Are we poised to become the ‘Wonder of Asia’?

Analysis of fundamentals and policy

By the analyst

There are contradictory views on the economic performance of the country. On one hand, the Central Bank of Sri Lanka (CBSL) has continued to maintain that “the stage is set for a high growth trajectory over the next few years” (CBSL 2013). On the other hand, the Opposition and some economists have persistently warned that the country is moving towards a weak economic footing. This article is an attempt to look at economic performance of the country using some key indicators, in order to provide some perspective to the ongoing debate.

Performance in the new millennium

Post 2000 period saw Sri Lanka making a swift progress in many fronts. The real GDP grew by over 7.5% during the post war period (2010-12) and by 5.6% during 2000-2012 compared to 5.2% reported in post 1977 era. The GDP per capita grew from around US$ 868 in 2000 to US$ 2,923 in 2012 posting a Compounded Annual Growth Rate (CAGR) of over 10% during this period. Poverty headcount ratio declined from 23% in 2002 to 9% in 2009.

Technology penetration at the household level amplified, for example, telephone density which was 8% in 2000 reached 105% by 2011. The country’s vehicle fleet rose from 1.7 m in 2000 to 4.5 m in 2011. These indicators collectively represent a significant improvement in consumption capacity of the country. However, a careful analysis reveals some worrying signs.

Real growth

The country experienced an improvement in real growth in the post 2000 period, especially in 2010 and 2011. And this recent growth seems commendable as it was achieved despite a continuing global turmoil that has negatively affected global demand for exports. Building on the recent growth, the CBSL forecasts a per capita GDP of US$ 4,800 by 2016 and sees significant upside in all macro variables (Refer the table below).

According to the forecasts, the growth is accelerating again, the inflation is coming down further, and the BoP current account and the fiscal operations are improving substantially. And the country is planning to become a net lender to outside (with national savings exceeding investments by 2016).

These forecasts seem a little too ambitious for structural and policy reasons. Policy makers will need to realistically take stock of what happened and prepare the country for future challenges. Economic fundamentals should be given priority to avoid plans becoming wishful thinking.

Discussed below are some of the macro challenges that need to be addressed, going forward. Challenges were identified based on trends; and inferences were made based on the publicly available data. Neither challenges nor inferences were discussed in detail to preserve brevity of the document. Author wishes to undertake a detailed analysis of these challenges individually in a series of articles.

1. The savings-investments gap is widening

The country needs around 33-35% of investments to GDP on an annual basis, in order to sustain an 8% growth. However, the country’s national savings is hovering around 22-24%, indicating a gap of around 10% between the level of investments and national savings. Out of this gap, around 1.5% is funded by FDIs. This necessitates bridging of shortfall using debt financing, potentially – further straining the already heavy debt burden.

2. The 2010 and 2011

growth model is not

sustainably replicable

2010 8% growth was driven mainly by a peace dividend. This was followed by another over 8% growth achieved through monetary stimulus in 2011.

Almost all key economic sectors revived in 2010. Positive sentiments along with increased access to country’s resource base accounted for the growth in 2010. The Colombo Stock Exchange doubled its value. The government started accessing international financial markets frequently to support its infrastructure drive. The country started tapping many of the previously unutilised economic resources including land and sea.

2010 growth resulted in a swollen economic base. To avoid it becoming just a one-timer, the country wanted structural adjustments and reforms in many fronts. Yet, the economic model advocated during 2011 was mainly targeted at achieving growth through monetary and fiscal stimulus. To support the growth, interest rates were kept low throughout the year although market liquidity had been continuously eroding (the excess liquidity in the daily Open Market Operations of Rs. 121 b at the beginning of the year had turned a Rs. 5 b shortage by the end of the year 2011). The low interest rates spurred a lopsided growth in credit, and the total domestic credit grew by 35%. Increased credit was mainly used for importation of consumer durables and infrastructure investment goods. Import trade, transport, and construction sectors have registered over 20% real growth out of the sectors that contribute over 5% of the economy during 2010 and 2011.

YoY imports growth for the year was above 50% that resulted in a major BoP imbalance in the absence of a compensating growth in exports. The resultant pressure on the exchange rate was mainly neutralised by running down forex reserves of the country. At the same time, CBSL continued to finance fiscal operations facilitating fiscal stimulus as well. The Government debt held by the CBSL grew by over 235% to Rs.263Bn from year 2010 to 2011.

Tightening measures taken to arrest over expansion of the economy including a) credit ceilings on commercial banks; b) policy rate hike; c) flexible exchange rate leading to exchange rate shocks; d) adjustment of fuel prices resulted in slower growth in 2012 ending an episode of monetary stimulus driven growth.

