Central Bank releases its 2007 Annual Report

Under Section 35 of the Monetary Law Act, the Monetary Board of the Central Bank is required to submit a report each year to the Minister in charge of the subject of Finance within four months of the commencement of the following year, giving details of the state of the economy, the condition of the Central Bank and the policies and measures adopted by the Monetary Board. For the second time since 1974, the Bank was able to submit its Annual Report for 2007 within 3-months from the end of 2007. The report was presented to President Mahinda Rajapakse, who is also the Minister of Finance yesterday. The Annual report contains following box articles on the topical issues.

• Moving towards Inflation Targeting from Monetary Targeting Framework
  
• The Development of the Eastern Province: Potential and Strategies
  
• Oil Exploration in the Mannar Basin
  
• Explanatory note on National Income Estimates
  
• Harnessing the Benefits by Effective Utilisation of the Exclusive Economic Zone in Sri Lanka
  
• Balanced Regional Development
  
• Conflicts of Public-Private Partnerships in Power Generation
  
• Higher Education in Sri Lanka – The Way Forward
  
• Carbon Trading
  
• New Colombo Consumers’ Price Index
  
• The Establishment of Commodity Exchange and Its Benefits
  
• Preferential Trade Access and its Implications
  
• Tourism Industry – Realising its Potential
  
• Fiscal Cost of the Fuel Subsidy and Its Economic Implications
  
• Sri Lanka’s Debut International Sovereign Bond Issue
  
• Money Printing; The Fundamentals and Process
  
• The Challenges of Foodflation
  
• The Subprime Mortgage Market Crisis and Its Lessons
  
• Corporate Governance in Banks
  
• Implementation of Basel II Capital Adequacy Standard in Sri Lanka
  
• Multi Level Marketing and Pyramid Schemes
  
• Major Economic Policy Changes and Measures - 2007
  Following are highlights of the report.

GDP grew by 6.8%in 2007
In 2007, the Sri Lankan economy recorded a growth of well above 6 per cent for the third consecutive year for the first time since Independence, demonstrating that Sri Lanka has now moved on to a higher growth path of above 6 per cent per annum from the historical average of around 4-5 per cent. The economy grew by 6.8 per cent in 2007, the annual average rate of unemployment reached its lowest ever recorded level of 6.0 per cent, while the per capita income rose further to US dollars 1,617 in 2007. This performance is commendable, as it was achieved in a challenging environment of heightened security concerns arising from intensified terrorist activities and rising petroleum and commodity prices in international markets which threatened the achievement of price stability.

In 2007, the Central Bank further strengthened its tight monetary policy stance to restrain the rising inflationary pressures. During 2007, the monetary policy implementation strategy was more geared towards not exceeding tight quantitative targets of monetary aggregates, thereby allowing market interest rates to adjust upwards in order to curtail excessive demand. Tighter monetary policy targets were set for the year, and strong measures were implemented to achieve them. The policy interest rates, viz., Repurchase and Reverse Repurchase rates, were raised by 50 basis points in early 2007. Open market operations were conducted aggressively, while imposing certain limits on the Banks on their access to the reverse repurchase facility of the Central Bank, thereby directly restricting the credit creating capacity of banks. In addition, moral persuasion was used to discourage banks from excessive credit creation, while continuing with the prudential measures introduced in 2006 to safeguard banks against unhealthy credit expansion. A more focused quantitative target approach was adopted in 2007 to fast track the transmission mechanism as the increase in policy rates by 350 basis points since end 2004 appeared to impact the monetary expansion with a long time lag.

The monetary policy strategy of the Central Bank with a focused quantitative target approach was more effective in containing monetary expansion, thereby curtailing demand-pull inflation. The growth in reserve money was contained well within the targets and restricted to 10.2 per cent, the lowest growth in the last five years. This helped to neutralise almost fully, the impact of excessive reserve money expansion experienced in 2006. The reserve money expansion was highly restrictive compared with the nominal GDP growth of 21.8 per cent. As a result, broad money growth also decelerated, though it remained above the level envisaged in the monetary programme. Both the net foreign assets (NFA) and net domestic assets (NDA) increased, contributing to the broad money expansion in 2007. Within the NDA, the growth in credit to the private sector decelerated by about 7 percentage points to around 19 per cent, responding to the higher market interest rates, resulting from the tight monetary policy measures. The borrowings by the government from the banking sector, which increased significantly in 2006, were contained at the budgeted level during 2007. However, credit to public corporations increased substantially compared to the expected level entirely due to increased borrowings by the Ceylon Petroleum Corporation (CPC).

