Economic perspectives from the Ministry of Finance and Planning

The 2012 Annual Report of the Ministry of Finance and Planning was launched on Friday with President Mahinda Rajapaksa as the Chief Guest. Following is the first chapter of the Report which was also the basis of Ministry Secretary Dr. P.B. Jayasundera’s speech. Part two focusing on the future challenges will be published tomorrow.

Overview

The year 2012 being the third year of the 2010-2012 three year fiscal framework within the 2010-2015 second five year development plan, ‘The Emerging Wonder of Asia – The Development Policy Framework of the Government,’ was yet another challenging year to the Sri Lankan economy.

Unusual and extreme weather conditions were witnessed in late 2011 and throughout 2012, with heat waves that seared through the country coupled with a severe drought, as well as massive showers which caused floods that affected many parts of the country, demonstrating the susceptibility of several growth sectors of the economy particularly agriculture and power generation, as well as wildlife and biodiversity, to climate change.

The rapid deterioration in global economic conditions particularly in major export markets in Europe and in the US also posed a challenge to sustain the growth momentum generated in 2010 and 2011 affecting export led economic activities. The rise in imports owing to higher oil prices that remained in the range of US$ 90-110 per barrel and the excessive demand for oil imports for power generation stemming from the prolonged drought undermined the stability of the balance of payments in 2011, due to the widening trade deficit. High international oil prices that exceeded domestic administrated prices of petroleum products, electricity, water and transport led to an accumulation of large losses in several state enterprises such as CPC, CEB and SriLankan, compelling the Government and State banks to finance such losses, in addition to their increased exposure to finance oil imports.

The private sector credit growth of 24.9% in 2010 and 34.5% in 2011 in the backdrop of a high economic growth of 8% in both years was excessive. In this context, ‘securing stability’ became the strategic economic priority, while protecting welfare expenditure and planned public investments. Balancing such a trade-off involved corrective policy actions through re-alignment of prices, interest and exchange rates, the cost of living and business operations. Hence, the Government initiated a series of policy actions to secure stability commencing from the presentation of the 2012 Budget in November 2011 in the interest of the medium term high growth scenario.

The Government policy stance in the wake of a large trade deficit encouraged greater flexibility in exchange rate movements, imposition of high tariffs on high demand motor vehicle imports, prescription of credit ceilings in the banking system, increasing policy interest rates and revision of administered prices on petroleum, electricity, water and transportation, to correct emerging imbalances in both external trade and the domestic economy.

The unavoidable implication of these policy actions which resulted in creating a dampening impact on the import demand and economic activities in the immediate term was also a challenge since it affected Government finance, mainly revenue flows as reduced imports compressed Customs based revenue in 2012. The Euro Zone financial crisis and the US Fiscal Cliff caused worries in the global financial outlook affecting foreign investments.

Overall performance

Amidst such challenges, the Sri Lankan economy generated a 6.4% annual growth in 2012 pursuant to an 8% annual growth in the two preceding years. This moderation of growth in 2012 was the combined outcome of subdued external demand, tightened domestic policies and the effects of adverse weather conditions that impacted agriculture and hydropower generation. The severe drought in the second and third quarters of 2012 limited agriculture sector growth to 5.8%.

The services sector growth moderated to 4.6%, despite the expansion in tourism and related services mainly due to lower domestic and external demand. The industry sector performed well in 2012 largely supported by the thriving construction activities. The development strategy of the Government continued to focus mainly on the development of maritime, energy, aviation, education, tourism, agriculture, rural development and export industries without allowing them to suffer from short term adjustment effects.

A significant expansion of productive capacity has been created through the development of infrastructure facilities, which have already been completed or nearing completion including 3 new sea ports, several fishery harbours, a new international airport, power plants, new roads and irrigation schemes, to support continued economic expansion.

As per the World Bank’s Doing Business Survey 2013, Sri Lanka further improved its position to the 81st from the 89th position in the previous year underpinning the continued progress in the creation of a supportive business environment in the country. The gross investment /GDP ratio exceeded 30% in 2012, after remaining at low levels for three decades. The disparity between the urban and the rural further narrowed. The overall poverty level declined from 15.2% in 2006/07 to 6.5% in 2012 (provisional), with a rapid decline in multifaceted poverty demonstrating that the rural centric development strategy of the Government has been effective. With continued economic expansion, the unemployment rate also declined further to 4.0% in 2012.

