|
Developments in the Economy in 2007
Following
are excerpts from the presentation made by Central Bank Governor
Nivard Cabraal last week with the launch of the Roadmap for 2008
Sri
Lanka’s economy grew by 6.5 per cent during the first three
quarters of 2007 and according to current projections the economy
is projected to have grown at around 6.7 per cent in 2007.
Broad based growth
The growth was reasonably broad based as all major sectors of the
economy recorded positive growth rates. It is also remarkable, that
such growth was achieved amidst a number of serious challenges including
high international oil prices, adverse weather conditions and the
unfavorable security situation.
The agriculture sector grew moderately, despite weather related
setbacks in tea and paddy cultivations. Performance in the rubber,
coconut, minor export crops and livestock sectors were on par with
expectations. The fisheries sector showed strong recovery reaching
the pre-tsunami levels. A recovery in the tea production was also
observed in the latter part of the year.
The industrial sector recorded a healthy growth, which was mainly
attributable to expansions in factory industry, construction and
mining and quarrying sectors. Special concessions available under
free trade agreements and the GSP +scheme supported the commendable
growth in the apparel sector during the year.
The services sector expanded with the continuing growth momentum
in ports cargo handling, telecommunications, financial services
as well as government services.
Monetray policy and Interest rates
To reduce future inflationary pressures arising from excess demand,
relatively tight monetary targets were announced for 2007 and such
tight monetary policy stance was implemented during the year. The
Central Bank raised its policy interest rates by 50 basis points
in February 2007. This increase was on the back of the increases
in policy rates by 300 basis points during the period 2004-2006.
Further, the Central Bank continued to conduct aggressive open market
operations on overnight and on a permanent basis to maintain market
liquidity at a level consistent with the reserve money targets.
The Central Bank also continued its policy of providing liquidity
through the reverse repurchase window only when the market had an
overall liquidity deficit, so as to reduce the risk of future inflationary
pressure due to excessive demand. At the same time, the Bank restricted
the number of times that commercial banks could have access to this
reverse repo window until mid August 2007. Such restrictions were
relaxed in late August 2007 in order to ease the pressure on market
interest rates that were somewhat volatile at that time. However,
towards the latter part of the year, the policy was once again modified
in order to attain the twin outcomes of discouraging the excessive
usage of reverse repurchase facility and reducing the volatility
in interest rates. Accordingly, a penal rate was introduced with
effect from December 2007, for banks, which borrow more than 4 times
during a calendar month, while allowing access to the reverse repo
on an unrestricted basis.
During the year, both the short term and longterm market interest
rates increased, responding to the tight monetary policy. Although
we were conscious that such high rates posed many challenges to
entrepreneurs and had an adverse impact on growth, in the interest
of achieving long term and medium term macro-economic stability,
and to deal with rising inflationary pressures, the maintenance
of such a policy was continued.
Consequently, we ensured that we adhered to the tight reserve money
limits that were pre-set for each of the four quarters of the year
and thereby effectively contained the injection of new money into
the economy. At the same time, even though broad money grew at a
higher rate than desired, the slowing down of the credit growth
to the private sector during the year indicated a clear sign of
deceleration in broad money with a certain period of lag. We however
note that credit to the government and public corporations did not
reduce as desired.
Inflation
Historically, Sri Lanka has been a relatively high inflation country.
During the last 30 years, we have recorded an average inflation
of around 12 per cent per annum. Notwithstanding our tight policies
in 2007, inflation was higher than expected last year too. This
was however mainly due to the phenomenal increases in international
commodity prices that were experienced during the year. In fact,
the increases in prices of imported commodities such as milk powder,
wheat and petroleum contributed to more than 25 per cent of the
inflation during the year.
However, inflation arising from demand pressures was notably curtailed
through tight monetary policy measures. In fact, inflation was on
a downward trend during the first half of 2007, although it increased
thereafter due to several factors, including the substantial increase
in worldwide oil prices and commodity prices that led to substantial
upward adjustments in prices of many domestic goods and services.
Although adversely impacting on inflation values and expectations,
and causing considerable economic tension, we consider the price
“pass-through” adjustments as being the appropriate policy
action in the medium to long-term, since this adjustment eliminates
the requirement of providing large subsidies by the government.
Such a policy action would naturally lead to a reduction in the
budget deficit, which in turn, would lead to lower inflation in
the future.
Our official consumer price index, the Colombo Consumers’ Price
Index (CCPI), had severe weaknesses, including very old weights,
non-addition of new items, being based on the consumption patterns
of 1948, etc. etc. Hence, it was not an accurate indicator of inflation
in the country that could be reliably used by policymakers. Recognizing
the vital need for a more representative and accurate price index
for the country, the Department of Census and Statistics (DCS) introduced
a new consumer price index in November 2007, named the New Colombo
Consumers’ Price Index - CCPI(N).
This
new index is based on a more recent 2002 household expenditure survey.
In this index, the weighting pattern is based on the consumption
expenditure of a sample of a much larger 1,300 urban households
of the Colombo District, irrespective of their level of income.