The tight monetary policy measures of the Central Bank helped to reduce inflation gradually during the first half of 2007. However, the substantial increase in international market prices of oil, the complete removal of fuel subsidies since July 2007 and sharp rises in several other commodity prices in international markets led to an upward adjustment in domestic prices of several goods and services, particularly during the second half of the year. The pass-through of international price increases, though it led to a one-off increase in prices, will have a favourable impact on containing future inflation by eliminating the need for subsidising the same through the expansionary borrowings of the government.

The Financial sector remained resilient and stable in 2007, despite increased pressures from external and domestic macroeconomic and financial market developments. The key financial institutions maintained their soundness through high profitability, increased capital levels and improved asset quality within an enhanced regulatory and supervisory framework, which has strengthened their resilience and risk absorption capacity. During 2007, the reach of the banking sector in the country improved with the expansion of the branch network of both licensed specialised banks (LSB) and licensed commercial banks (LCB). The US subprime housing mortgage issues, which resulted in tighter credit conditions and higher risk premiums in international financial markets, have not affected Sri Lanka, as local financial institutions did not have exposure to the asset backed securities and derivatives. Although the outlook for financial system stability remains positive, the prevailing downside risks require continued vigilance and risk mitigation to prevent the occurrence of events that could have an adverse impact.

The supervisory and regulatory framework governing the financial sector was upgraded with several directives and measures introduced to strengthen the soundness of both banks and non-bank financial institutions. The preparatory work for the implementation of the Basel II Capital Adequacy Framework for banks from 2008 was completed. The adoption of Basel II is expected to improve the soundness and risk management of banks by better aligning the bank’s capital with its risk profile and by providing more comprehensive capital coverage for credit, market and operational risks. A Direction on corporate governance for banks was issued by the Central Bank and a mandatory code for companies listed on the CSE was issued by the Securities and Exchange Commission (SEC).

Growth drivers
The economic growth in 2007 was mainly driven by the performance in industry and services sectors which grew by 7.6 per cent and 7.1 per cent, respectively, while the agriculture sector grew moderately by 3.3 per cent. The services sector made the highest contribution of 62 per cent to the overall growth, while the industry and agriculture sectors contributed 32 per cent and 6 per cent, respectively. The shares of GDP from the services, industry and agriculture sectors remained almost unchanged at 60 per cent, 28 per cent and 12 per cent, respectively.

In 2007, most of the sub-sectors in the agriculture sector achieved relatively high growth rates except for tea and paddy. Tea production decreased by 2.0 per cent to 305 million kilogrammes, while paddy production declined by 6.4 per cent to 3.1 million metric tons. Continuous efforts to enhance the quality of Sri Lankan tea, higher global demand and increased value addition led tea prices to rise well above the global average price, offsetting the decline in production in 2007. Rubber production benefitted from attractive prices, combined with the adoption of new technologies. Coconut production rose by 3.0 per cent during the year benefitting from favourable weather but the prices of coconut and coconut based products increased sharply reflecting the world trend of increasing demand for organic oils to produce bio-fuel as a supplement to expensive fossil fuel.

With a view to increasing domestic food production, the government presented the National Policy on Agriculture in 2007. A national campaign was introduced under the theme “Api Wawamu – Rata Nagamu” with the objective of increasing domestic agricultural production and containing the rising cost of goods and services.

The growth momentum in the industrial sector in 2007 was mainly attributed to the dynamism in factory industry. The government continued to focus on regional industrialisation and small and medium enterprise development with the aim of improving the quality of products to international standards for export markets, and addressing regional income disparity. Duty, tariff and tax concessions for establishing, relocating or expanding industries through special programmes, establishment of new economic zones and industrial parks, human resource development through vocational training and university courses, facilitation of expanding market access and brand promotion activities were the major initiatives taken by the government to promote the industrial sector during 2007. Meanwhile, industrial sector performance also benefited significantly from the Generalised System of Preferences (GSP+) granted by the EU countries, and from bilateral and regional trade agreements during the year. However, the industrial sector needs to be able to compete without preferential market access as non-reciprocal preferential market access such as GSP+ could be withdrawn for non-economic reasons.

