic stability, including increasing revenue generation and fiscal consolidation measures. The EFF reform agenda has gained considerable traction in recent months, with ongoing fiscal rationalisation and tax reforms brightening the country’s 2018 growth outlook.

Tax Reforms

Tax reforms are an important pillar of the EFF programme. Sri Lanka’s tax collection rate rose by 9.2% to earn LKR1.66trn ($10.8bn) in 2016, and tax revenue as a percentage of GDP has held steady at 12.4% in 2016 and 2017, after improving from 10.1% in 2014. This is still one of the lowest tax realisation rates globally, with low government income one of the largest structural challenges to sustainable macroeconomic development.

Reforms to the taxation system offer the potential to create much-needed new fiscal space, with recent efforts to boost value-added tax (VAT) rates showing promising early results. In November 2016 authorities hiked VAT from 11% to 15%, and the World Bank reported that VAT collection nearly doubled during the first four months of 2017, with total tax collection increasing by 25.6% y-o-y, even as total tax revenue realisation fell 4.4% below the government’s budgeted volume over that period. According to the 2018 budget statement, tax reforms have helped reverse a decades-long trend of shrinking government income, with revenue rising by 41% between 2014 and 2016 to hit 14.2% of GDP, compared to 11.5% in 2014.

Fiscal Management

The government continues to undertake fiscal consolidation efforts outside of tax reforms, with SOEs and ministries required to submit quarterly spending and revenue reports to Parliament in an effort to reduce expenditure.

In an important step towards fiscal management reforms, the CBSL’s Monetary Board also approved a roadmap for implementing flexible inflation targeting (FIT) in October 2017. This includes suggestions for reaching a consensus between the government and CBSL on inflation targets and timelines, using FIT as a monetary policy framework.

The reforms came after the CBSL stopped defending the rupee and began buying US dollars in January 2017 to build up foreign currency reserves, which had fallen to $4.7bn in November 2016. In November 2017 authorities announced plans to slash import taxes – valued at up to $10m per month – in an effort to contain inflation, which had risen to a record high of 7.8% in October 2017. The roadmap also calls for legislative reforms to ensure a clear separation of monetary and fiscal policies, monetary policy implementation using monetary instruments, liquidity management and market development.

This process reportedly involves significant institutional and technical capacity-building, which will strengthen the credibility, autonomy and governance of the CBSL. This will be supported by enhanced monetary and fiscal policy coordination, and revisions to the Fiscal Management Responsibility Act.

Steady Progress

Reform and consolidation efforts are beginning to yield results, and the CBSL reported that government expenditure as a percentage of GDP fell from 20.9% in 2015 to 19.7% in 2016, even as total expenditure and net lending rose by 1.9% to hit LKR2.33trn ($15.2bn). According to CBSL data, recurrent expenditure increased by 3.3% to LKR1.76trn ($11.5bn) in 2016 – largely as a result of higher interest payments – while public investment declined somewhat moderately, from 5.4% of GDP in 2015 to 4.9% in 2016.

In January 2018 the MoF reported that efficient fiscal management and steady revenue growth pushed the primary balance, which reflects budgetary operations and excludes interest payments, into a LKR21.9bn ($143m) surplus during the first 10 months of 2017 – the first primary account budget surplus in decades. Treasury officials believe this indicates positive growth and improved debt-management capacity.

The foreign exchange situation also improved in 2017, and the IMF reported that gross international reserves rose from $6bn at the end of 2016 to $7.9bn at the end of 2017, giving the country a 3.3-month reserve cover for imported goods and services, and reflecting $1.6bn of foreign exchange purchases made by the CBSL between March and October 2017, as well as the successful placement of $1.5bn of sovereign bonds in May 2017.

Reform Plans

More improvements are expected after Parliament passed long-awaited reforms to simplify the tax system, widen the tax base and boost government revenues. Reuters reported that the Inland Revenue Act’s promulgation in September 2017 was the most significant tax reform Sri Lanka had undertaken since independence in 1948. It is expected to boost government revenue by at least LKR45bn ($293.8m) per year after taking full effect in April 2018 (see analysis). Reforms to the import/ export tax regime are also under way, with the government announcing plans to reduce or eliminate up to 1200 para-tariffs under the planning of the 2018 budget, as part of the government’s new trade policy (see Trade & Investment chapter).