Despite price adjustments, the monetary policy was able to curtail the growth in money and credit expansion and contain the annual inflation at around 8%. The single digit inflation achieved was further strengthened by the agriculture policy of the Government that recognises food security as an explicit objective and also encourages generation of a greater surplus in food production.

The country’s per capita income reached near US$ 3,000 level in 2012, underscoring sustained positive movements in the per capita growth that was witnessed since 2005, in which year the per capita income was US$ 1,200. Increasing domestic demand, along with expected improvement in the global economic outlook, prospects remain strong to return to a high growth path of 7.5-8.0% in the medium term. Hence, the year 2012 can be reckoned as the year in which the economic transformation that is in place in Sri Lanka was facilitated having put in place the required adjustments towards securing stability, to ensure reaching the upper middle income economy status by 2016, without compromising the US$ 4,000 per capita income target.

Fiscal policy

Continuing to maintain a consistent downward trend in the reduction of the budget deficit remained a challenge. In spite of the setback in revenue, the Government was able to contain the fiscal deficit at 6.4% for the third consecutive year, encouraging the commitment to direct the fiscal deficit towards a manageable level in the medium term. Revenue from Custom based taxes, such as VAT, NBT, Import Duty and Excise Tax moderated due to the decline in imports, particularly motor vehicle imports.

Despite the moratorium on loan repayments and interest payments on the loans provided to Ceylon Electricity Board, deferred payments by the Water Supply and Drainage Board due to its tight liquidity situation, non-compliance by certain state owned business enterprises on the payment of PAYE tax, a contraction in domestic economic activities and the decline in excisable commodities such as liquor and cigarettes, the Government’s steadfast efforts for fiscal consolidation resulted in containing the fiscal deficit at 6.4% of GDP in 2012.

This is a continued progress in the reduction of the deficit from 9.9% in 2009 and 6.9% in 2011, with a slight departure from the targeted 6.2% for 2012. However, comprehensive tax reforms introduced in 2010 and 2011, simplified the tax structure and broad based the tax system, brought down the corporate income tax from 35% to 28%, unified the VAT rate at 12%, abolished several multiple taxes, and enabled the tax system to consolidate in a low tax regime to improve medium term compliance and promote a buoyant revenue growth in line with other fast growing economies. These reforms are yet to spawn its intended outcomes.

The unfavourable global and domestic economic sentiments had a somewhat cloudy impact on the positive effects so far witnessed and made an economic contraction in 2012. The drop in revenue was offset to some extent by the containment of recurrent expenditure, which declined from 18.2% in 2009 to 14.9% of GDP in 2012. This mainly reflected the moderate growth in salaries, transfers and subsidies, and interest payments. The Government was able to maintain public investment which was above 6% of GDP in recent years at 5.8% of GDP in 2012, mainly due to time slicing of capital expenditure in the backdrop of reduction in revenue.

Moving further forward, the Government also committed to reduce the fiscal deficit to 5.9% of GDP in 2013 and below 5% by 2016 through revenue improvements projected to increase to 16% of GDP over the medium term in line with the expected economic growth of around 7% in 2013 and 7.5 to 8% thereafter, along with the expansion in the tax base and improvements in profit and dividend income from state enterprises.

Taxation

The recent tax reforms focused on creating an enabling environment for investment and growth while promoting the medium term revenue base. Accordingly, tax incentives were realigned under the Inland Revenue Act and Strategic Development Projects Act to expedite the approval process and to rationalise tax incentives, to prevent possible erosion of the future tax base. Steps have already been taken to bring the wholesale and retail sectors under the VAT system to further broaden the tax base. A moratorium is being applied to prevent the grant of ad-hoc concessions.

