Post-conflict Economic Boom: Looking beyond the headline statistics
During the five years following the end of the civil war in 2009, the Sri Lankan economy grew at an average annual rate of 7.4 per cent. This was by far the highest average growth rate for any consecutive five-year period in the country’s post-indepenent history. Per capita income increased from US$ 2031 in 2009 to $3,536 in 2014.
File picture of a garment factory
The rate of inflation came down from a historical height of 22.6 per cent in 2008 to an average annual rate of 5.5 per cent during the ensuing years. The unemployment rate fell from 5.8 per cent in 2009 to 4.3 per cent in 2014. Between 2006 and 2012 the poverty head count ratio declined from 15.2 per cent to 6.7 per cent. The Gini coefficient, a measure of income disparity among households, declined from 0.40 to 0.36 between these two years, indicating that rapid growth was accompanied by a more equitable distribution of gains from the economic boom.
However these impressive headline economic figures need to be treated with caution for a number of reasons. Sri Lanka’s system of national accounts has not been revised/updated since the early 1970s. It suffers from insufficient data sources and underdeveloped statistical techniques. Given the unavailability of detailed data needed to measure both output and intermediate inputs, some of the gross value-added figures are estimated indirectly using fixed ratios obtained from outdated studies or based on ad hoc assumptions.
Of course, while the resulting biases can go either way, such a virtual ‘non-system’ naturally leaves room for ‘creative’ accounting. This is particularly important because of concerns raised about political influence on the generation of sensitive data following the transfer of the compilation of national accounts and the consumer price index (CPI) from the Central Bank to the Department of Census and Statistics (DCS), which comes directly under the President. In January 2014, the DCS sacked the Acting Director of its National Accounts Department after he revealed that the CDS, in his absence, revised up the 2013 first quarter growth rate from 5.4 per cent to 6 per cent.
New index
The new consumer price index (CPI) compiled by the DCS since 2007 excludes alcohol (a commodity that accounts for a substantial share of household expenditure, particularly in working class household) from the commodity basket, and some important items (such as the cost of transport and housing) are estimated using regulated (controlled) rather than market-determined prices. Quite apart from understating the cost of living, these limitations of the CPI are bound to overstate the rate of growth in the economy because CPI and its sub-indices are used for estimating real value-added in a number of sectors (in particular, many subcategories in the services sector).
Even if we ignore these limitations and take the official data at face value, there are several qualifications that must be made to the rosy picture shown by the headline official statistics when we analyse the overall growth experiences from a long-term sustainability perspective.
First, the main drivers of growth have been the non-tradable sectors (construction, transport, utilities, trade and other services), reflecting largely the role of the debt-financed public infrastructure development.These sectors accounted for over 70 per cent of the total increment in real GDP between 2004 and 2014. The manufacturing sector grew only at a modest rate, resulting in a decline in its share in GDP from 18.3 per cent during 2000-04 to 16.2 per cent during 2010-2014. Within manufacturing, the largest contributor to growth has been the food, beverages and tobacco product sector in which the production is predominantly domestic market oriented.
Sectors such as non-metallic mineral products, rubber and plastics, and miscellaneous manufacturing where export production is concentrated, have recorded much slower growth. The only notable exception has been the export-oriented ready-made garment industry, which had already been well integrated within the global apparel value chain as a producer of upmarket apparel products (lingerie and fashion casual wear) thanks to trade-cum-investment liberalisation reforms in the 1980s and 1990s.
Second, the national-level data on poverty and income distribution naturally hide interregional differences. For instance, the disaggregated data available from DCS shows that poverty levels in some districts and sub-regions in the Eastern and Northern provinces still remain stubbornly high, notwithstanding massive government infrastructure investment in these areas. Relating to income inequality, there is a large discrepancy between the latest available figure of the Gini ratio (for 2012) reported in the Central Bank report (0.36) and the one reported by the Department of Census and Statistics on its website for the same year (0.48).
Third, the decline in the unemployment rate was partly due to an increase in public sector recruitments and surge in overseas employment of Sri Lankans.