Fiscal reforms are expected to continue over the medium term as the government seeks to reduce its debt burden. In November 2017 the World Bank recommended that Sri Lanka promulgate an audit bill to support greater administrative and financial independence, a comprehensive public finance act and a legal framework for SOEs. Combined with the IRA, these reforms will help the country meet its EFF and domestic revenue collection targets, paving the way for public spending and ensuring long-term economic stability.

Vision 2025

Perhaps most importantly, Vision 2025 calls for significant structural reforms to be carried out over the 2018-21 period. In September 2017 the government unveiled the economic development agenda of this programme, which aims to transform Sri Lanka into “the hub of the Indian Ocean”, as well as an upper-middle-income country with a competitive, knowledge-based, social market economy. Vision 2025 targets a structural transformation that will include trade policy and investment climate reforms, and will see the private sector significantly increase its contribution to infrastructure development (see Trade & Investment chapter).

The headline intermediate targets of the initiative are boosting annual per capita income to $5000, creating 1m new jobs, increasing FDI inflows to $5bn per year and doubling exports to $20bn over the period leading up to 2021. Private sector participation will play a critical role in achieving these targets, and Vision 2025’s associated Public Investment Programme (PIP), running from 2017 to 2020, calls for substantial private sector investment in infrastructure to transform Sri Lanka into a regional and global transport centre, with the government recently moving to establish a dedicated public-private partnership agency under the MoF to improve partnership deployment and project delivery (see analysis and Transport & Logistics chapter).

Growth Model Shift 

The World Bank reported that the country must change its growth model to achieve its Vision 2025 targets, recommending the government pivot to a model driven by private investment and the tradeable sector, as opposed to public investment and the non-tradeable sector. The bank identifies four key areas for policy reforms to achieve the targets of the programme, including fiscal policy, trade policy, public debt and contingent liabilities, and natural disasters and climate change.

These priorities are reflected in the 2018 budget, which seeks to continue the IMF-backed fiscal reform agenda, reduce import taxes, capitalise on oceanic resources and implement long-awaited investment reforms (see Trade & Investment chapter). Meanwhile, it remains a priority to promote environmentally friendly, green expansion, and work to develop a knowledge-based economy.

“Two major advantages were taken in consideration when drafting the 2018 budget. First, Sri Lanka has a favourable geographical location that enables the country to be a logistics hub between two huge markets – China and India. Second, even though Sri Lanka is small, it has a well-educated human resource base,” Eran Wickramaratne, the state minister of finance, told OBG.

Budget

Unveiled in November 2017, the 2018 budget aims to boost GDP growth to 5%, reduce annual inflation to 6%, and enact reforms to push the primary surplus to 1% of GDP.

Together, these moves are expected to reduce the budget deficit to 4.8% of GDP in 2018 – slightly higher than the IMF’s recommendation of 4.7% – with the statement projecting it will decline in absolute terms from LKR680m ($4.44m) in 2017 to LKR675m ($4.41m) in 2018.

Furthermore, the budget seeks to develop the “blue economy” through measures to protect its ocean resources, and boost both agri-business and fisheries. The government announced plans to adopt a multi-pronged strategy to this end. The 2018 budget proposed projects including a LKR25m ($163,000) integrated coastal management mechanism, a LKR400m ($2.6m) beach replenishment programme, LKR800m ($5.2m) of spending to protect coastal belts from Negombo to Marawila and a LKR1bn ($6.5m) lagoon investment programme.

Agri-business and fisheries initiatives include a LKR1bn ($6.5m) project to de-silt tanks for harvesting rainwater in the northern regions, LKR250m ($1.6m) to build three agricultural warehouses and LKR3.33bn ($21.7m) for fisheries projects, including refrigerated storage development, upgrades to anchorages and landing sites at fishing harbours, and a sea cucumber export processing zone in the Kilinochchi district. There will also be a model Aquaculture Industrial Park built in Batticaloa district.

Planning for Climate Change

Green and environmentally sustainable development play a more prominent role in the 2018 budget than they did before, having become critical priorities for Sri Lanka. Through the budget initiatives the MoF has adopted an innovative approach to managing the short- and long-term costs of climate change.

Sri Lanka has been increasingly affected by climate change in recent years, according to a 2017 report published by the International Journal on Food System Dynamics, which found that as a low-latitude country, Sri Lanka is already operating at the maximum temperature limits for crop growth, making it especially vulnerable to temperature rises and increased incidence of extreme weather.

