Achievements, prospects and challenges

The Sri Lankan economy has shown an impressive performance over the last seven years. The macroeconomic stability currently enjoyed by the people in the country is an outcome of the timely implementation of prudent policies and effective macroeconomic management backed by a stable and strong political environment.

Continuation of the policy consistency and close coordination between fiscal and monetary policy could be recognised as the major factors that contributed to the uninterrupted expansion of the capacity of the economy.

Restoring a peaceful environment in the country after three decades of terrorist activities has transformed the country into a place with new opportunities for investors, both local and foreign. The post-war achievements in the economy have been a combined outcome of the peace dividend and the foresighted policies adopted by the Government during the pre-war and subsequent period.

Capacity constraints

With the constraints faced with regard to the macroeconomic management, the main issue raised by many investors and policymakers before 2006 was the insufficient capacity in the economy to sustain a higher economic growth. The most notable constraint was in the energy (electricity) sector which was stifling growth in all sectors of the economy.

In addition, capacity constraints in the areas of roads, railways, port (sea and air) services, telecommunications, water supply was leading to serious obstacles to investments thereby affecting economic growth, regional development and the country’s competitiveness in the international market.

On the other hand, inadequate development of human resources was reflected in the large number of people travelling abroad to receive education and health services, insufficient managerial skills and the low level of research and innovation activities in both private and public sectors. There was a critical need for a new strategy within a comprehensive policy framework to address these issues and enhance the potential of the economy by expanding capacity.

10-year vision

The development strategy ‘The 10-Year Horizon Development Framework – 10-Year Vision’ introduced by the Government in 2006 was a broad policy framework consistent with the ‘Mahinda Chinthana’ overall policy vision. This was prepared through an intensive consultative process involving all stakeholders of the country.

The overall policy strategy has been designed to integrate the positive attributes of market based economic policies with domestic aspirations by providing the necessary support to domestic enterprises and encouraging foreign investments. Recognising the need for maintaining macroeconomic stability in achieving a sustainable and broad based economic growth, the new strategy has targeted low and stable inflation and fiscal consolidation by reducing the budget deficit and public debt.

The thrust of the new vision was to unleash the growth potential of the country by addressing the existing infrastructure and service bottlenecks by channelling a larger volume of investment into developing the required infrastructure in terms of roads, sea ports and airports, energy, telecommunication, drinking and irrigation water as well as required health and educational facilities to match the requirement of a growing economy.

In the past, delays in the implementation of major public investment programs have been cited as one of the major reasons for the low realisation of the country’s full growth potential. The new policy strategy has given greater emphasis to addressing implementation issues that has helped to complete most of the planned infrastructure projects within the stipulated period contributing to expanding the production capacity of the economy which is necessary for high economic growth.

In line with these activities, proactive action was taken to attract foreign investors from international capital markets. Since the economy has graduated to a lower middle income status, alternate funding resources need to be found to bridge the shortfall from concessionary funding sources.

Accessing the international capital market by issuing sovereign bonds, opening of the Government rupee securities market for foreign investors and allowing the corporate sector to borrow abroad were new funding channels created to attract uninterrupted investments into the economy.

In addition, the doing business environment was improved to attract foreign direct investors and increase private partnership in the public investment program. With the restoration of peace and the successful implementation of the new development strategy, the outlook of the economy has witnessed a paradigm shift in the post-war period.

Improved macro-economy

The notable developments observed in the recent past were the continuous improvement of macroeconomic fundamentals in the economy. The foundation laid in the new policy strategy has begun to realise the expected outcomes and any deviation from expected targets were addressed in a timely manner through corrective measures to ensure that the economy moves in the right direction.

The consolidation of the improved macroeconomic environment that began in the post-war period and the blending of the peace dividend with the policy driven programme targets further improvements in all key sectors; real, fiscal, external and monetary sectors in the economy. As a result, the Sri Lankan economy today enjoys the highest level of stability since regaining independence.

After several decades, the Sri Lankan economy has re-gained the opportunity to realise its full growth potential by utilising all its available resources; i.e. land, labour and capital. As a result the economy has now entered a high growth trajectory of 7-8%. In 2010 and 2011 real economic growth was maintained at over 8%. The first time in Sri Lanka’s economic history that growth was maintained at over 8% in two consecutive years. The average growth rate in the post war period (2010-2012) rose to 7.5%, while this rate was 6.7% during the period 2006-2012 in comparison to the average growth rate of 4.5% during the period 1951-2012. However, the country’s growth potential in the medium term is higher than the current realised growth rate as it has been significantly affected by global factors and adverse supply conditions that have prevailed during the post war period.