The Government has placed greater emphasis on improving the tax administration to perk up compliance and intensified tax audits and revenue collection measures with greater focus on the large and corporate tax payers. A Tax Appeals Commission and a Tax Interpretation Committee have been set up to minimise long delays experienced in resolving tax disputes. Measures are under way to move towards payment of taxes on a self-assessment basis, to ensure greater coordination among Sri Lanka Customs, Excise, and Inland Revenue Departments and to provide facilities to make tax payments on-line, with a view to promote tax compliance, timely filing of tax returns and effective enforcement. The human resource skills required to manage an advanced tax administration are being strengthened.

Institutional modernisation including the transition to an IT-based processes is in progress. These measures together with the already established relatively low tax regime are expected to increase both income tax as well as VAT revenue, to assist the over 15% GDP tax effort in the country over the medium term fiscal framework.

Debt reduction strategy

The Government debt to GDP ratio, which has been declining consistently from 105.6% in 2002, increased slightly from 78.5% in 2011 to 79.1% in 2012, largely reflecting the impact of the Rupee depreciation and the appreciation of Yen denominated foreign debt but underpins the positive impact of the continuously reducing budget deficit and the relatively strong GDP growth that is being maintained, both of which are essential in the effort to reduce debt in proportion to GDP.

The sustained fiscal consolidation coupled with the high economic growth in the range of 7-8% over 2013-2015, is expected to bring down the debt to GDP ratio to around 70% by 2016. The country’s external debt service indicators have remained well within the target of less than 18% denoting less indebted country status, which is confirmed as per the recently published UN- ESCAP’s country comparison.

Monetary policy

The concerted efforts being made by the Government to improve financial management and improvements witnessed in food production and supply conditions have helped to maintain inflation at a single digit level continuously since 2009, despite adverse domestic and external supply side-shocks.

 The year-on-year headline inflation recorded as low as 2.7% in February 2012 but gradually increased to the upper boundary level of 9.8% by July 2012, mainly reflecting the impact of upward adjustments in energy prices, supply disruptions due to adverse weather conditions, the pass-through effects of the rupee depreciation as well as underlying demand pressures associated with credit expansion in the past two years.

Inflation has moderated since then to 6.4% in April 2013 and a further deceleration is expected in the coming months in response to a relatively stable money and credit growth as well as supply side improvements in food production and distribution. The Central Bank’s ‘Road Map: Monetary and Financial Sector Policies for 2013 and Beyond’ assures the commitment to maintain inflation at mid-single digit levels over the medium term.  In response to tight policy measures adopted at the beginning of 2012, the credit growth decelerated rapidly to 17.6% from 34.5% in the previous year. In 2012, the reserve money and money supply growth also decelerated to 10.2% and 17.6% respectively. These developments together with the declaration of inflation, improvements in budgetary operations and adjustments made to administered prices by state enterprises to phase out borrowings from the banking system, created new space for the Central Bank of Sri Lanka to moderately ease monetary policy.

The Central Bank has reduced policy rates by 25 bps in December 2012 and proceeded to further reduce by 50 bps in May 2013 to facilitate the liquidity growth required for the revival of the economy. Towards this end, the Central Bank has also taken steps to allow greater flexibility to commercial banks in managing their day-today liquidity and reserves and raise funds from abroad. Foreign exchange transactions have also been further relaxed to promote exports and capital inflows.

Exchange rate flexibility

Greater flexibility has been allowed in the exchange rate since November 2011, by limiting Central Bank’s intervention in the domestic foreign exchange market. The intervention of the Central Bank during 2012 was limited only to the extent needed to settle a portion of petroleum import bills, mainly during the first six months of the year, while surplus foreign exchange liquidity in the market was absorbed as and when appropriate. The rupee depreciated vis-à-vis the US$ by 11.6% during 2012.

Consolidating on the successful completion of the three-year Stand By Arrangement (SBA), external stability was further strengthened in 2012. Gross external reserves increased to US$ 7.1 billion by end 2012 from US$ 6.7 billion by end 2011. In terms of months of imports, the gross official reserves were equivalent to 4.4 months by end 2012, a significant improvement compared to the import coverage of 4.0 months recorded in 2011.The limits on the Net Open Positions (NOPs) and forward transactions of commercial banks were relaxed in January 2013 and are expected to relaxed further along with market developments. The improved external reserves also covered 100% of short term commercial debt.

