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Sri Lanka: State of the Economy 2011
Prospects free download / e-version
18. Prospects
The outlook for a sustained global economic recov-
ery received a significant blow in mid-2011 with a
deepening of the debt crisis in the Euro Zone econo-
mies, and political intransigence in resolving a deal
to raise the US debt ceiling and avert a debt default.
The uncertainty rattled financial markets across the
world, signalling loss of investor confidence in eco-
nomic leadership worldwide.
In the Euro Zone, a string of sovereign debt crises in
Greece, Portugal and Ireland began to spread to the
larger EU economies of Spain and Italy - and more
recently France - threatening to unravel the single
currency at the heart of the European integration pro-
cess. As borrowing costs for the already weakened
economies rose in the face of half-hearted measures
to stabilize the Euro Zone, the European Central Bank
(ECB) moved in to support Spain and Italy by ex-
panding its bond-buying programme on the under-
standing that they continued to cut fiscal deficits.
Despite this immediate relief, pessimism about Eu-
ropean economic prospects is deeply rooted. Second
quarter 2011 growth figures for the Euro Zone rose by
a mere 0.2 per cent, the slowest quarterly economic
growth since mid-2009. Any attempt to come to grips
with the potential escalation of the sovereign debt
crisis will require a commitment from more fiscally
prudent EU member states such as Germany to raise
the current 440 billion European Financial Stability
Facility (EFSF) rescue fund and/or for the Euro Zone
to issue bonds backed by all member nations. Whilst
such a move will no doubt calm markets, it will be a
difficult sell for many of the stronger Euro Zone econo-
mies given the significant economic and political costs
representing such a bailout. The shakier Euro Zone
economies will be called on to undertake deep struc-
tural reforms carrying painful austerity measures, as
governments attempt to persuade their creditors that
they can meet their debt obligations. Austerity mea-
sures are likely to hurt growth, but there appears to
be little choice for the debt-ridden governments.

An important lesson from

the debt crises in the Euro
Zone economies is that
dependence on private
capital to finance public
expenditure can create
stresses and strains on an
economy when they are
least expected
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Institute of Policy Studies of Sri Lanka
Sri Lanka: State of the Economy 2011
Prospects free download / e-version
The problems for the US economy are as
complex. Political brinkmanship on a deal
to raise the US debt ceiling - agreed on al-
most at the last moment on 31 July 2011 -
was purportedly a key factor in the decision
by Standard & Poor's to strip the country of
its AAA credit rating on August 5, 2011. The
final debt deal that focused more on spend-
ing cuts than tax increases to tackle fiscal
problems was lopsided, and unlikely to help
a faltering economic recovery. Nonetheless,
unlike the Euro Zone - which lacks true po-
litical integration - the US has favourable
factors working for it, including a greater like-
lihood of tackling fiscal problems if politi-
cal leadership is able to rise above partisan
politics. The reasoning behind the US dollar
'exceptionalism' - the global reserve currency
of choice - also suggests that the downgrad-
ing will have a limited impact, especially
given that the euro is hardly likely to be
viewed as a viable alternative to the dollar
anytime soon. However, with an unemploy-
ment rate of over 9 per cent, an annualized
GDP growth rate of a mere 0.8 per cent in
the first half of 2011, and consumer spend-
ing at its weakest in two years, the US eco-
nomic downturn is clearly more severe than
was previously understood. Indeed, the eco-
nomic woes of the US and EU have been
described as a second 'Great Contraction' of
growth (the first being the period after the
Great Depression) as opposed to a typical
recession or even a double-dip Great Reces-
sion.
1
The symptoms - slow growth over
many years - are argued to be the result of
deep financial crises that require bailouts by
states, which are then left with few resources
and tools to cope with stagnant growth and
high unemployment.
Even as the developed world is being plagued
by record levels of debt and weak growth as
economies struggle to recover, a slow but
steady re-balancing of the global economy is
taking shape, moving the centre of global
economic gravity from the West to the East.
Emerging economies of Asia - particularly
China and India - have already begun to play
a more prominent role in global economic
governance reforms through membership of
key forums such as the G20. However, the
region is unlikely to escape unscathed from
the recent developments. While demand for
exports may shrink, the direct impact on
growth will be less severe as the larger Asian
economies rely ever more on stimulating
domestic demand to keep growth buoyant.