Certain areas need to be addressed to improve the industrial sector performance further, including productivity enhancement by increasing the usage of modern technology and human resources developments, increasing competitiveness by promoting the quality of products to international standards, introducing energy efficient production methods to mitigate the rising cost of fuel and energy, promoting backward linkages and maintaining international standards on labour regulations and environment.

The growth in value addition of the services sector decelerated marginally, mainly due to the contraction in the hotels and restaurants sub-sector, which was affected by the unfavourable security situation, and also due to the slowdown in import trade and domestic trade activities. The services sector growth was driven by export trading services and port related services, reflecting the healthy external demand, while the domestic oriented services, such as banking and telecommunication services, also contributed significantly towards the better performance. The growth momentum in the telecommunications sector continued in 2007, largely supported by further expansion in the coverage, introduction of advanced technology and value added services, increased competition and affordability, and higher investments. Several new telecommunication projects were implemented during the year to improve the capacity, technology, coverage and efficiency of the service.

A slowdown in real domestic aggregate demand reflects the effectiveness of the tight monetary policy stance maintained by the Central Bank. Both consumption and investment demand in real terms decelerated to 4.9 per cent and 8.7 per cent in 2007 from 7.1 and 13.4 per cent, respectively in 2006. Deceleration in domestic aggregate demand also reflected in a slower growth in the demand for import of goods and services. However, the impact of slowing down in the domestic aggregate demand on overall growth was partly mitigated by the higher external demand. In real terms, export of goods and services increased by 6.8 per cent in 2007 compared to 3.8 per cent growth in 2006.

Savings-Investment gap
The savings-investment gap, as a per cent of GDP, improved during 2007. The government managed to reduce its dis-savings, thus helping to raise overall domestic savings. However, the still high domestic savings-investment gap of around 10 per cent highlights the important role played by foreign capital and worker remittance inflows in filling the required gap in investment in order to achieve the desired rate of economic growth. The gross domestic investments at 28 per cent of GDP remained at a level almost similar to 2006, while the domestic savings ratio improved to 17.6 per cent in 2007 from 17.0 per cent in 2006. With the lower current account deficit in fiscal accounts, the government was able to reduce the dis-savings ratio to 1.6 per cent of GDP in 2007 from 2.4 per cent in 2006, contributing to the overall increase in the domestic savings ratio. Consequently, the domestic savings-investment gap as a per cent of GDP dropped to 10.3 per cent in 2007 from 11.0 per cent in 2006. Savings by Sri Lankan residents abroad by way of worker remittances helped to reduce the national savings-investment gap to 4.5 per cent, which was reflected in the improvement of the current account deficit of the balance of payments as well. The remaining gap was financed through FDI inflows, loans and grants to the government and portfolio inflows.

The external sector demonstrated its resilience to external shocks, with the balance of payments recording a surplus of US dollars 531 million, which raised the country’s external reserves to a higher level, along with a greater stability in the exchange rate. Country received the highest ever foreign direct investment (FDI) inflow of around US dollars 734 million demonstrating the continuous foreign investor confidence. Foreign exchange inflows from the major sources, such as garments and textiles and tea, further increased in 2007 with earnings from tea exceeding the US dollars 1 billion mark. While higher growth in exports and a steady increase in worker remittances mitigated the impact of higher petroleum and commodity prices on imports to some extent, the higher expenditure on import of investment goods required for infrastructure development was financed partly through debt and partly through FDI inflows. Despite turbulence in the worldwide stock markets due to the subprime issue, the Colombo Stock Exchange (CSE) attracted more foreign inflows on both gross and net basis, confirming investor confidence in Sri Lanka. Under the floating exchange rate regime, the Sri Lankan rupee can no longer be regarded as a steadily depreciating currency. With the maturing domestic foreign exchange market, the exchange rate is now more responsive to, and determined through, market forces of supply and demand, while the intervention by the Central Bank is limited to mitigate excessive volatility in the market and to build up official external reserves. The recent stabilisation of the Sri Lanka rupee underlines the need for the export and import competing sectors to focus more on productivity improvements and market access in order to maintain external competitiveness.

