Sri Lanka: Fighting the odds

Sri Lanka has caught the attention of the world intermittently, though more often than not for the wrong reason – its ethnic conflict.

According to an HSBC Global Research report on Macro Asian Economics published this month, the report states that a closer look at Sri Lanka reveals 'an economy with substantial growth potential, given a resilient and hard-working populace, geographical advantage and increasing private sector investment.' However, to release that potential, the country needs to overcome a number of challenges such as infrastructure bottlenecks, ethnic conflict and fiscal consolidation.

The report says that Sri Lanka has grown by an average rate of 5% per annum over the last 20 years. 'Although by no means a stellar growth performance, it is impressive for a country that has been torn by ethnic conflict since 1983.' Sri Lanka graduated to 'middle income' status in 2004 ahead of India and Vietnam and given the recent pick up in growth to around 7% and positive outlook, the report predicts that per capita GDP should hit US$2000 by 2010.

Volatile but growing
According to the report, despite economic growth being far from stable, ranging from a high of 8% to low single digits, the economy has contracted only once in the last 50 years. The report suggests that the country has the potential to push up the sustainable growth rate to around 7 to 8% in the medium term. 'Firstly, Sri Lanka is still a fairly young country with over 43% of the population below 25 years. The working age population is expected to grow by roughly 1% per annum over the next five years, providing a positive impetus to growth, after which the pace will slow.'

The report also says that employment growth should continue at around 3% per annum, allowing the unemployment rate, currently at a 20-year low of 6.3%, to fall further. The quality of labour input should improve steadily as well. Basic education has made substantial strides, however the performance at the university level has been disappointing. 'The government is aware of the shortcomings and is actively promoting knowledge based education.'

Second, the report states that rising fixed asset investment, improvements in tertiary education and increasing foreign direct investment will boost labour productivity, which accounts for 60% of economic growth. Much of the increase in productivity wil come from the continuing shift of employment out of agriculture and into industry and services.

Agricultural production has grown steadily at around 2% per annum over the last five years while industry has expanded by 5% per year, mainly on the back of manufacturing, with electricity production also increasing in importance. However since 2005 industry has been clocking 7-8% growth which is likely to continue. Service sector output has grown at around 7% per annum over the last five years with post and telecommunications and financial services being the main growth industries. Looking ahead, the report is optimistic about the prospects of the service sector given Sri Lanka's high literate and trainable workforce but further investment in information and communication technology is needed.

In order to achieve the government's growth targets, substantial capital needs to be mobilized to push the investment to GDP ration to above 30% from 25% currently. Domestic savings have averaged 22% of GDP over the last five years and with rising income levels, there is scope for further improvement. The other key source of funds has been remittances from overseas Sri Lankans which touched nearly 8% of GDP in 2006 and should remain strong. The remaining gap can probably be filled by foreign direct investment given the efforts by the Board of Investment to improve the attractiveness of Sri Lanka as an investment destination.

Historically high inflation
The report states that historically, inflation has tended to be high in Sri Lanka with the Colombo Consumers' Price Index average 11% per annum since 1990. Even according to data taken over only the last five years, the average remains at 11% suggesting that policy management has been consistently unsuccessful in controlling inflation. The report suggests that inflation is largely a 'fiscally caused monetary phenomenon arising from the government's large borrowing requirement and the Central Bank's ability to print money to meet the requirement. Excessive monetary and credit expansion is boosting demand and hence fanning price pressures.' The solution to the inflation problem lies in fiscal consolidation, something which the government is planning to achieve, the report states. 'Officials aim to bring down the budget deficit to 5% of GDP by 2010. This would allow the Central Bank to move to an inflation targeting framework which would not only help in anchoring inflation expectations but also making policy management more transparent.'

Monetary policy: behind the curve?
The main objective of monetary policy is economic and price stability which the Central Bank currently attempts to achieve within a quantitative framework of targeting reserve money growth. The Central Bank conducts monetary policy under a system of open market operations with the key policy instrument being an interest rate corridor, similar to India.

The report says that although the Central Bank has been tightening policy since November 2004, in retrospect it does not seem that it has raised rates enough as real interest rates have been mostly negative over the last four years. Given that policymakers feel that the current policy rates are a 'little too low' and inflation risk remain pertinent, there is a strong possibility of interest rate hikes.

Fiscal policy: consolidation is the key
Sri Lanka's fiscal position has mostly been in the red with the government running an average budget deficit of 9% of GDP since 1990. The bulk of the deficit can be explained by the government's large salary and wage bill and rising interest rate payments, the report says. Public investment has also been increasing but at 6% of GDP, it pales in comparison to 10% in Vietnam. 'On the revenue side, things aren't that bad with collections averaging 17% of GDP – better than that of India or Pakistan though there is definitely scope for improvement.'

Given the large deficit, the government has substantial funding needs, the bulk of which are mobilized domestically. However, domestic borrowing has a cost as the government's large borrowing requirement pushes up local interest rates, thus crowding out private investment. The other point the report makes is that not all the deficit can be financed in the domestic market so the government relies on Central Bank financing which has led to excessive money/credit growth and hence inflation. The consistently high deficits have also led to the build up of public debt which has averaged 100% of GDP over the last five years. (NG)