Financial Times

Gloomy outlook for economy
By Muttukrishna Sarvananthan, Principal Researcher, Point Pedro Institute of Development
The second-quarter of 2004 saw a new government taking office after the abrupt dismissal of the previous government in February and calling of elections in April. However, it did not bring much needed political nor economic stability to the country because it is a minority coalition government with no clear policies either on the economy or the peace process.

The Gross Domestic Product (GDP) data for the second-quarter has not been released yet. The latest available data is for the first-quarter; accordingly the GDP grew by 6.2% in real terms. In spite of the negative growth recorded by the agricultural sector (as a result of prolonged drought) the services and industrial sectors steered the economy to a fairly high growth rate. However, quarterly GDP growth in the first-quarter was marginally lower than the preceding quarter. The second-quarter GDP is anticipated to be lower than the first-quarter as the following indicate.

In the agricultural sector, while tea output increased rubber and coconut outputs decreased during the second-quarter. The Colombo auction price of tea, in dollar terms, was on the decline during the quarter under review. Moreover, industrial output indices (public sector industrial production index & private sector industrial production index), and industrial exports in value terms were on the decline during the quarter under review.

Interest rates, viz. prime lending rate and treasury bill rate, were on an upward trend though the repo and reverse repo rates remained static. Inflation, both in terms of the Sri Lanka consumer price index and Colombo consumer price index, was also on the rise. These two indicators point to the beginning of strains experienced by the Sri Lankan economy during this year.

Public debt incurred during the quarter under review was greater than that of the previous quarter. While domestic debt dominated the market in the first-quarter it was external debt that dominated the market in the second-quarter. Continuing shortfalls in public revenue is a cause for worry. This coupled with re-introduction of various subsidies by the new government may increase the budget deficit more than what was originally planned for in the budget.

On top of straining of the domestic sector of the economy the external sector also experienced strains as a result of soaring world oil prices and depreciation of the rupee. Total exports dropped and total imports increased, in dollar value terms, resulting in a significantly greater trade deficit during the second-quarter compared to the preceding quarter. As a consequence the gross official foreign exchange reserves dipped at the end of quarter; the first quarterly drop in the past two and half years.

To compound the above problems faced by the external sector there was considerable drop in net private remittances received, and foreign exchange earnings from tourism during the quarter under review. All in all, the external sector of the economy is beset by a downward spiral causing concern about the stability of the balance-of-payments position of the country.

In contrast, performance of the stock market was upbeat during the second-quarter in comparison to the first-quarter. The pause-in-conflict economy of the N&E Province failed to receive any impetus after the new government took office because of lack of breakthrough in the resumption of peace talks between the government and the LTTE.

Worrying signs
In sum, performance of the economy during the second-quarter is cause for worry and all indications are that it may get worse in the following quarters due to prolonged severe drought in many parts of the country, soaring world oil prices, protracted stalemate in the peace process, and absence of unambiguous economic policies of the new government. The impending American presidential election in November, inter alia, is causing a meltdown of the American economy, which in turn is hurting the Sri Lankan economy because America is the largest export market for Sri Lanka.

One of the indications of the worsening Sri Lankan economy from the government side is the failure of the Finance Minister to present the mid-year fiscal position report to the legislature in compliance with section 10 of the Fiscal Management (Responsibility) Act No.3 of 2003.

It appears that the new coalition government (UPFA) was put together to unseat the previous government as its sole objective, without clear policies on either the economy or the peace process. Though the UPFA government professed a "mixed economy" there is no clear and tangible economic policy framework from the government as yet. On the issue of resumption of formal peace talks with the LTTE the new government appears to be in a much more precarious state than as regards the economy.

Not only does the UPFA government not appear to have a viable economic policy framework to work with, it is also on a course of rolling back progressive economic reforms undertaken by the previous regime. This shortsightedness coupled with a prolonged drought and soaring fuel prices in the world market are straining the economy. Rising cost of living and interest rates are just two indicators of an overstretched economy.

Despite winning the Provincial Council elections resoundingly the new government is finding it hard to put together a common policy towards the resumption of peace talks. The parliament was convened less than five times during the second quarter because of lack of a simple majority for the ruling coalition, and an opposition member being elected speaker of the house making passing of legislation very difficult (if not impossible).

According to the latest available data the GDP grew by 6.2% in real terms during the first quarter of this year. Though this GDP growth rate was lower than the preceding quarter (4th quarter 2003) it was second highest in the past two years. Lower growth rate during the first quarter was caused by negative growth (-1.4) in the agricultural sector.

Negative growth in the agricultural sector was due to prolonged drought affecting primarily Northern, North Central, and North Western Provinces. This has caused a sharp drop in output of paddy. The industrial sector recorded 5.8% growth rate, which was negligibly better than the preceding quarter. The services sector recorded 9.5% growth, which was considerably higher than the preceding quarter.

While tea output improved, rubber and coconut outputs declined during the second quarter in comparison to the previous quarter.

Industrial output falling
Industrial output was on a declining trend. The private sector industrial production index (1997=100) dropped to 129 points in April from 136 points in March, and then increased marginally to 130 points in May. Similarly, the public sector industrial production index (1997=100) dropped to 61 points in April from 91 points in March, then increased to 85 points in May, and dropped to 83 points in June. As a corollary, industrial exports also dropped significantly in April but improved in May and June.