This new index, which is now recognized as the official measure
of inflation in Sri Lanka, is expected to record less volatility
than the old CCPI, which was based on about 400 items only.
Unemployment
Another noteworthy development during the year was the continuous
decline in unemployment to its historical lowest level of 5.6 per
cent by the third quarter of 2007. This result was mainly due to
the employment created through several infrastructure projects launched
by the government, the implementation of a large number of BOI projects,
and the new recruitments to the public sector.
External trade and reserves
In the year 2007, the external sector displayed an impressive performance
despite many challenges. Exports grew by 13.1 per cent during the
first ten months of 2007. The growth was mainly supported by the
enhanced trading opportunities derived through:
(a) trading agreements, particularly GSP+; (b) improvements in the
quality of exports; and (c) initiatives adopted by the government
and major exporters a few years ago.
Persistently strong demand for apparel had provided a basis for
the strong trade performance during this period, while the GSP+
scheme had significantly helped to diversify markets and products
to the EU as well as to expand backward integration in the industry.
Meanwhile, imports grew modestly by 7.3 per cent during the first
ten month period, mainly reflecting the increased investment goods
imports.
Increased
imports of investment goods was underpinned by the accelerated development
projects launched by the government and investment projects undertaken
by the private sector, especially in the construction sector. The
rapid growth in the telecommunication and information technology
sectors also contributed significantly to the increase in investment
goods.
Since exports grew at a higher rate than imports, the trade deficit
in the first ten months of 2007 was lower than that recorded for
the corresponding period of 2006.
The surplus in the services account and a sharp rise in current
transfers helped to contain the current account deficit.
Worker remittances increased to US dollars 2,048 million (an increase
of 14 per cent) in the first ten months of 2007. As a result, the
current account deficit narrowed down to around US dollars 936 million
in the first nine months of 2007 as against a figure of US dollars
1,167 million in the first nine months of 2006.
This
also reflects a favourable trend of the narrowing savings-investment
gap as the current account deficit is the mirror image of the savings-investment
gap. During the year, a remarkable increase was also seen in the
foreign inflows to government and foreign direct investment. This
was mainly possible because the government raised US dollars 500
million from its debut international bond issue and allowed the
investment by foreigners in treasury bonds up to a sum of 10 per
cent of the outstanding Treasury Bond Stock.
Accordingly, increased inflows to the capital and financial accounts
helped to record a projected surplus in the overall Balance of Payments
of around US dollars 550 million in 2007.
Meanwhile, the gross official reserves have risen to a level where
it is now sufficient to meet more than 3 months of imports, and
this outcome has been achieved despite the serious challenges posed
by the increased oil and commodity prices.
The successful completion of Sri Lanka’s debut international
bond issue was a remarkable achievement as this bond was issued
in the midst of several political and economic challenges.
Domestically, the Government had to (a) counter the politically
motivated opposition that threatened the country’s unblemished
debt service record, and (b) mitigate the impact of the negative
publicity that arose because of continuing terrorist activity.
Internationally, a small window of opportunity had to be made use
of to enter the bond market during a turbulent time when the USA
sub-prime issue was dramatically destabilizing the global financial
markets. Despite these challenges, the fact that Sri Lanka’s
inaugural bond issue was oversubscribed by over three times reflected
global investors’ strong belief in the prospects of the Sri
Lankan economy.
This confidence was also confirmed by the removal of the “negative
outlook” on the sovereign rating by the Rating Agency, Standard
and Poors, as well. The success of the bond issue was further recognized
by international market watchers as it was voted the “best
sovereign bond of the year” by two highly reputed international
financial magazines, namely, Finance Asia and The Asset.
The floating exchange rate regime has so far served the country
well. Under the floating regime, gross official reserves has increased
well above US dollars 3 billion from less than US dollars 1 billion
before the floatation of the currency in 2001. The recent behaviour
of the exchange rate confirms that it moves not only in line with
inflation differentials, but also in line with financial flows and
other shortterm demand and supply conditions, thus making it difficult
to predict the medium to long term changes in the exchange rate.
Overall, the Sri Lankan Rupee depreciated marginally during the
first quarter, experienced high volatility resulting in heavy pressure
to depreciate during the second and third quarters, and appreciated
sharply in the final quarter with the completion of the international
bond issue. The overall depreciation of the Sri Lanka rupee against
the US dollar, during 2007, was only 0.9 per cent, and the fourth
quarter movement of the Sri Lanka rupee against the US dollar was
in fact a sharp appreciation of 4.4 per cent. This behaviour highlights
the need for export and import-competing industries to improve their
productivity to maintain their profitability in a stable exchange
rate regime, rather than relying on the continuous nominal depreciation
of the currency to compensate for domestic inflation.
Budget
The fiscal strategy of the government continued to be in the direction
enunciated in the ‘Mahinda Chintana’ policy document,
which was the forerunner to the Government’s ‘Ten-year
Vision’ Framework. The gradual reduction of the overall budget
deficit to a sustainable level is the centerpiece of the fiscal
policy framework. We are pleased to note that the Government has
been successful to some extent, in this difficult and highly challenging
effort.