Financial system stability

The Central Bank has continued to strengthen its regulatory supervision of the financial system to address systemic vulnerabilities and risks, to further consolidate financial system stability. Despite challenging global and domestic market conditions, the overall soundness of the financial sector showed improvements with higher levels of capital, adequate liquidity buffers, strengthened corporate governance, risk management priorities and healthy earnings. These were achievable primarily due to improved supervisory and regulatory frameworks and integrated risk management arrangements promoted by the Central Bank.

The public confidence in the financial system improved with the financial safety net mechanisms that were put in place such as mandatory deposit insurance schemes.

 To create greater awareness of mutual responsibilities, obligation of customers and banks were published in the form of a Customer Charter.

 The access to finance increased with the extension of branch networks, especially benefitting those in distant regions and conflict affected areas. Constant close supervision and timely guidance helped to sustain the credit quality amidst the sharp credit growth witnesses in 2010 and 2011, although continued close surveillance is necessary on banking and financial institutions in the wake of adjustments to low interest rates and in view of risks associated property mortgages and gold pawning.

The challenge ahead is to facilitate the banking and financial institutions elevate themselves to be able to meet the demands of an emerging middle income country that demands institutional capacity building, innovating new financial instruments and developing modern financial infrastructure to deepen country’s financial market. Monitoring fiscal consolidation has been further strengthened to support development with

stability.

Enterprise reforms

Having recognised the urgent need to address financial difficulties confronted by the Ceylon Petroleum Corporation (CPC) and the Ceylon Electricity Board (CEB) in the backdrop of the widening gap between international cost price and domestic selling price of oil, the Government allowed upward adjustments of energy prices both in 2012 and 2013, in addition to operationalising low cost power generation plants and reducing transmission losses to move closer to cost reflective pricing.

Accordingly, the prices of petroleum products were raised by 37-51% in February 2012 and further adjustments were done in December 2012 and in early 2013. Moreover, sale of heavy fuels to the CEB below the cost price, which is a major source of CPC’s losses, was discontinued from April 2013. With regard to the CEB, a tariff increase of around 24% was implemented from April 20, 2013, while continuing with the Fuel Adjustment Charge (FAC) which together reflects 25-40% of a monthly bill, was implemented from February 2012, excluding however those households consuming electricity less than 60 units per month.

Steps are being taken to improve operational efficiency and financial management by drawing professional inputs, raising productivity through long term supply contracts, improving treasury operations and modernising the production and distribution capacity of both enterprises. With the low cost 600 MW coal power plant being commissioned in 2013 and having re-negotiated the 15 year old power purchase agreements while giving weightage to prevailing circumstances and recognising the need to adopt a stable power generation mix, it is expected that these entities will reach a breakeven level in their operations during 2013/14.

Public financial management

The focus of public financial management is placed on key aspects of budget preparation, budget controls and execution, accounting, reporting and internal/ external audits. The budget preparation in recent years has adopted a broad based approach, involving wider consultations not only with line ministries and devolved as well as decentralised administration units of the Government but also with the private sector, the self-employed and even trade unions. The process has mobilised the political leadership, technocrats and the civil society into the process before the budget is ultimately submitted to the legislature for approval. The use of supplementary provisions and passing ad hoc revenue legislations has been minimised, although variations of actual outcomes still exist in revenue and expenditure estimates due to systemic weaknesses and unpredictable events that affect budget outcomes.

Fiscal transparency and accountability have been improved with the disclosure of information as required in terms of the annual Appropriation Act and the Fiscal Management (Responsibility) Act. The Government has also encouraged development partners to support policy based budgeting by sharing a part of budget expenditure instead of accommodating isolated projects, particularly in education, health, poverty reduction, social sector, agriculture and disaster management areas in which policy based budgeting is evolving. As part of ongoing improvements in budget controls and execution, project management and monitoring, procurement, cadre management, commitment and imprest controls have been prioritised for further improvements.