The high and volatile inflation which remained at double digit levels during the post economic liberalisation period since 1977 was a critical issue faced by economic agents pressurising policymakers to address the issue to bring down both the level and volatility. With the implementation of a new macroeconomic management framework, inflation has been successfully contained at a single digit level in the last four consecutive years through effective demand management policies and improved domestic supply conditions in the economy.

Inflation, which has been maintained at single digit levels for 52 consecutive months, has helped to arrest inflation expectations and unfolded a new era of price stability in the country. The longest period of single digit inflation recorded before 2009 was 23 months in the late 1990s. Currently, both headline inflation and core inflation are maintained at around mid-single digit levels and are expected to remain at these benign levels. The government has committed in its medium term macroeconomic program to maintaining inflation at mid-single digit level creating the right conditions for sustained high economic growth.

The fiscal sector which was adversely affected during the pre-war period has improved tremendously during the post war period. The most credible achievement is the high degree of discipline brought under the new fiscal consolidation programme that compels the government to stick to the original deficit targets while lowering the overall deficit on a gradual and sustainable basis over the medium term.

After ending the conflict, the reduction of defence expenditure and the cost of servicing debt with the downward shift of the yield curve contributed significantly to lower the recurrent expenditure of the Government, enabling the Government to lower its fiscal deficit while maintaining public investment at over 6% of GDP. The overall deficit was gradually reduced from 9.9% of GDP in 2009 to 6.4% of GDP in 2012 and is expected to be reduced further to 5.8% of GDP in 2013.

These improvements are reflected in other key fiscal aggregates such as the current account balance which indicates the saving position of the Government and the primary balance which reflects the outcome of current year’s fiscal operations, which have improved significantly during the post-war period.

In addition, a series of new initiatives were taken to diversify the funding of the fiscal gap in the recent past. Accessing the global capital market by issuing sovereign bonds from 2007 was a major step in this regard, which has been successfully managed over the last six years. The demand for Sri Lankan bonds has significantly increased and currently there are over 400 foreign investors engaged in the sovereign bond market.

A similar approach was introduced to the domestic rupee securities market by opening the Treasury bond and Treasury bill market to foreign investors subject to certain restrictions. At the same time, the private sector was permitted to participate in public investment through public-private partnerships, lowering debt financing of the budget. These new funding arrangements helped to lower the pressure on domestic resources and crowd-in private sector investments in the economy. Further, new funding sources helped to fill the gap arising from the reduction in traditional funding arrangements such as concessionary financing through multilaterals and bilaterals, as such funding are inversely related to the improvement in the per capita income of the country. The current fiscal and macroeconomic strategy would ensure further improvement in fiscal sector operations.

In line with the fiscal consolidation program and the improvements in the overall macroeconomic conditions of the country, debt dynamics have made a positive contribution to lowering the debt to GDP ratio from 91% in 2005 to 79% in 2012.

According to UN-ESCAP classification, Sri Lanka is a less indebted country in terms of external debt. Because all external debt indicators except one fall under the less indebted category. This classification is designed to reflect the servicing of external debt stock and ability of the authorities to service their external debt. Sri Lanka is one of the few countries in the world that has been maintained an unblemished debt servicing record over the last 62 year period.

Further, the current public debt management strategy mainly focuses on risk management of the debt stock in order to keep rollover risk and market risk within a manageable level. The share of external debt in total debt as well as total external debt in terms of GDP are on a declining path. The medium term targets envisaged under the debt management strategy expect to lower the external debt further and extend the duration of the debt stock. In addition, the share of short term debt to total debt stock is also expected to decline gradually thus improving the rollover risk. These new strategies are expected to improve the country’s debt management further.

The external reserve management of the country reached a new height in the post-war period in comparison to the pre-war period. During the pre-war period, gross official reserves of the country remained below the US$ 3,000 level except in 2007. In contrast, total gross official reserves more than doubled from US$ 2,403 million in 2008 to US$ 5,357 million in 2009 with investor confidence improving dramatically after ending the war. This level further increased to over US$ 7,000 million in 2010 and has remained around the same level during the last two years.

External reserve coverage which was below four months of imports during the pre-war period has improved to four to six months during the post war period. This improvement reflects the resilience of the economy and the ability of the economy to withstand any shocks arising from the external sector. The active external reserve management policy of the Central Bank helped generate a high rate of return which was considerably higher than the benchmark rate of return in the global market. The new reserve management policy expects to maintain gross official reserves equivalent to four to five months of import coverage and be sufficient to cover 100% of short term liabilities of the Government.