According to “The Economic Cost of Climate Change and the Benefits from Investments in Adaptation Options for Sri Lankan Coconut Value Chains” from the 11th International European Forum on System Dynamics and Innovation in Food networks, there is already evidence that the climate has changed in recent decades, with daytime maximum and night-time minimum mean air temperatures rising by an average of 0.021°C and 0.02°C per year, respectively, between 1960 and 1990. The country’s average temperature rose by 0.016°C per year over the same thirty-year period.

Meanwhile, average annual rainfall declined by 7%, or 144mm over the same period, while, according to the report, “the occurrence of single-day heavy rainfall events has shown an increasing trend.” Such unpredictability can have disastrous effects.

Climate Costs

Severe weather patterns have been detrimental to the country. Sri Lanka was struck by severe floods in May 2017, which affected 15 of its 25 districts and recorded 600mm of precipitation over two days. Flash floods and landslides led to the death of 213 people, damage to 88,000 houses and displacement of more than 100,000 people. The World Bank reported that economic losses from the event reached LKR70bn ($457.1m), extending to the housing, agriculture, transport, industry and commerce sectors, with total recovery needs estimated at a further LKR116bn ($757.4m).

The country was also hit by severe drought, which affected 1.93m people across 17 districts in 2016 and 2017, according to Disaster Management Centre data. Over 50,600 ha of rice paddy crops during Maha season, which runs from September to March, were damaged as a result. The Department of Agriculture later reported that rice production in 2017 would be the lowest it had been in 10 years, forecasting this output would cover an average of just over seven months of household consumption, thus increasing the risk of widespread food insecurity (see Agriculture chapter).

In October 2016 the UN reported that Sri Lanka’s drought was the worst it had experienced in 40 years, with hydropower declining to just 25% of total energy generation in the year, down significantly from 38% in 2015 and 99.84% in 1990. Agricultural exports also dropped as a result, while hydrocarbons imports rose to cover hydropower shortages, with the World Bank reporting that the government spent a total of LKR1.4bn ($9.1m) on disaster relief during the first four months of 2017 alone, including LKR163m ($1.1m) for drinking water and LKR734m ($4.8m) to rebuild houses affected by landslides.

Rising fuel imports to meet hydropower generation shortfalls have been especially expensive, with the Ministry of Power and Renewable Energy reporting that crude oil, coal and refined petroleum imports were set to cost the country $5bn, equivalent to 25% of total import expenditure and nearly 50% of export income (see Energy chapter). Rising hydrocarbons prices throughout 2017 and early 2018 indicate that this supplementation of energy will likely be increasingly expensive in the near term.

Green Budget

The Institute of Policy Studies of Sri Lanka (IPS) reported that the total cost of natural disasters in 2017 were equivalent to an estimated 1% of GDP, noting that the 2018 budget has “a pioneering nature, as it pays due attention to enhancing climate resilience of the country through short, medium and long-term interventions.”

The IPS has released a statement that most proposals primarily focus on improving rural resilience in agricultural areas, mitigating urban floods and capacity-building at the Department of Meteorology. A LKR3bn ($19.6m) weather-indexed agricultural insurance scheme has also been recommended.

An estimated LKR4.9bn ($32m) was allocated to scale up the Kelani River basin’s existing Climate Resilience Programme, with an emphasis on flood protection. The government unveiled plans to build new reservoirs upstream at Wee Oya, Nawatha, Holombuwa and Reucastle as part of efforts to enhance water retention capacity. The budget’s proposed Urban Rehabilitation Project also includes specific components for integrated flood mitigation within Colombo’s city limits, with the IPS reporting that this programme is expected to expand to other cities in the coming years.

Drought is substantially more difficult to mitigate than many other crises, and most proposals in the 2018 budget focus on rural irrigation and rainwater harvesting programmes. However, a recent shift in the government’s medium- and long-term energy policy should also help support drought resilience.

Renewable & Sustainable Energy

Indeed, the government has recently announced a number of new energy sector development priorities, including meeting 100% of its electricity demand with renewable resources by 2050. In the medium term policymakers will shift their power plant development efforts towards liquefied natural gas (LNG)- fired electricity generation, after near-constant breakdowns at its largest coal-fired power facility drove the cost of coal energy generation higher than gas-fired generation (see Energy chapter).

