Downturn – a downtrend in economic performance

By the Economist

The economy has weathered serious storms in the first half of the year. The continuing rise in oil prices, a deteriorating security situation, a high rate of inflation and tight monetary policies have all affected the performance of the economy. It has also affected expectations that determine investment decisions. Therefore the downturn in economic performance in the first quarter of this year, though slight, was not unexpected. Since these conditions not merely prevailed but accentuated after the first quarter, the downtrend in economic performance is expected to have continued into the whole of the first half of the year. The Central Bank’s optimistic prediction of a 7.5 per cent growth for 2007 is unlikely.

The Central Bank’s optimism on the economy has not been dampened by these facts. It expects the economy to grow by 7.5 per cent this year on top of a 7.4 per cent growth last year. This is indeed a high expectation of economic growth in the context of the unfavourable external and internal conditions. The Central Bank’s optimism is based on a good performance in industry and services in the first quarter and expectations of a continuation of the trend in the rest of the year. In the first quarter industry grew by 7 per cent and services by 7.1 per cent yielding a growth of 7 per cent in the non-agricultural sectors.

Agriculture that has declined in the first quarter is expected to decline in the second quarter as well. Tea production has fallen by about 20 per cent in the first four months of the year and the Maha paddy harvest was lower. Since agriculture’s contribution to GDP is only 16 per cent, the improved performance in industries and services is expected to offset the adverse developments in agriculture. Although there is an expectation that fisheries will grow this year too, though not by the massive extent it did last year owing to the recovery after the tsunami, even a modest growth expectation would be hard to realise given the unstable security situation in the North and East. Last year’s massive growth in fisheries contributed much to the robust growth in agriculture.

One of the worst affected sectors of the economy is tourism, whose plight is not quite captured by the statistics as other foreign visitors, official delegations and business visitors are included in the statistics on tourist arrivals. Tourist arrivals and tourist earnings have declined by around 20 per cent according to official statistics. In fact the impact on the hospitality trade and its backward linkages are much more serious that what these figures suggest. Except for some of the Colombo hotels where most business visitors stay, the other holiday resort hotels are virtually empty. The low hotel rates being offered to locals is clear evidence of this. The downturn in tourism has adverse backward linkages well beyond the hospitality trade, affecting gem and jewellery trade, suppliers of produce by hotels, handicrafts manufacture and transport services for tourists. These adverse developments have affected the services sector that too has shown signs of reduced momentum. The impact on services too may take time although some services may grow to offset at least to some extent the decline owing to the economic shocks that the economy as a whole is facing.

Industrial production has increased by 6 per cent so far this year. However, industrial output has also been affected adversely though not necessarily captured adequately by the statistics. This is owing to many of the adversely affected industries being small and medium scale industries whose downturn is only indirectly captured as there is a time lag in figures on some areas of industrial production. The higher costs of credit and lesser availability, higher costs of fuel, as well as a slowdown in domestic demand that appears inevitable in the context of rising prices is not likely to boost industries catering to local demand.

Agricultural output has fallen due to other reasons, the weather being as usual the foremost factor. The Maha harvest this year is estimated as much lower. Perhaps other food crops too have suffered. The Tea output has fallen a significant 20 per cent that may not be caught up later in the year. The growth in rubber production that has been boosted in recent years by higher prices continues to rise. In the first four months it increased by nearly 15 per cent. This uptrend is likely to continue during the rest of the year though its impact is rather small on economic growth as it contributes much less than 1 per cent to GDP.

There is clear evidence that production in several sectors of the economy was affected by the prevailing security conditions and the tight money policy. The performance of the first half of the year is likely to show further signs of economic slowdown. What is disturbing is not the statistic of a slower growth but that the factors affecting growth adversely appears to be here for sometime and the economy’s performance this year is likely to fall quite significantly. While inflation will continue spiralling upwards the economy will spiral downwards. If however the monetary policies succeed in curbing inflation somewhat it is likely to be at the expense of investment and growth. Some of these impacts will not be seen immediately as they are more likely to affect growth after a time lag of 6 to 12 months.

The important issue is not the slight decline that the statistics indicate. It is the factors behind those statistics. The fact is that the war and the security situation are once again setting back economic progress and the attainment of higher rates of growth. Substantial development of the economy is being retarded.

There are the sectors directly affected by the terrorist acts that are visible such as the hospitality trade, but then there are many other areas that the terrorist activities have affected adversely. These include investment, foreign inflows of funds for portfolio investment and retardation of project implementation. The indirect impacts on the economy arise from the high rate of inflation, the consequent tight money policies that are affecting the supply and cost of credit, and the depreciation of the currency that is raising import costs of raw materials and other inputs. The higher inflow of remittances is continuing to be of help. Foreign borrowing is restraining further depreciation of the currency but heaving a burden for the future.

Time will tell whether the scenario sketched here would unfold or whether the optimism of the Central Bank would hold. In the interests of the country, we hope the Central Bank would be proved correct in the fullness of time.