Fiscal management
Meanwhile, the total external debt of the country, as a percentage of GDP, increased to 44.1 per cent in 2007 from 43.3 per cent in 2006 mainly due to the government’s higher reliance on external sources to finance its deficit in an environment of rising domestic interest rates. This strategy eased pressure on domestic resources and released resources to the private sector and helped to stabilise domestic interest rates towards the end of the year. However, it is important to maintain the recent favourable trends in public external debt in order to improve debt and macroeconomic sustainability.

The fiscal consolidation process pursued by the government moved in the right direction; both the fiscal deficit and public debt continued to improve in line with the trend observed in recent years despite the lower than expected revenue collection during the year. This was achieved amidst significant challenges faced by the government such as rising defence expenditure, rising domestic interest rates and the need to grant several tax and duty concessions in order to rein in the escalating cost of goods and services. At the same time, the government continued with its higher public investment programme, aiming at expanding the country’s economic and social infrastructure to facilitate future economic growth. The government’s ability to reduce the deficit financing from domestic banking sources substantially, despite a deviation from the revised target, was a welcome development as such fiscal policy complemented the tight monetary policy stance of the Central Bank.

In 2007, total revenue in nominal terms increased by 18.3 per cent, compared to 2006. The increase was due to the continuous efforts made by the government in further strengthening tax administration, streamlining tax incentives and exemptions, enhancing tax compliance and strengthening enforcement. However, total revenue was lower than the budgetary target mainly due to the provision of tax concessions on essential imported commodities to counter the rising cost of goods and services, and lower volume and total value of vehicle imports in 2007, as people opted to import lower value motor vehicles due to the high import duty structure maintained on fuel inefficient vehicles as a measure of managing the impact of escalating oil prices. Public investment continued its rising trend and reached 6.4 per cent of GDP compared to 6.0 per cent in 2006. The implementation of economic and social infrastructure projects with an emphasis on mega infrastructure development projects and rural development initiatives contributed to this improvement. The recurrent expenditure exceeded the target mainly due to higher than planned expenditure on national security, salaries and wages, pension payments and interest payments. As a combined outcome of these developments, the overall deficit in 2007 turned out to be 7.7 per cent of GDP, a decline compared to both the original target of 8.4 per cent and the deficit of 8.0 per cent in 2006.

The declining trend in the outstanding debt to GDP ratio continued in 2007 and reached 85.8 per cent from 88.7 per cent at end 2006, improving the sustainability of public debt. This was mainly due to the stabilisation of the rupee vis-a-vis major foreign currencies towards the end of 2007 and slower growth in outstanding debt relative to nominal economic growth. Meanwhile, a number of debt service indicators continued to reflect improved performance. However, there is a need to smoothen the maturity profile of the domestic debt to minimise the pressure on government fiscal operations. In order to avoid bunching of the repayment of foreign currency denominated commercial loans, their maturity structures also need to be lengthened.

Development framework
The “Ten-year Horizon Development Framework 2006-2016” (Ten-year Vision), the policy document of the Government, envisages maintaining a sustainable high growth path in excess of 8 per cent in the medium-term. This is a challenging task, which requires a further expansion of the productive capacity of the economy, addressing existing bottlenecks in infrastructure and utility services, and achieving significant productivity improvements to utilise available resources more efficiently. Achieving these objectives entails channelling enhanced investment to ensure continuous supply of competitively priced energy, telecommunication services, drinking and irrigation water, roads, ports and airports and health and education facilities, etc. The slow progress in the implementation of some planned infrastructure projects announced in the Ten-year Vision needs to be addressed as a matter of priority sooner rather than later. Cost escalations in power generation and their potential adverse impact on the economy have brought about some satisfactory progress in the implementation of certain crucial power sector projects such as Kerawalapitiya, Norochcholai and Upper Kotmale. However, other flagship projects are making slower progress than expected. These projects need to be expedited to achieve sustainable high economic growth in the medium term and to prevent cost escalations.