The 2018 budget also includes a strategy to phase out combustion engines by 2040, with plans to replace all government vehicles with hybrid or electric models by 2025. In an effort to both widen the tax base and expand electric vehicle adoption, the budget introduced an import tax regime for conventional automobiles, with import duties calculated using the vehicle’s engine capacity. Customs fees on electric vehicles will be cut by at least LKR1m ($6530), while those on fossil-fuel-powered vehicles will rise by a minimum LKR2.5m ($16,300), according to the 2018 budget statement.

Knowledge-Based Economy

Planned projects also support Vision 2025’s long-term target of transforming Sri Lanka into a knowledge-based economy, with the 2018 budget introducing a number of measures to support entrepreneurship and export-oriented small businesses. It also hopes to build up a technologically savvy domestic talent pool to support innovative growth.

The IMF reported that private sector credit growth reached 17.5% y-o-y in the first nine months of 2017 – nearly double the country’s nominal GDP growth rate. Despite this, credit access remains a challenge, particularly for smaller businesses, and Sri Lanka’s credit gap rose to 7% in January 2018.

The budget attempts to address this challenge. The Enterprise Sri Lanka Credit Scheme, for example, will be introduced as a SME support mechanism and will include extra lending subsidies for female entrepreneurs, in an effort to boost female labour force participation higher than the 36% recorded in 2016.

SMEs will also benefit from a new development bank with an export-import window, which will be allocated LKR10bn ($65.3m) of paid-up capital to provide long-term SME loans, as well as LKR800m ($5.2m) for an export market access programme, which will be offered to companies with less than $10m of exports, to support export-oriented SMEs.

The 2018 budget also includes plans to create 50 new agriculture and fishery companies, 25 female-owned businesses and 150 start-ups. Start-ups will play an increasingly important role in economic development under both Vision 2025 and the government’s expansive Western Region Megapolis Master Plan (WRMMP), which envisions transforming Colombo and its surrounding environs into a diversified, vibrant global supercity by 2030 (see Construction & Real Estate chapter).

The WRMMP adopts a zone-based approach to long-term development, with planned zones including industrial townships in Horana and Mirigama, a plantation city in Avissawella and a forest city in Mathugama. Importantly for knowledge economy targets, it also includes plans to develop a science and technology city in Malabe, which will be home to specialised, large-scale research and development technology parks, as well as new universities.

Innovation Spending

Innovation is emphasised in the 2018 budget, including plans to launch the IT Initiative, which aims to boost ICT export earnings to $5bn by 2021. Under the supervision of the Export Development Board, the IT Initiative will act as a public angel fund for new start-ups, benefitting from LKR3bn ($19.6m) of investment over the 2018-21 period to support local start-ups, attract new foreign start-ups and small- and medium-sized IT companies, and establish a start-up incubator.

Innovation-oriented human resource development is also emphasised, and the budget allocates LKR2bn ($13.1m) to strengthen skills development programmes, with an emphasis on meeting private sector labour market requirements.

Skills development efforts will also benefit from a LKR2.5bn ($16.3m) Employment Preparation Fund, to be established under the Ministry of National Policies and Economic Affairs. Furthermore, LKR5bn ($32.6m) of funding is flagged to help expand the offerings of degree programmes in ICT, engineering technology and bio-systems technology, with a substantial amount of funding allocated to establishing seven new faculties at the universities of Rajarata, Ruhuna, Sabaragamuwa, Kelaniya, Colombo, Sri Jayewardenepura and South Eastern University.

Outlook

As the government continues its expansive reform agenda with Vision 2025, Sri Lanka’s economy is expected to record moderate improvements in 2018. In January 2018 the IMF projected that real GDP growth would increase to 4.6% in 2018 – up from 3.1% in 2017 – as the agriculture sector recovers from drought and flood, and construction is anticipated to lead robust services sector growth. Inflation is forecast to ease to 5% in 2018, while the current account deficit should contract to 2.5% of GDP in 2018. Meanwhile, medium-term growth will average 5% over the years leading up to 2022, according to IMF estimates.

The CBSL’s outlook is somewhat more positive, with the bank reporting that it expects economic growth of between 5% and 5.5% in 2018, supported by a stronger global economy, export growth, and potential fiscal and monetary loosening. Although high levels of public debt, currency depreciation and extreme weather events could continue to pose a challenge to development goals, ongoing efforts to meet Vision 2025 targets should see FDI inflows and trade volumes improve in 2018. Economic stability is set to be further supported by increasing government revenue and easing public expenditure.