Work is in progress to replace Financial Regulation (FR) of 1992 that had subsequently already undergone certain amendments, with a new Financial Regulation, to ensure greater effectiveness in public finance management, while simplifying the processes. While the internal audit responsibility is being strengthened, a risk based audit systems is also being introduced to ensure greater accountability. However, greater supervision and controls are warranted with regard to field level distribution of the fertiliser subsidy, the procurement of pharmaceutical products which cost the National Budget over Rs. 100 billion and the use of fuel and electricity in Government establishments, for more effective results.

External trade

Sri Lanka has one of the most open and least restrictive trade regimes in the region in terms of tariff and non-tariff barriers supported with a market driven exchange regime. It has progressed well, with required adjustments to correct ill effects of unfair trade practices and protective actions of trading partners, as well as to safeguard the environment, health and security concerns, food security and the SMEs, in recent years.

A composite tax on selected agricultural products, imposed at the point of import was introduced to maintain stable remunerative prices for farmers, especially those engaged in farming in hitherto untapped agricultural areas that were opened for cultivation having completed demining in the conflict affected areas and new areas in which agriculture is being incrementally promoted having brought them under the cover of new irrigation systems. Hence, with regard to certain agricultural items, tax at the point of import and on wholesale trade are increased during the harvesting season and decreased during the off-season, to ensure that prices remain stable within a range throughout the year, in a bid to balance benefits between both farmers and consumers.

Further, the supply of these commodities by exporting countries is sometimes subject to unpredictable trade restrictions, and such situations make the domestic market vulnerable to those events. Since such trade is largely done by small timers, a simple, single and transparent instrument has become effective also to ensure effective tax administration. This mechanism has in fact encouraged food security, through the transformation of paddy agriculture to a level that can generate a buffer stocks with a possible export surplus, improved the production of liquid milk, maize, onion, green gram, black gram and soya beans thereby contributing to reduce imports and has also improved domestic supply conditions and livelihood of farmers engaged in small holder agriculture in the country.

While focusing on food and energy security which has considerable export and import substitution potentials, external trade regime has been further strengthened with the full implementation of Free Trade Agreements with India and Pakistan, being two large South Asian economies. Opportunities are being explored to promote exports from Sri Lanka in these two countries as trade balances still remain unfavourable to the country.  Bilateral discussions with Japan, China and South Korea also focus on trade and tourism activities to allow them increased market access by relaxing both tariff and non-tariff barriers, to promote exports from Sri Lanka on the same scale that Sri Lankan trade and payments system provides market access to such countries. The Government has also increased market access to branded products of global repute in addition to allowing up to 40% of production of export industries to be sold in the local market to promote global trade, tourism and investment activities. Infrastructure

The rapid development of basic infrastructure is a key policy objective of the 2006-2016 Government’s development policy framework. The annual public investments on average have been targeted at 6% of GDP since 2005 in the National Budget accommodating investment expenditure in physical infrastructure and human resources development.

Investments in power generation and distribution, port and airport development, expressways and the national highway network, water supply and urban facilities, irrigation and agricultural infrastructure and downstream development activities and improvements in railway infrastructure have facilitated private investments in many sectors. The uninterrupted supply of electricity covering almost 93% of the population in the country and the expanded transportation and communication connectivity have encouraged private investments in IT and BPO services, aviation services, integrated tourism, urban property development, ports and logistic facilities, telecommunication services, renewable energy, basic industries such as cement, steel, and ceramics and the construction industries. Domestic and private investments in such areas have gathered momentum in recent years.

Foreign Direct Investments (FDIs) have reached US$ 1,000 million per year, since 2010. In addition to Government’s continued public investment drive through the National Budget, State-Owned Enterprises have also been encouraged to expand their investments in infrastructure facilities, particularly in petroleum refinery and storage and in solid waste management.

The private sector has also been incentivised to enter infrastructure development and expressway maintenance, renewable energy sources, solid waste management and urban housing construction, to augment the country’s infrastructure facilities by complementing the public investment drive. The improved business climate, fiscal incentives, new infrastructure facilities, improved access to finance and relaxation of capital account transactions, will help to increase export oriented investments.