An economy could be given a boost by stimulus in the short-run. However, economic theory suggests that stimulus based growth could have long term negative implications on the economy. In the long run, painful adjustments will be needed for chilling the overheated stimulus effect of the economic engine; for example, 2012 February structural adjustments.

Bank of International Settlement research work argues that credit driven imbalances could potentially lead to boom-bust processes that might threaten both price and financial system stability. Simply, systemic break downs could occur in anywhere in an overstretched system. Other contemporary economists also agree with this view. A. Leijonhufvud contends that the end results of such credit driven processes could be either hyperinflation or deflation, with the outcome being essentially indeterminate prior to its realisation; and W. A. White argues that easy monetary policies can lead to moral hazard on a grand scale.

3. The Government finances

are under pressure

Fiscal sector is faced with formidable challenges. The tax revenue as a percentage of GDP has come down from 14.5% in 2000 to 11.1% in 2012. From the mid 1990s, Government revenues have not been adequate to meet at least its day-to-day expenses. Initiatives targeted at improving tax revenue have not brought in anticipated results. Thus, the entire public investment was met by borrowings, compelling the Government to be extra cautious in prioritising public investments.

Despite difficulties, the Government has continued with its infrastructure drive. The fact that the long neglected, weak infrastructure is a stumbling block to sustainable growth has been a strong justification for government making huge investments. It seems, however, the infrastructure investments have been made sometimes without establishing the feasibility and/or financed without considering maturity mismatches. (According to some news reports and Parliament debates, the Hambantota Port will have to generate at least Rs. 6 billion a year to pay its annual instalment starting from 2012, which seems far from reality. Sections of opposition charge that only 25 ships have arrived during the 25 months since the port was opened. However, these charges could not be verified independently.)

With the country moving towards the middle income status, concessional financing options have increasingly dried up. These circumstances have skewed the country’s debt composition to commercial borrowings – some of which are short-term as well.

4. SOE operations are adding woes to fiscal operations

Due to various reasons, two main SOEs are making colossal operational losses; and reform prospects seem to be remote. The implication on macros is that these losses will need to be borne by people now or in the future. If the Government subsidises these SOEs, the fiscal deficit widens, increasing the borrowing needs of the Government. Invariably, debt servicing will fall on the people through increased taxes or curtailed Government expenditure. If SOEs continue to borrow from State banks, again the problem is only deferred. Private sector crowding out, upward pressure on interest rates and possible strains on financial system stability will be the adverse consequences. The last option is to pass the burden of losses to the consumer through increased prices for commodities that the SOEs offer in spite of the argument whether any inefficiency at SOEs should be borne by the end user. (Both MOF and CBSL annual reports refer to the inefficiencies of the SOEs.)

5. Trade is deteriorating.

The country’s external sector is suffering from structural deficiencies. The main export, garments and textile (contributing to over 40% of export earnings), is competing on cost with low domestic value additions. Also, it was recently confronted with major setbacks such as loss of GSP and continued sluggish demand from the main buyers, i.e. the US and the EU. Being a less sophisticated product manufactured by many low cost competitors, the garment industry’s potential as a middle income country seems to be low in the Sri Lankan context, unless the industry seeks to move towards value added niches in the near future.

On the other hand, Sri Lanka is losing its competitiveness in the tea industry for many domestic and global reasons. Most of the other export commodities are also at a basic product level without much value addition. The impact on macros of the present basic exports structure is that the export demand is elastic. Therefore, the trade revenue is vulnerable very much to external developments and shocks. On the other hand, import structure is mainly less elastic or inelastic. Over 25% of the import bill represents fuel and another 25% represents investment goods. Another 10% is spent on raw-materials of textile industry. Thus, action should be taken sooner than later to improve the merchandise trade without leaving a big gap to be filled in by tourism earnings and remittances. When the remittances and tourism receipts are not adequate, it will be portfolio investments, FDIs and other capital (loan) flows that will have to set off such deficit. It is noteworthy that around 3-4% of GDP had come as net inflows to the government during the last few years to compensate the BoP deficit.

Conclusion

It is safe to believe that there are many tough challenges ahead of the country. Mere wishful thinking/optimism (or pessimism) will not take the country anywhere. It is the prudent economic management that will steer the nation to its development aspirations. Policymakers shall act with a broad understanding of the reaction of economy to policy changes in discharging their noble national duty. It is noteworthy that all macro variables fundamentally cannot perform well simultaneously, policy makers will need to plan striking a balance between different economic trade-offs rather than thinking everything will move in a favourable direction.

“No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future” – Ludwig von Mises

(The writer can be reached via [email protected].)