Alternatively, their growth prospects are more
likely to be impacted by the possibility of
investors fleeing to safer havens. The Asian
region may experience a renewed inflow of
foreign capital, raising the risks of overheat-
ing even further, and requiring a tighter mon-
etary policy response that will take a toll on
growth. While economic growth in Asian
emerging markets, particularly in China and
India, is already forecast to slow relative to
historical trends over the last decade, the re-
gion will still be the driving force behind
any global economic recovery process.
For Sri Lanka, renewed concerns about the
global economic outlook will have mixed
bearings. The most obvious concern will be
in regard to the medium term prospects for
the country's major export industries that are
heavily reliant on US and EU markets. In the
first half of 2011, export growth remained
strong, albeit on the back of a steady im-
provement from the poor performance expe-
rienced in 2009. While the immediate im-
pact on key exports such as garments may be
limited, if consumer demand in the US and
EU continues to weaken further, it will
clearly have an impact on order books in the
months to come. On the import side, ex-
penditures have outpaced export earnings,
with Sri Lanka's trade deficit expanding by
62.7 per cent in the first six months of 2011.
1
http://www.project-syndicate.org/commentary/rogoff83/English.
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Sri Lanka: State of the Economy 2011
Prospects free download / e-version
A slowdown in export earnings could be off-
set if international oil prices were to ease as
global growth falters. However, a general
downward movement in commodity prices
could be double-edged, if there is a knock-
on impact on some of Sri Lanka's key non-
industrial exports such as tea and rubber.
Even as the trade deficit swells, Sri Lanka has
continued to see a strong surge in worker
remittances, with inflows growing by 26.4
per cent in the first half of 2011. Addition-
ally, earnings from tourism remain healthy,
estimated to have grown by over 50 per cent
to US$ 370 million over the same period,
2
with an increase in tourist arrivals of 37 per
cent. However, such inflows are not suffi-
cient to bridge the trade balance, as a result
of which Sri Lanka is likely to see an ex-
panded deficit in its current account of the
BOP in 2011.
Overall, however, the outlook for the
country's external payments position remains
positive in view of inflows on the capital
account transactions. The CBSL reported of-
ficial reserves of US$ 7.5 billion by end June
2011 - sufficient for 5.4 months of imports,
country's official reserves jumped to US$ 8.1
billion by end July 2011, adequate for 5.8
Box 18.1
External Sector Performance (January-June)
% growth 2009 2010 2011
Exports -18.0 13.7 35.2
T&G -4.1 -2.5 34.7
Imports -36.7 42.1 46.5
Petroleum -56.6 97.3 27.7
Trade balance -59.9 108.6 -62.7
Remittances 5.4 13.5 26.4
Source: CBSL, External Sector Performance, various issues.
months of imports. On the face of it, there-
fore, the country appears favourably posi-
tioned to withstand an immediate external
shock to the economy. However, as Sri
Lankas trade balance widened, non-borrowed
reserves have declined steadily in recent
months amidst efforts to hold the exchange
rate within a pre-determined band.
Despite a faltering global economy, with a
GDP growth rate of 8 per cent recorded dur-
ing the first half of 2011, Sri Lanka's growth
forecast for the year of around 7-8 per cent
is also likely to remain unchallenged. Much
of the country's recent growth momentum is
derived from domestic stimulus as the
government's public investment programme
is implemented. However, this is not to sug-
gest that Sri Lanka should be complacent and
overlook more medium term risks to eco-
nomic performance and macroeconomic sta-
bility. The risk is all the more should the
debt crises in the developed countries lead
to a protracted and slower global economic
recovery process.
As already noted, Sri Lanka's export earnings
could be adversely affected. Apart from this,
there are also other adverse spillover effects
that could materialize. These relate in the
2
CBSL, External Sector Performance June 2011, www.cbsl.gov.lk.
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Institute of Policy Studies of Sri Lanka
Sri Lanka: State of the Economy 2011
Prospects free download / e-version
main to the possible impact on global finan-
cial flows. Short term capital inflows to Sri
Lanka's sovereign debt market are necessar-
ily curtailed by regulatory restrictions cap-
ping the holdings of foreign investors. The
risk for a small economy such as Sri Lanka,
making a slow but steady post-conflict eco-
nomic recovery, is investor perception with
regard to the outlook for medium term eco-
nomic stability. Should the current global
economic uncertainties make investors highly
risk-averse, smaller emerging economies such
as Sri Lanka could see a slowdown - or even
a reversal - of capital flows. Such a develop-
ment could also come about, as previously
experienced in 2008, if foreign investors face
a liquidity crunch. The underlying pressures
on global flows of FDI are likely to be simi-
larly driven. In the first half of 2011, Sri Lanka
is estimated to have attracted gross FDI in-
flows of US$ 413 million as part of the
government's target of raising US$ 1 billion
by end 2011.
