Overview of economic developments in 2012

• Asia Wealth Management Ltd. recently reviewed the economic performance of the country in 2012 and provided a sneak preview of 2013. Here are excerpts:

Sri Lanka managed to successfully avoid an external payments crisis in 2012 and maintained a robust real economic growth of 6.4% during the first three quarters of 2012 outpacing most regional economies amidst a challenging external and internal economic environment and become one of the fastest growing economies in Asia-Pacific. However, 3Q2012 saw real GDP growth moderating to 4.8% YoY mainly on the back of the sharp dip in paddy output by 38.2% YoY in the face of adverse weather conditions.

Further, contractionary monetary and tax policy measures adopted by state authorities to avoid an external payments crisis coupled with the waning demand from export destinations curbed the pace of real growth of manufacturing and services to 3.3% and 4.6% YoY respectively from 7.7% and 7.8% YoY from the previous year. The major contributors to real output growth in 3Q2012 were Mining and Quarrying (16.2% YoY), Construction (16.5% YoY), Hotels and Restaurants (25.3% YoY), Transport and Communication (7.8% YoY), Banking, Insurance and Real Estate, etc., (7.1% YoY) and Private services (6.7% YoY).

With regard to the external sector, deficit in the trade account and imports expenditure dropped 1% and 4% YoY respectively from Jan-Oct 2012 owing to the market and nonmarket corrective measures adopted by the fiscal and monetary authorities with the aim of narrowing the deficit in the trade account of the balance of payments. On the face of this shift in government’s response to overcome contradictions in the economy’s growth process, gross official reserves improved significantly to US$ 6.6 billion by October 2012 from US$ 5.5 billion in February 2012 despite exports receipts falling 6.6% YoY in Jan-Oct 2012. Improvement in gross official reserves in the face of declining exports receipts was achieved by monetary authorities raising the level of domestic real interest rates significantly above that of the regional economies to attract foreign savings into economy’s financial sphere primarily targeting government securities.

This was further assisted by the changes in the monetary policy environment which allowed the sharp depreciation of the currency, rendering domestic financial and real assets more price-competitive in world markets.

On the back of these developments, interest yield on government paper and market interest rates spiked over 500 basis points during the year raising the foreign inflows to the government securities by a massive 129.3% YoY to US$ 2.1 billion in Jan-Oct 2012, strengthening the official reserves and balance of payments position amidst declining exports receipts of the economy. For instance, the yield on Sri Lanka’s on-the-run 10 year government bonds increased to 1297 basis points(bps) while financially troubled Greece has a 10 year bond spread of 990bps; 307 points lower than Sri Lanka.

In the face of these adjustments, coupled with the credit growth ceiling imposed on the banking sector by the monetary authorities, credit growth to private sector from the domestic banking system eased to 23.5% YoY in Jan-Oct 2012 from a high of 33.4% YoY in the previous year. As a result, reserve money growth moderated to 10.7% YoY from 22.1% YoY in the previous year. This is to say that the influence of capital account dynamics in determining the changes in monetary and external sector variables and the overall growth performance increased during the year relative to the changes in the trade account of the economy.

On the other hand, nonmarket fiscal measures were adopted by treasury authorities to stem the flow of imports by sharply raising domestic fuel prices, increasing taxes on essential goods such as milk powder and other imported food products and raising taxes on imports of consumer vehicles and parts and agricultural equipment, etc. Inflationary pressures set in on the back of these developments curtailing domestic demand and reducing the expected 2012E GDP growth to 6.5% from over 8%. The tax revenue growth of the government in this setting slid to 7.6% YoY in Jan-Sep 2012 from 12.1% in 2011.

Unavoidable liabilities in the form of interest and salaries expenditure, procurement costs and welfare expenses picked up during the year, which in turn caused the fiscal authorities to raise consumer taxes to remain close to the deficit target of 6.2% of 2012 GDP. On account of these fiscal developments the general price level of the economy increased further towards the end of the year and the point to point inflation in November reached as much as 9.5% while the annual average rate of inflation remains at 7.6%.