There is now clear evidence that the Revenue to GDP ratio has continued
in its favourable trend for the third consecutive year in 2007,
thereby confirming the success of the strenuous efforts taken by
the government. In this regard, strengthening the tax administration
further, streamlining the tax incentives and exemptions regime,
enhancing tax compliance and strengthening enforcement would be
among the major policy actions that need to be pursued with commitment
over the next few years as well.
The Central Bank has also been carefully watching the measures introduced
by the government that are aimed at rationalising recurrent expenditure.
In our view, the virtual elimination of the fuel subsidy was one
of the difficult decisions taken by the government towards reducing
the subsidy cost in the short run and containing inflation in the
medium to long term. However, we may also need to be mindful of
the difficulties that the government is facing in the recurrent
expenditure front, where they have to control the levels of expenditures
while meeting the threat of terrorism and developing infrastructure
and the newly liberated areas. Despite these challenges, the recurrent
expenditure has been contained at 14.1 per cent of GDP during the
first ten months of this year, which perhaps is not too unsatisfactory.
However, even greater attention may need to be paid to this aspect,
possibly by moving towards more outcome and output based systems
of accounting, which imposes a greater degree of accountability
in the evaluation of government expenditure.
At the same time, the Government may wish to carefully evaluate
and study the impact of offering a plethora of tax incentives, concessions,
and other exemptions, including (a) exempting capital gains of the
transactions at the Colombo Stock Exchange, and
(b) providing various other concessions such as tax holidays and
duty free imports for projects under the Board of Investment (BOI)
regime.
In that context, it should be appreciated that it would certainly
not be easy to continue subsidy programmes, tax holidays, tax concessions,
duty waivers, etc., while also providing benefits to the public
and increasing government investment on infrastructure development
works.
Accordingly, the government may do well to perhaps carefully evaluate
whether the expected long-term benefits of such tax holidays and
concessions have actually materialized and whether on that basis
the reduction in government revenue to accommodate such concessions,
could be justified.
Infrastructure
In the meantime, it is noted with satisfaction that there is a considerable
improvement in the investment towards the vital infrastructure facilities
in the country.
The
government has, in this context, commenced a number of key infrastructure
development projects, which did not take off the ground for a number
of years due to various reasons. In this regard, it is important
to understand the importance of addressing infrastructure bottlenecks
that hamper the growth prospects of the country and take the necessary
measures to fast track the implementation of the planned projects.
In that background, we welcome the increase of capital expenditure
and net lending by 37 per cent during the first ten months of 2007.
We also believe that the rapid implementation of the work of mega
infrastructure projects, acceleration of rural infrastructure development
projects, higher expenditure on health, education, road development,
water supply and irrigation projects and tsunami reconstruction
would be vital for Sri Lanka’s future progress and trust that
the required efforts in this regard would be intensified in the
next few years.
Public debt
During the year 2007, measures were initiated that diversified the
deficit financing options. As already mentioned, the government
successfully completed its debut bond issue in the international
market. We are confident that this new initiative would pave the
way for Sri Lanka to reach new heights in the international financial
environment, thereby further facilitating our future funding requirements.
At the same time, the search for alternatives to debt financing
is gaining a new momentum with the government continuing to actively
promote public-private partnerships (PPPs) to finance infrastructure
projects so that the debt creating financial flows will be gradually
reduced, while private sector involvement in economic development
would be enhanced.
We also note with cautious optimism that the outstanding debt to
GDP ratio is now on a declining path. This ratio is expected to
have reached 85.5 per cent by the end of 2007 as compared to 89.2
per cent as at the end of 2006. This improvement indicates that
we are gradually moving towards the levels as stipulated in the
Fiscal Management (Responsibility) Act, for this indicator.
Nevertheless, we need to appreciate that we have to work intensely
towards maintaining these favourable trends in the medium term.
Financial sector
The financial sector further expanded during 2007 with increased
competition and innovations. This expansion was supportive of the
growing economic activities. Profitability, capital and asset quality
of banks improved, thereby contributing to further stabilizing the
financial sector. However, we observed some volatility in the money,
exchange and capital markets as a result of periods of political
and market uncertainty, high inflation expectations and international
pressures, which in almost all instances dissipated gradually, responding
to the various policy measures taken by the Central Bank and other
agencies.
During the year, the Central Bank took several measures to:
(a) strengthen and improve the efficiency of the financial
sector,
(b) improve risk management,
(c) enhance access to finance,
(d) strengthen the payment and settlement systems,
(e) improve supervision and regulation, and
(f) enhance the governance structures.
With these initiatives, the outlook for financial system stability
remains favourable, as the capacity of the financial system to withstand
and manage risks at the institutional and infrastructure level is
being continuously strengthened.
In the meantime, the Central Bank continued to adopt a facilitator
role to expand access to banking and financial services. A number
of new deposit products with added features and technology driven
services, such as mobile banking, were approved to be introduced
to the market, based on advancements in information and communications
technology.
As
a result, both households and businesses, including SMEs, gained
greater access to financing through these improved financial inclusivity
initiatives.
|