More efficient provision of services by SOEs without being a burden on the public is a prerequisite for macroeconomic stability. A major source of macroeconomic imbalance has been arising from inefficient operations of SOEs, in providing utility services such as electricity, water, transport services, petroleum products and marketing services such as purchasing paddy and selling essential commodities through state owned marketing networks. Such SOEs burden the general public by their reliance on budgetary financing or bank borrowings. In addition to the policy of non-privatisation of existing enterprises, there is a recent trend of the government venturing into new SOEs or reviving hitherto troubled SOEs, eg., Mihin Air, the Central Transport Board (CTB), Paddy Marketing Board, Co-operative Wholesale Establishment (CWE) and Co-operative marketing networks. It is essential that proper governance and pricing structures are established in managing those SOEs if they were to achieve the intended objectives through commercially viable operations without relying on government subsidies.

Although Sri Lanka’s educational achievements in terms of literacy rates, primary and secondary education are commendable and on par with developed countries, tertiary education, particularly the university education, is lagging behind regional peers. The admission to university education in Sri Lanka is extremely competitive, and not more than 14 per cent of those qualified for university education gain admission to local public universities. Even those 14 per cent of best students have to face a supply driven university education system which has little relevance to labour market requirements and entrepreneurial culture, creating a mismatch between labour supply and demand. About 32 per cent of the students admitted to local universities study social sciences and humanities and a substantial proportion of such graduates encounter difficulties in finding productive employment. They remain unemployed or underemployed for a long period, leading to frustration and social problems. Therefore, the higher education system requires urgent reforms to provide a more relevant higher education for all and to address the mismatch in labour supply and demand.

Inflation
Bringing down inflation to a single digit from the current high levels would be a challenging task in view of rising commodity prices in international markets. The Central Bank in its “Road Map for Monetary and Financial Sector Policies for 2008 and beyond” has announced strategies to bring down the inflation rate to around 10-11 per cent by end 2008. However, the achievement of this target will be significantly affected by various developments in the global economy, especially movements in the international prices of oil and other essential commodities. Currently, serious inflationary pressures are building up world-wide, largely due to a sharp rise in commodity prices, including higher food prices resulting from increased use of certain food crops for bio-fuel production, and adverse weather conditions. In this context, monetary policy will be directed towards containing inflationary pressures arising from higher domestic demand, without affecting the continuous higher growth prospects. The Central Bank has been modifying and improving the monetary targeting framework in line with global developments with a view to moving towards an inflation targeting framework in the medium-term.

Sri Lanka, being an importer of petroleum products, has been effectively meeting challenges from the continuous rise in global oil prices. However, the external sector vulnerability may increase if oil prices exceed sustainable levels. The oil import bill is projected to exceed US dollars 3 billion in 2008, accounting for about 25 per cent of total import expenditure, and is likely to exert pressure on the balance of payments, unless the country receives sufficient foreign flows. In this context, reducing oil imports by encouraging efficient use of energy through the introduction of energy saving devices, discouraging imports of fuel inefficient motor vehicles, streamlining traffic congestion, passing on international price increases to final consumers, economising on the use of power and motor vehicles in the state and local government institutions, and educating the general public on the need for saving energy would help to mitigate the adverse impact of rising oil prices on macroeconomic stability.

Inefficient transport facilities, poor road network and traffic congestion in almost all major cities remain serious problems and adversely impact on economic growth through reduced productivity. As an efficient transport system with a better road network is necessary to support higher economic growth and improve total factor productivity of the economy, the government should accelerate the implementation of highways and expressway projects, while implementing necessary measures to improve the public transport system. An improvement in road networks and transportation would also contribute to the poverty alleviation efforts of the government by providing increased market access to goods produced in the provinces.

The process of oil exploration in the Mannar Basin was launched in 2007. An analysis of seismic data acquired by the government shows a significant potential of presence of hydrocarbons (oil/gas) in the surveyed area in the Mannar Basin. Out of the eight blocks demarcated, two blocks have already been reserved for India and China for exploration, while the Petroleum Resources Development Committee (PRDC) has called for international competitive bids for exploration licences for three blocks and bids are currently being evaluated. The petroleum resources, if explored successfully, would generate major economic and social benefits to the country, provided that exploration of petroleum resources are managed professionally and prudently. In this respect, marketing effectively and thereby attracting credible investors, maintaining transparency and accountability, designing constructive long-term policies and strategies, setting up an effective institutional framework, strengthening data management and analysis, managing, regulating and monitoring effectively, etc., would be crucial in successful exploration of petroleum resources.