Public sector workers rise
In a dramatic reversal of the contraction in the size of the public sector workforce maintained over the previous decade, total employment in the public sector increased from around 900,000 (11.1 per cent of the total labour force) in 2005 to over 1.4 million (14 per cent) in 2014. During 2005-2014, on average, a quarter of a million Sri Lankans were leaving annually for overseas employment, with the number increasing every year. By 2014, the total stock of Sri Lankan overseas contract migrant workers would have reached 2.3 million, amounting to over 14 per cent of the total working-age population of the country.
Fourth, although the official aggregate figures show a notable increase in total FDI inflows during 2010-2014, data at the sector/industry level reveal that the increase has come largely from projects in the construction and services sectors. The manufacturing sector accounted for only about a third of total realised FDI, and the bulk of these flows were to domestic market oriented industries (mostly food and beverages), with garments being the only export-oriented industry to attract some FDI. According to the firm-level records of the Board of Investment (BOI), a large number of export-oriented foreign firms have closed down their operations in Sri Lanka during this period. By contrast, the majority of newly established firms (over 80 per cent) are fully locally owned. Investors from India now dominate the BOI list of foreign firms operating in Sri Lankan. Many firms from Korea, Hong Kong and from a number of developed countries, which played a pivotal role in the expansion of manufacturing exports from the country, have left the country.
Fifth, the external payments position of the country has become increasingly fragile. There has been a massive contraction in exports of goods and services as a share of GDP, from average level of 25.6 per cent during 2004-09 to 16.8 per cent during 2010-14. In 2014, export earnings covered only 57 per cent of total outlay on imports. While weak global demand in the aftermaths of the global financial crisis (2008-9) and the recent withdrawal of ‘GSP Plus’ tariff concessions by the European Union would have played a role, a comparative analysis of Sri Lanka’s export performance suggests that the problem is mostly ‘home grown’. Sri Lanka’s share in both world exports and exports from developing countries has declined sharply, indicating that Sri Lanka has failed to keep pace with the expansion in world demand. Viewed against the experience during the 1980s and 1990s, two main factors behind the export slowdown are Sri Lanka’s failure to attract export-oriented foreign investors (and also to retain those who had set up production based in the country) (discussed above), and the continuous erosion of the international competitiveness of Sri Lankan exports (as indicated by the appreciation of the real exchange rate index compiled by the Central Bank).
Deficit widens
Reflecting largely the sluggish export performance, the current account deficit widened from 0.5 per cent of GDP in 2009 to 7.8 per cent in 2010. It has come down since then thanks to rapid increase in inward remittances by Sri Lankan overseas migrant workers and also slower import growth. But, at 3.9 per cent of GDP in 2014, it is still well above the average level of the emerging market economies (1.8 per cent of GDP).
Total outstanding external debt doubled from $20.9 billion (49.7 per cent of GDP) in 2009 to $42.1 billion (57.4 per cent of GDP) in 2014. This increase was underpinned by a palpable shift in the composition of external debt from concessional loans from bilateral donors and international developmental agencies to borrowings on commercial terms. Within commercial borrowing, private sector debt in the form of foreign bank borrowings and international debt securities issued by the state-owned banks under government guarantee has increased rapidly. There has also been a rapid growth of short-term debt in the form of foreign capital flows to government securities and banking sector external liabilities. As a result of the overall increase in debt and the shift of its composition from concessional debt to loans on commercial terms, the debt service ratio (debt repayments and interest payments on debt as a percentage of exports of goods and services) increased from an average level of 12.5 per cent during 2004-08 to 22.2 per cent in 2014. This is bound to increase rapidly in three to five years’ time when the accumulated long-term debt begins to mature.
Import bill
By the end of 2014 total gross foreign-exchange reserves ($8.2 billion) was adequate to cover 5.1 months of imports. However, net foreign exchange reserves (gross official reserves after netting out short-term (less than one year) contractual payment obligations and foreign exchange swap arrangements with domestic banks ) amounted to only about $5.2 billion. This is sufficient to cover the import bill of the country for only about 3.2 months, which barely meets the traditional ‘rule of thumb’ criterion of reserve adequacy (which stipulates that the Central Bank hold reserves equivalent to at least three months’ worth of imports). Be that as it may, this import-based reserve adequacy measure, which originated in the days of the old Bretton Woods system, is not an appropriate yardstick for measuring reserve adequacy for a country like Sri Lanka, which is now significantly integrated into global capital markets through foreign borrowing with an increased short-term debt exposure. Under the Bretton Woods era, given the binding controls on capital flows, the worst situation that could be imagined relating to balance of payments management was that a country could lose access to trade credit (which normally matures in three months).