Human resource development

The progress made in Human Resource Development (HRD) in Sri Lanka is ahead of many developing economies. This has placed the Government in a more advantageous position to steer forward country’s education system with focus on advanced skills development and higher learning opportunities, while also ensuring that health services will improve healthy living and longevity. Accordingly, public expenditure on education and health has increased to Rs. 235 billion in 2012 from Rs. 108 billion in 2005, accounts to around 22% of Government revenue in 2012.

This scale of expenditure has enabled the engagement of around 250,000 teachers and academic staff and around 100,000 health sector employees to improve the service delivery for the development of human resources while networking the entire country to ensure access to all. The improvements shown in the United Nations HRD Index to 0.7 in 2012, and the earning capacity of the work force in newly emerging sectors of the economy and the large number of overseas employees that generated around US$ 6,000 million in 2012, in comparison to US$ 1,918 million in 2005, signify the benefits derived through improved HRD in the country.

The continuously reducing unemployment, improved livelihood opportunities including such prospects in self-employment activities in technical and professional services and the high employee demand prevailing in the construction, tourism, IT and high tech manufacturing and commercial services, suggest that the country should sustain its HRD endeavours while also expanding into new areas involving multifaceted skills.

The 1,000 Mahindodaya schools developed throughout the country, networked with 5,000 feeder schools and the remaining primary schools would provide child-friendly modern infrastructure to the schools network, over the medium term. This is facilitated with teacher training programs and curricula development in mathematics, English, science and IT as part of improving general education. The expansion of vocational education is tilted towards improving high skills that are in demand in an emerging economic environment. University townships nourished with motivated academic commitments focusing research and technology initiatives, will facilitate to place country’s higher education on par with its parallels in other emerging economies.  The ongoing modernisation of country’s healthcare network with around 1,000 hospitals including dispensaries in the rural areas, with required staff and equipment will improve pre-emptive as well as curative health services. The expansion of Government facilities while encouraging private sector involvement in skills and higher education and in quality health services, has enabled the country to divert enhanced expenditure for human resource development which was around 4.5% of GDP to over 6% of GDP and consolidate country’s advantage to attract knowledge based industries and services into the economic progress.

Poverty reduction

The central focus of Government’s overall development strategy is to reduce poverty beyond targets set in Millennium Development Goals (MDGs) by 2015. Reflecting this priority to promote rural development with an inclusive growth, a well-integrated rural livelihood development strategy that embraces households (Divi Neguma/ Samurdhi), and provides welfare benefits and promotes community empowerment (Gama Neguma) through the development of required infrastructure such as access roads, rural electricity, community water and sanitation, minor irrigation systems and market centres have been implemented by the Government.

Sri Lanka has made a steady progress in reducing poverty through these initiatives during the recent years and is well poised to meet the Millennium Development Goal of halving the incidence of Income Poverty before the target year of 2015, from the 2005 level. The number of poor living below the poverty line has reduced from 15.2% in 2006/07 to 8.9% in 2009/10 and has further declined to 6.5% in 2012 (preliminary results of HIES 2012/13).

The most encouraging outcome of this process is that the reduction of poverty levels has taken place among all geographical areas and across all sectors. Poverty in the estate areas, which has been strongly higher than in rest of the country has reduced from 32% to 11.4% between 2006 and 2010 and has further dropped to 6.2% in 2012. During the same period, inequality has also reduced from 0.4 to 0.36 as reflected in the Gini Coefficient as per the said HIES.

The overall development and poverty reduction initiatives that have been implemented has helped the country to perform equally well with regard to the Multidimensional Poverty Index (MPI). The multi-dimensionally poor in Sri Lanka is 1.9% (preliminary results of Household and Income Expenditure Survey (HIES) 2012/13), since Sri Lanka has performed better compared to many other countries in relation to child mortality, nutrition, schooling, access to safe drinking water, sanitation, cooking fuel, and housing and assets, indicating the effectiveness of the Government poverty reduction strategy by effectively reaching targeted poverty segments in the society.  Consolidating these gains, the President declared in the Budget 2013, the goal to create a poverty free Sri Lanka by 2015 by intensifying poverty reduction efforts based on evidence reflected in the HIES of 2012/13, having addressed the remaining facets of poverty connected with malnutrition, disabilities, housing and sanitation conditions, school-dropouts, non-communicable diseases and natural disasters.