Industrial exports, in terms of dollar value, dropped significantly by 26% to USD 290 million in April compared to March. Then it picked up by 13% to USD 329 million in May, and further by 10% to USD 361 million in June. Total industrial exports for the quarter recorded USD 980 million compared to USD 1,040 million in the last quarter. Overall, there was a 6% drop in industrial exports (in USD value terms) during the quarter under review compared to the first quarter despite monthly increases in May and June.

The Prime Lending Rate (PLR) and Treasury Bill Rate (TBR) began to rise during the 2nd quarter and are expected to continue in the following quarter as well. At the same time the Repo Rate (RR) and Reverse Repo Rate (RRR) remained static during the quarter under review.

The average PLR during the last week of April increased to 9.44% from 9.30% during the last week of March. Then it dropped to 9.07% during the last week of May, but increased again to 9.59% during the last week of June. Similarly, the average TBR (12 month) during the last week of April increased to 7.71% from 7.62% during the last week of March. Then it remained at 7.71% during the last week of May, but increased to 7.77% during the last week of June.

The repo and reverse repo rates remained unchanged at 7.00% and 8.50% respectively throughout the quarter under review. Generally, the PLR and TBR have tended to be on the rise while the RR and RRR remained static during the last weeks of every month this year until June.

Cost of living was on a rising path during the second quarter after a sustained drop since mid-2002. This, along with the rise in interest rates, indicate looming strains in the economy of Sri Lanka due to prolonged drought, rising fuel prices, political instability, and economic uncertainty.

Public debt increasing
Public debt increased as the government revenue fell short of target. Total public debt incurred during April dropped to LKR 3 billion from LKR 9 billion in March. Then it increased to LKR 14 billion in May and LKR 46 billion in June. Total public debt of LKR 64 billion incurred during the quarter under review was 8% higher than that incurred during the previous quarter (LKR 59 billion).

Total government revenue during the first six months of the year recorded LKR 143 billion, falling short of the targeted LKR 166 billion. On the other hand, total government expenditure during the first six months of the year recorded LKR 227 billion, falling short of the targeted LKR 235 billion. Hence, in sum there was a net revenue shortfall of LKR 15 billion for the government during the first six months of this year.

External sector of the economy appears to be on a downward spiral as is the domestic sector. Whilst total exports dropped imports increased in value terms during the quarter under review. Hence, trade deficit soared during the quarter.

Total value of exports dropped significantly by 27% in April to USD 374 million from USD 514 million in March. Then it increased to USD 409 million in May (9% rise) and to USD 459 million in June (12% rise). At the same time total value of imports dropped by 14% to USD 633 million in April (in comparison to March), and by 8% to USD 580 million in May. However, total value of imports increased to USD 691 million in June recording a 19% rise in comparison to the preceding month.

Rising oil prices in the world market caused by continuing disruptions in Iraq has destabilised the economies of America and Britain; the two largest export markets of Sri Lanka. The drop in total value of exports is even more worrying given the continuing depreciation of the rupee.

Foreign exchange reserves of the government were on the decline during the second quarter. The gross official reserves dropped marginally (1 %) to USD 2,242 million by end of April (from USD 2,262 million at end of March), to USD 2,035 million (9% drop) by end of May, and then increased (3% rise) to USD 2,104 million by end of June. The marginal rise in official foreign exchange reserves in June could be due to increase in foreign aid received during that month.

Gross official reserves by the end of quarter were sufficient to finance imports for 5.2 months (a drop from 5.7 months imports by the end of first quarter). Sri Lanka is expected to experience worsening balance-of-payments due to surge in world oil prices and prolonged drought (which leads to greater use of thermal power, as opposed to hydropower, resulting in higher fuel cost).

There was marked drop in net private remittance received during the second quarter compared to the first quarter. Further, net private remittance received during the second quarter was lower than that received during the corresponding quarter last year. Net private remittance received during the quarter under review declined by 19% in comparison to the first quarter, and by 7% compared to the second quarter last year.

Pause-in-Conflict economy
The pause-in-conflict economy in the North&East Province of Sri Lanka is defined in this report as transitory economy in-between the conflict time economy and post-conflict economy. The economy of the North&East Province is hampered by the continuing stalemate in the peace process and heightened individual violence in the eastern region of the province. The donor community keeps on insisting that the disbursement of donor funds committed at the Tokyo donor parley held in June 2003 is contingent upon resumption of formal peace talks.

Access to institutional credit seems to be a major impediment for the resurrection of small and medium enterprises (SMEs) in the N&E Province. Some statistics reveal that except Ampara, Vavuniya, Trincomalee, and Jaffna no other district in the N&E has received loans under an Asian Development Bank (ADB) credit line to SMEs in the recent past. Even the SMEs in the aforementioned four districts have received the lowest numbers of loans worth the lowest values.

This is because, firstly, there are only a handful (if at all) of branches of banks in the N&E that are nominated to disburse donor-funded loans to SMEs. Secondly, collateral demanded by the banks appear to be high because of additional risk factors in the N&E.

Thirdly, many SMEs in the N&E are ineligible to receive formal institutional credit as they are unregistered, and hence in the informal economy. In these difficult circumstances there need to be innovative institutional setups in the N&E to serve the credit needs of entrepreneurs. Needless to say, there is a huge pent up demand for credit during this pause-in-conflict period.

What are required are proactive and flexible credit institutional setups to serve the special needs of the entrepreneurs who appear to be sick and tired of the overcautious traditional banking system.

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