Reducing regional imbalances

The new development strategy which focuses on inclusive growth has had a significant impact in lowering the disparities among regions. The inclusive growth program includes the improvement of infrastructure in regions, easy access to finance, better marketing arrangements, effective extension services and promoting private investment outside the Western Province. This has been complemented by the peaceful environment prevailing in the country after the end of the war.

As a result, regions outside the Western Province have shown tremendous improvement in the recent past. The dominance of the Western Province in the overall economy has gradually reduced with its share of GDP in total GDP declining from 50.8% in 2005 to 44.4% in 2011. Reflecting the combined impact of the inclusive growth strategy and the peaceful environment, the Northern Province recorded the highest nominal growth rate in the post-war period. (22% in 2010 and 27% in 2011). At the same time, all regional provinces reported higher nominal growth rates than the Western Province over the three year period, thus narrowing the income gap between the Western Province and the rest of the country.

The lifestyle and consumption habits of the general public have significantly changed with the rapid increase in the incomes of people. Moreover, the distribution of the income generated in the economy has been a more equitable as reflected in the high and increasing demand for durable goods. This has been the reason for the rapid increase in demand for various durables goods including mobile phones, televisions, radios, transport equipment such as motor cars, motor cycles, three wheelers, etc. Increased expenditure on these products is a clear reflection of the improvement in the incomes of households and their living standard.

Improving Sri Lanka’s position in global rankings

A rapid improvement in the Sri Lankan economy was recognised by most international organisations which compile various global indices by assessing the improvements in specific sectors and activities of the economy for global comparisons. Most of those global indices show the improvement in Sri Lanka’s ranking in the recent past endorsing the real improvements in the domestic economy. The most improved global indicators include the Human Development Index (HDI), the Doing Business Ranking, Index of Economic Freedom and Logistics Performance Index, reflecting the socioeconomic developments and improved business environment in the country.

Future prospects

The Sri Lankan economy is currently passing through the ‘take-off’ stage and is on track to achieving the medium term targeted per capita level of US$ 4,000 by 2016. Since the agriculture sector and industry sector have limited capacity, the services sector will continue to play a dominant role to maintain the economy on a high growth path. Therefore, the thrust of the future development will be centred around the ‘five hubs’; namely, maritime, aviation, energy, knowledge and commercial hubs, which will be the key drivers of the Sri Lankan economy beyond USD 4,000 per capital level. Necessary infrastructure is being developed in the ‘five hubs’ sectors in order to exploit their full potential in the future. In addition, the tourism sector is expected to deliver its potential by making Sri Lanka an attractive destination, becoming a high end hospitality market.

The macroeconomic environment is expected to improve further in the medium term. The continuation of the fiscal consolidation process would lower the budget deficit and the debt burden in the country. With the full operation of the ‘five hubs,’ Sri Lanka is expected to become a hub to the sub-continent. This new development will help to improve services income, thus generating surpluses in current account and overall BOP and thereby strengthening the external reserves in the economy. Inflation will continue to be maintained at a mid-single digit level and unemployment is expected to be reduced to 3%.

High priority will be given to developing the financial sector while maintaining overall financial system stability. The stock market and corporate bond markets are expected to grow in line with the developments in the economy. Promoting FDI and integrating with global commodity and capital markets will be further strengthened to get the maximum possible benefit to the economy.

Labour productivity will be improved to enhance production as well as competitiveness of Sri Lankan products in the international market. Necessary steps will be taken to improve the country’s ratings position and to reach investment grade. With this broader approach, the protection of property rights of investors and improvement of the governance structure will also be given high priority in order to strengthen investor confidence in the Sri Lankan economy.

Challenges

The Sri Lankan economy is still in its first wave of growth, largely driven by increased utilisation of untapped and underutilised resources. The second wave of growth is expected to start after the country reaches a per capita income of US$ 4,000. Necessary steps need to be taken to avoid the economy falling into a ‘Middle Income Trap’.

Exploring new innovations and maintaining competitiveness in the global market are the options available to avoid the economic gravity that could pull back the economy to stagnation, five hubs and the tourism sector are expected to play a key role to take the economy beyond US$ 4,000 per capita. In this process, a well-coordinated policy framework with a high degree of policy consistency and transparency is vital for the continuation of the growth momentum.



(The writer is Assistant Governor of the Central Bank of Sri Lanka.)