Sri Lanka’s economy marches slowly into 2017

By Dushni Weerakoon

Sri Lanka’s meandering economic progress received a boost in November 2016 with the announcement of the proposed 2017 Budget. Under the watchful eye of the IMF, reversing flagging revenue collection is finally the centrepiece for fiscal consolidation after more than a year of policy disarray. 

The revenue reforms include a sharp jump in the value-added tax rate from 11 to 15%, which will draw more people into personal income tax thresholds, and new taxes on capital gains and property. The tax changes are modestly redistributive, but the risk is that almost everyone will feel worse off.

This risk appears to have already materialised, with Sri Lanka’s share market remaining flat following the Budget announcement, as has overall business confidence with sporadic strikes against some of the announced measures by traders and unions. With the economy growing at a modest 4% in the first nine months of 2016, the prospect of higher taxes means that consumers will tighten their belts just when the economy could do with some extra spending.

Investors will also be deterred by higher taxes on corporate incomes and capital gains in the midst of a tight monetary policy stance that has seen a steady upward movement in interest rates. Fiscal tightening, a soft inflation target and a flexible exchange rate are the three key elements of the medium-term macroeconomic adjustment framework under Sri Lanka’s IMF agreement. Once implemented, these measures are expected to restore macroeconomic stability amid a modest overall growth outlook.

The IMF-aligned measures have drawn the usual criticism that fiscal austerity leads to a stagnant or shrinking economy, at least in the short run, and needlessly exacerbates debt burdens. The hard reality is that there is little choice but to push ahead with the announced proposals to fix Sri Lanka’s fiscal woes. Once a semblance of fiscal control has been restored, the impact of such austerity on the country’s immediate growth outlook can be partially offset by easing monetary policy.

The most pressing question is whether the period of austerity will be used effectively to help revive a sluggish economy. Recent available data for the first eight months of the year paints a worrying picture; export earnings have contracted by 4% (on top of a 3.4% contraction in 2015) and FDI inflows have continued to contract by 37% (adding to the 41% contraction in 2015). On a more positive note, trade deals with both India and China — expected to be signed in 2017 — may help boost investor confidence.

Other positive contributors to growth could include the resumption of Chinese-financed infrastructure projects — such as the $1.4 billion Colombo Port City — and efforts to tie up exclusive export processing zones for Chinese investments in southern Sri Lanka. But these policy initiatives need to be coordinated and prioritised on a much broader scale if the economy is to see a transformational shift from consumption and public investment driven growth to private investment and export-led growth. Much of the blame lies in the Government’s slow-footed response to present a promised medium-term economic agenda that sets a clear direction on the economic front and details structural reforms for growth.

There is no obvious political constraint for this delay. In July 2016, Sri Lanka’s National Unity Government — made up of the United National Party and the Sri Lanka Freedom Party — announced that it will extend the alliance from the initial two years until the end of the current parliamentary term in 2020. This politically expedient move brings with it a convergence of interests and an assurance of stability.

But 2017 promises to be a testing year for the governing alliance. It has to ensure political and social consensus for a successful constitutional reform effort. At the same time, it has to deliver economic relief to consumers disaffected by tax-induced price increases and tight economic conditions.

It is perhaps not the most propitious moment to unleash an economic reform agenda. The Government has been peculiarly inept in fostering public support or a social compact for reforms; even as the general public is being asked to tighten belts, there is little evidence of leading by example on the part of the country’s parliamentarians.

But economic policy changes to help markets work more efficiently are needed if the Sri Lankan economy is to lift its medium-term growth outlook. It will be better for the Government to ride out any fallout now rather than later, keeping in mind that there is still time for the benefits of reforms to be felt before 2020 approaches. If Sri Lanka’s Government begins to deliver on reforms in 2017 — in what is expected to be a more conducive macroeconomic environment — then at least there can be some incremental progress towards a Sri Lankan economic resurgence.

(Dushni Weerakoon is Deputy Director at the Institute of Policy Studies of Sri Lanka.)

(Source: http://www.eastasiaforum.org/2016/12/22/sri-lankas-economy-marches-slowly-into-2017/)