The drawback on domestic demand was held back to a considerable extent by the inward flow of labour remittances gathering pace significantly during the year despite the negative growth of exports receipts. Worker’s remittances rose 17.6% YoY to US$ 4.9 billion in Jan-Oct 2012 increasing its share as a percentage of total exports receipts of the economy to 60.5%. The ratio more than doubled from 27.1% in 2004 and worker’s remittances have become the single largest net foreign exchange earner of the economy.

Further, in this connection, CBSL estimates that approximately 30% -40% of the worker’s remittances are channelled in through unregistered sources, indicating that its contribution to the growth of domestic demand is significantly exceeding the figures provided by official sources. It’s also indicative of the fact that rising inflow of remittances boosts household disposable income independent of the level of aggregate incomes derived within the economy. The increase in the flow of remittances coupled with the growth in government’s deficit spending to nearly 7% of the 2012E GDP held up domestic demand amidst tight monetary and tax policy environments and waning external demand for domestic suppliers.

The rapid growth in the number of workers proceeding for foreign employment has become a key force in keeping Sri Lanka’s unemployment at low levels compared to the region (3.9% 3Q2012) and in maintaining domestic purchasing power in the face of unfavourable external and internal economic developments. This is indicated by 24.6% of economy’s workforce resorting to foreign employment by end of 2011 and the ratio almost doubling from 13.1% in 2003. The other important aspect in this connection is that over 96% of the departures are for non-technical employment and 91.5% of the migrant workers are finding employment in the Middle East region with a per capita remittance of Rs. 15,264 per month.

Further, the growing contribution of workers’ remittances to total exports receipts over the years as mentioned earlier indicates that the composition of Sri Lanka’s comparative advantage is shifting from industrial production aimed at supplying domestic and world markets to exporting surplus labour and supplying services targeting a captive home demand. This demonstrates that the direction of economy’s aggregate investments is increasingly turning inwards. For instance, highest percentage shares of 3Q2012 GDP at constant 2002 prices was attained by fields related to Construction (8.1%), Wholesale and Retail Trade (23.9%), Transport and Communication (14.6%), Banking, Insurance and Real Estate (8.7%), Private Services and Ownership of Dwellings (4.7%), Government Services (6.7%) and Food and Beverages (7.3%), accounting for 74% of the 3Q2012 real GDP.

This peculiar phenomenon of investments acquiring nonindustrial and inward characteristics under the guidance of market forces and state’s facilitation tends to periodically produce external payments issues in the absence of tight monetary and fiscal measures and affects the overall growth of factor incomes and factor endowment in the economy. Hence, we are of the view that the Sri Lankan economy bears one of the highest potential in the Asian region, since except for South Asia, the rest of Asia-Pacific to a considerable extent has been able to correct its structural imbalances and are now growing at a more stable rate of real growth. Hence, more emphasis should be made on the qualitative nature of Sri Lanka’s growth process rather than its quantitative aspects, with the aim of reaching equilibrium in the growth structure. Hence, it appears that a structural shift in the general pattern of investments is critical.

In this light, it is our view that productive investments should replace the relative dominance of nonindustrial forms of socially less productive investments to achieve a more productive use of factors in the economy. The lack of dynamism in export oriented industries and the relatively slow growth of industries supplying for a captive domestic market and the expansion of nonindustrial investments remains a key reason in the external payments issues and tight nonmarket policy measures that arise periodically. The importance of Sri Lanka’s economic structure weighs over and above of its developments at the financial level and is the key in determining its future course of expansion.

A sustained high rate of growth depends upon a continuous emergence of new inventions and innovations, providing the bases for new industries whose high rates of growth compensate for the inevitable slowing down in the rates of growth of the older industries. A high rate of overall growth is thus accompanied by considerable shifting in relative importance among industries, as the old decline and the new increase in relative weight in the nation’s output. Hence, a carefully structured state intervention may be one possible solution to support and guide market forces to achieve the shift in resource allocation from less productive to productive sectors.

The East Asian governments in this regard during its development process managed to achieve a balance between market forces and planning, fostering more desirable aspects of market forces while avoiding its excess. However, fiscal frameworks announced in Sri Lanka’s post-war era in this regard, sought to facilitate economic growth without necessarily considering these qualitative and structural aspects of the envisaged growth pattern.