The main concerns for Sri Lanka for 2009 and 2010 are slowing growth, a deteriorating balance of payments and meeting fiscal targets, the Asian Development Bank (ADB) said this week.
Growth is expected to fall to 4.5% this year as the global slowdown deepens, affecting export industries. Sri Lanka has a large fiscal deficit at 7% of GDP and its current account balance which is 7.1% of GDP, both significant factors in policy measures.
At a media briefing on Tuesday to launch the Asian Development Outlook (ADO) 2009, the ADB’s Economist for Sri Lanka Dr. Narhari Rao said the country’s fiscal policy is a major area of concern. He said Sri Lanka’s stimulus package of Rs.16 billion is small, less than 1% of GDP because the government does not have the funds to stimulate the economy. According to the International Monetary Fund (IMF), stimulus packages should be at least 2% of GDP.
Dr. Rao said that unless there is a change in fiscal policy, the burden of any adjustment falls on capital expenditure. Sri Lanka should raise revenues and streamline expenditure wherever possible, adding that the fiscal deficit remains at 6% of GDP. He also raised concerns about the worsening current account deficit which is forecasted to be 7.5% of GDP in 2009 and 7% of GDP in 2010. He said export demand will shrink around 8% in terms of volume and there will be some impact on remittances, a huge source of foreign exchange for the country, due to a slowdown in the Middle East.
Dr. Rao said it is encouraging that the government is negotiating for a stand by loan agreement of US$1.9 billion with the IMF and hopes a successful conclusion to the negotiations will help Sri Lanka in the process of fiscal consolidation, boosting its foreign exchange reserves as well as increasing investor confidence. Dr. Rao stated that the rupee is expected to depreciate more in the first half of 2009 and Sri Lanka should have a more flexible monetary policy.
The ADB said 2009 growth will slow on depressed export demand with the worst effects of the global downturn felt in the balance of payments, creating pressures on reserves and the exchange rate. Meeting fiscal targets for 2009 will be a challenge due to tight financial markets and a fiscal stimulus package. With major military operations expected to end in early 2009, the ADB said rehabilitation and reconstruction in the north might start this year.
The ADB said the Sri Lankan economy maintained healthy growth in 2008 with a GDP of 6%, bolstered by agriculture although high global food and oil prices boosted inflation and widened the trade deficit. Agriculture recorded strong growth of 7.5% while services and industry recorded moderate growth. Although the government already had a policy of maximizing agricultural production and minimizing food imports, the shortage of rice in early 2008 together with sharp increases in global food prices spurred its efforts.
The ADB said annual average inflation in 2008 was high at 22.6%, well above the prior year’s 15.8%. Year on year inflation peaked in June 2008 at 28.2% and stepped down gradually to 14.4% by December 2008. In fact, the ADB stated that the economy had experienced a persistent rise in inflation since 2006, a phenomenon linked primarily to bank-financed government deficits. However, the spike in June 2008 stemmed from higher fuel and food prices, originating in the lifting of fuel subsidies in 2006 and on electricity in 2008 which allowed global oil prices to be fully reflected in price developments.
The government’s total external foreign currency commercial debt declined to US$460 million in 2008 from US$485 million at end-2007.
The ADB said that authorities have been increasingly turning to foreign commercial borrowing in recent years, the share of which, in total foreign debt, rose to 13% in 2007 from 5% in 2003. As the maturities are relatively short, the roll-over risk of this debt is high in the current environment. The CB had proposed to borrow US$300 million in the international capital market in the latter part of 2008 but failed due to prevailing global conditions.
The CB has intervened in the foreign exchange market since 2007 to keep the rupee stable against the US dollar. With the eruption of the global financial crisis, foreign exchange drained from the country occasioned by a fall in non-resident holdings of Sri Lankan Treasury paper and the settlement of large petroleum bills in the last quarter of 2008.
This, with high inflation, exerted depreciation pressure on the local currency. In response, the CB intervened, seeking to maintain the rupee at about Rs.107 to US$! But this intervention entailed a large drop in the official international reserves to US$1.8 billion at end December 2008 from US$3.4 billion at end August 2008, equivalent to 1.5 months and 3 months of imports respectively.
Maintaining fiscal discipline in 2009 will remain a major challenge according to the ADB. The 2009 budget expects the deficit to fall to 6.5% of GDP, a view underpinned by assumptions of discipline in current spending and strong revenue performance. Historically, the ADB said both these targets have been hard to meet, leading to cuts in the capital budget to maintain the deficit at a manageable level. The public investment programme will also depend on the government’s ability to raise funds in the international capital markets which will remain problematic this year. Sri Lanka’s sovereign rating was downgraded in 2008 both by Fitch (to B+ from BB-) and Standard & Poor’s (to B from B+).
The rating was further downgraded by Fitch to B in February 2009. In terms of the trade balance, the ADB said the global downturn’s impact on exports will be softened by a lower import bill, largely reflecting lower fuel prices. As international financial markets remain tight, financial inflows will be substantially lower than in 2008.
This, coupled with falling reserves, will pose serious risks to the economy. The rupee is expected to depreciate further in the first half of 2009. Given the relatively low foreign exchange reserves, the government’s decision to allow more depreciation in the exchange rate in late 2008 was correct according to the ADB. The overvalued currency is hurting exports. However, any depreciation of the rupee will increase debt repayments in rupee terms and add to the fiscal burden. The ADB said the government needs to follow a more active exchange rate policy which should be supported by greater fiscal restraint to minimize risks and maintain export competitiveness.
The ADB stated that the government’s announced strategies to boost reserves in January 2009 such as current swaps with central bank’s, promotion of investments in treasury bills and bonds among the Sri Lankan Diaspora and other measures, their effectiveness remains to be seen. |
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