3
The anticipated upsurge in
FDI inflows to Sri Lanka in 2011 is tied largely
to the leisure and real estate sectors. Attract-
ing FDI inflows more strategically into manu-
facturing and skilled services sectors can be
expected to become more difficult if global
2008
a
2009
a
2010
b
Loans Grants Loans Grants Loans Grants
Bilateral 397.4 79.9 870.7 99.4 2402.5 104.6
China 46.3 0.8 295.4 2.4 821.4 7.5
India 0.5 30.2 17.2 483.8
Japan 263.3 15.4 295.8 15.6 396.6 42.3
Multilateral 380.1 213.7 427.0 224.5 762.3 19.0
ADB 248.2 41.7 243.4 40.5 366.7 5.5
World Bank 96.0 49.6 147.6 54.5 347.4
Total 932.0 293.6 1297.9 323.9 3136.9 123.6
Table 18.1
Sources of Foreign Financing (US$ million)
Note: a: Disbursed; b: Committed.
Source: Department of External Resources, Performance Report, various issues.
economic conditions deteriorate to a signifi-
cant extent.
FDI, however, accounts for only a fraction
of Sri Lanka's Gross Domestic Capital For-
mation (GDCF). Net FDI amounted to only
3 per cent of GDCF in 2010. Sri Lanka's cur-
rent investment drive, driven by an expanded
public investment programme, is largely de-
pendent on a mix of private capital and mul-
tilateral/bilateral development finance. In July
2011, Sri Lanka issued its fourth US dollar
benchmark offering in global bond markets,
raising US$ 1 billion. In addition, Sri Lanka
has also been raising larger volumes of de-
velopment finance through loans in recent
years. Access to such finance is unlikely to
be affected by the global debt upheavals. For
Sri Lanka, Asian economies such as China
and India - with significant foreign exchange
reserves - have emerged as the main source
of bilateral development finance. Indeed,
these two countries accounted for over 40
per cent of total foreign financing commit-
ments made to Sri Lanka in 2010.
While Sri Lanka may not see its access to
sources of foreign savings drying up, there
3
CBSL, Monetary Policy Review August 2011, http://www.cbsl.gov.lk.
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Institute of Policy Studies of Sri Lanka
Sri Lanka: State of the Economy 2011
Prospects free download / e-version
could be other risks. For one thing, rating
agencies are likely to adopt a tougher stance
in the aftermath of the US downgrading which
means that room for policy slippage narrows.
A downgrade in ratings can be costly for a
country that relies on private capital for pub-
lic investment, as Sri Lanka has done in
recent years.
The medium term outlook with regard to
macroeconomic stability is, therefore, criti-
cal. The positive inroads Sri Lanka had made
in fiscal restructuring have continued into
2011 and the government appears to be well
on target to achieve a reduced fiscal deficit
of under 7 per cent in 2011, helped by im-
proved revenue generation. The deficit for
the first half of 2011 was estimated at 3.4
per cent, compared to 3.8 per cent in the
same period a year ago. A stronger fiscal per-
formance will help in maintaining price sta-
As % of GDP 2010 2011
Revenue 4.3 4.4
Recurrent expenditure 5.8 5.6
Public investment 1.6 1.6
Overall budget deficit 3.0 2.7
Table 18.2
Fiscal Trends (January-April)
Source: Ministry of Finance and Planning, Mid-Year Fiscal Position
Report, June 2011.
bility, in spite of rising inflationary pressures
in more recent months.
In June 2011, the CCPI (with 2002 as the
base year) was revised by the DCS to take
the two year average (2006/07) as a base pe-
riod, computed on the basis of the House-
hold Income and Expenditure Survey 2006/
07. The most significant change was a drop
in the weight assigned to food items from
46.7 to 41.0 per cent in the new index. While
the revision was justified on the basis of more
recent data, the lower weight assigned to food
items in the midst of rising food prices, saw
the new CCPI recording a lower rate of in-
flation as compared to the previous index
(Figure 18.2). Nonetheless, with annual in-
flation touching 7 per cent by end June 2011,
ensuring that the country continues to enjoy
a low inflationary environment will be a pri-
ority for the government.
Figure 18.1
Inflation Trends
Source: CBSL, Colombo Consumer Price Index, www.cbsl.gov.lk.