An important lesson learned from the string of financial crises that engulfed emerging market economies (eg. Mexico in 1995, East Asia in 1997, Brazil in 1999, Turkey in 1994) in the 1990s was that the prudential level of reserves of a country needs to be determined in relation to the volume of short-term foreign-currency liabilities. Holding reserves equal to the stock of short-run debt is an appropriate starting point for a country with significant but uncertain access to capital markets. But it is only a starting point. Countries may need to hold reserves well in excess of this level, depending on a variety of factors: macro-economic fundamentals; the exchange rate regime; the quality of private risk management and financial sector supervision; and the size and currency composition of the external debt.
In terms of this criterion, Sri Lanka’s ability to defend the rupee in the event of an external shock that could trigger short-term capital exodus has rapidly eroded in recent years. In 2008, when Sri Lanka entered into the Stand-by Agreement (SBA) with the IMF, gross foreign exchange reserves amounted to a mere 48 per cent of the total stock of outstanding short-term debt. The SBA helped restore the external reserve position during the two following years, lifting the reserve cover of short-term debt to 112 per cent in 2010. This improvement was rather short-lived, however. During the next three years this figure had come down to about 70 per cent when estimated using gross and net foreign-exchange reserves. The decline in the short-term debt cover is even sharper when measured in terms of net foreign-exchange reserves, from 78 per cent in 2009 to 52.2 per cent in 2014.
Finally, the other side of the coin to the worsening current account deficit and massive foreign debt accumulation is the widening budget deficit. A current account deficit means that the aggregate (public + private) domestic expenditure of a country exceeds aggregate income. In the Sri Lanka case, the private sector has continued to remain a net saver and the current account deficit solely mirrors the public-sector deficit (budget deficit).
From about the late 1990s until 2008, the budget deficit hovered around 7 per cent of GDP, with military expenditure accounting for the lion’s share of deficit financing, and it reached a historical high of 9.9 per cent of GDP at the final stage of the conflict in 2009. Notwithstanding a mild decline during the past three years, the budget deficit (6 per cent) is still well above the internationally considered ‘safety range’ of 3 per cent to 5 per cent. Also the recent decline in the officially reported budget deficit figures needs to be treated with caution because from about 2012 the government has been shifting budgetary transfers to the loss-making public enterprises ‘off budget’, by forcing these enterprises to borrow on their own from domestic banks under government guarantee.
Unsustainable
In sum, despite the glowing headline economic numbers, there are clear signs that the growth dynamism of the Sri Lankan economy over the past five years is not sustainable. The ‘economic boom’ has so far been underpinned by a widening current account deficit (which mirror a widening budget deficit) financed with an equally large inflow of funds from the rest of the world, with a notable shift in its composition from foreign aid and concessionary credit to commercial borrowings. The contemporary policy dilemma of the country is how to contain debt dependency while maintaining the living standards of the population and an adequate growth momentum to maintain employment levels. A prerequisite for sustaining robust growth requires restoring international competitiveness of the economy through depreciation of the real exchange rate. Realistically, this will require a substantial depreciation of the rupee. However, under the current economic conditions, relying on nominal exchange rate depreciation alone for achieving this economic adjustment could be a recipe for economic disaster.
Given the massive build-up of foreign-currency denominated government debt, exchange rate depreciation naturally worsens budgetary woes. And given the increased exposure of the economy to global capital markets a large abrupt change in the exchange rate could also shatter investor confidence, triggering capital outflows. What is required is a comprehensive policy package encompassing greater exchange rate flexibility and fiscal consolidation (which requires both rationalisation of government expenditure and widening the revenue base) to achieve a durable reduction in public debt, and complementary measures, including trade and investment policy reforms, to improve the overall investment climate in the country.
(The writer could be contacted at Prema-chandra.athukorala@anu.edu.au)