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Institute of Policy Studies of Sri Lanka
Sri Lanka: State of the Economy 2011
Prospects free download / e-version
Box 18.2
Select Monetary and Financial Indicators (January-June)
% change 2009 2010 2011
Reserve money -2.2 6.4 10.2
Broad money (M
2b
) 8.1 4.2 8.6
Credit to private sector -5.8 6.5 14.0
Rate of Inflation 12.5 3.9 7.0
Source: CBSL, Monthly Economic Indicators, various issues.
The acceleration of credit growth to the pri-
vate sector in the second half of 2010 has
continued into 2011. The onus for the CBSL
will now be to try and cool down credit
growth to prevent the economy from over-
heating. It did so in April 2011 with an in-
crease in the SRR of commercial banks, while
also using moral suasion on commercial
banks to ease on credit allocation, as op-
posed to raising policy interest rates that could
have an impact on the country's growth pros-
pects. For the moment, such a policy stance
may suffice. Nonetheless, it is critical that
as Sri Lanka aims to achieve rapid develop-
ment progress in the coming years, the coun-
try does not lose sight of striking the appro-
priate balance between growth and stability.
A stable macroeconomic outlook will have
a strong bearing on investor confidence in
the Sri Lankan economy, particularly in the
context of disarray in the outlook for the more
advanced economies globally.
Sri Lanka's monetary policy stance in the
coming months will also have an impact on
another fundamental indicator of macroeco-
nomic stability - i.e., the exchange rate. Sri
Lanka has being experiencing a steady nomi-
nal appreciation of the rupee against the US
dollar since the beginning of 2010 (Figure
18.3). Despite carrying a current account
deficit - which suggests that the rupee should
ideally be depreciating - strong net capital
inflows have put upward pressure on the ex-
Figure 18.2
Exchange Rate and Interest Rate Trends
Note: REER = Real Effective Exchange Rate; AWPR =Average Weighted Prime Lending Rate.
Source: CBSL, Monthly Economic Indicators.
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change rate. The CBSL has intervened in the
foreign exchange market to ensure that the
rupee stays within a pre-determined band.
The policy stance has been to target the ex-
change rate by mopping up capital inflows.
The consequent build-up of foreign exchange
reserves can potentially raise inflationary pres-
sures - i.e., it allows the domestic monetary
base to expand without a corresponding in-
crease in production. If inflationary pressures
are to be countered, interest rates should be
allowed to move up.
Ensuring a stable exchange rate and interest
rate policy regime raises a critical policy di-
lemma for countries that face a surge in for-
eign capital inflows. If an independent mon-
etary policy - i.e., setting interest rates - takes
precedence over an exchange rate target, then
the exchange rate has to be allowed to move
in line with market developments and vice
versa. If global economic growth contracts -
dampening aggregate demand in Sri Lanka -
there could be an easing of credit growth
and any potential build-up of inflationary
pressures. If not, the current monetary and
exchange rate policy stance will need to be
reviewed.
In more recent months, the upward pressure
on the currency has reversed as import ex-
penditures have continued to outpace export
earnings. Efforts by the CBSL to ensure the
stability of the exchange rate have seen a
gradual decline in Sri Lanka's non-borrowed
reserves. Clearly, a stable exchange rate has
a bearing on fiscal outcomes, particularly as
dependence on foreign capital borrowing
rises. Notwithstanding the above, the under-
lying market fundamentals driving move-
ments in the rupee raise concerns. There are
many difficulties in ascertaining what con-
stitutes an equilibrium real exchange rate -
particularly in distinguishing between 'per-
manent' and 'transient' capital flows. What
counts as sustainable levels of net capital
flows is the relevant issue in determining the
equilibrium rate, and any deviation suggests
a misalignment. Such a misalignment can
be costly for longer term export growth.
Sri Lanka needs to be extra vigilant to ensure
a healthy growth in earnings from exports of
goods and services which has a critical bear-
ing in meeting the country's growing foreign
debt service obligations. Although, the coun-
try appears to be comfortably placed with
gross official reserves of US$ 8 billion, these
include net foreign inflows into Treasury bills
and bonds as well as other forms of com-
mercial borrowing. An important lesson from
the debt crises unfolding in the Euro Zone
economies offers a reminder that dependence
on private capital to finance public expendi-
ture can create stresses and strains on an
economy when they are least expected. Thus,
maintaining macroeconomic stability is criti-
cal. Any perceived weakening can have a sig-
nificant impact on investor confidence, mag-
nified by the uncertainties currently gripping
the global economy.